On February 4, 2021, the European Supervisory Authorities (ESAs) published their final proposal for the delegated regulations under the Sustainable Finance Disclosure Regulation (hereafter referred to as Level 2 SFDR). In the previous newsitem, we discussed the guidance provided by the ESAs on the interpretation of the the do no significant harm principle.
However, the aforementioned document - which runs to just under 200 pages - discusses multiple topics. This month we take a closer look at the rules around adverse sustainability impacts at entity level. Financial market participants (hereafter companies) that state they consider principal adverse impacts (hereafter PAIs) are required to explain on their websites how they do so (hereafter referred to as a consideration statement).This requirement follows from Article 4 of the SFDR. Level 2 SFDR will further specify the requirements for such a consideration statement as of January 2022. It will result in a rather detailed statement. What exactly must be reported may vary depending on the type of investment.
Before we discuss how PAIs should be taken into account, it is important to note that it is not mandatory for companies to take PAIs into account. Article 4 of the SFDR is a so-called “comply-or-explain” article. It means that companies have two options:
1. The company considers PAIs, and explains how it does so (comply); or
2. The company does not consider PAIs, and explains why they do not do so, including, where relevant, whether and when they intend to consider such adverse impacts (explain).
Companies exceeding the number of 500 employees do not have this option; they are obliged to take PAIs into account as of June 30, 2021.
When a company chooses to consider PAIs, it must explain by a statement on its website how it does so. Article 4 of the SFDR sets general requirements for this consideration statement. Once Level 2 SFDR becomes applicable, the company must start using a template (attached as Annex I to level 2 SFDR). This template consists of six parts:
When Level 2 SFDR becomes applicable, it will affect the interpretation of the entire Consideration Statement of companies. We foresee the biggest impact for the description of the identified PAIs. The Level 1 SFDR (currently in force) requires companies to identify the most significant PAIs of their investments. This requirement is still fairly abstract. What qualifies as a PAI? What indicators should you take into account? And when is such a PAI 'significant'?
As companies are currently allowed to interpret the requirements of Article 4 SFDR as they see fit, it is relatively easy to comply with these requirements. For example, if your company measures the climate impact of all investments, you can state on your website that you consider the climate impact of investments when investing. Or, if your company is focused on respecting human rights, you can state that as such.
As of January 2022, companies are no longer allowed to decide which PAIs to include in the consideration statement. The Level 2 SFDR divides PAIs into two groups: mandatory PAIs, and opt-in PAIs.
The 14 mandatory PAIs must always be taken into account. Companies must supplement these mandatory PAIs with 2 opt-in PAIs. The list in Annex I of opt-in PAIs consists of several environmental PAIs and social PAIs. A company must select at least one environmentally related PAI and one socially related PAI. As a result, a consideration statement includes at least 16 PAIs. At least 16 PAI as a company may supplement its consideration statement with any other additional PAI. It is expected that not many companies will use this option. It is expected that not many companies will take advantage of this option.
Most of the 14 mandatory PAIs are environmentally related: 9 of the 14 indicators address issues such as greenhouse gas emissions, waste generation and biodiversity loss. The remaining 5 mandatory PAIs are socially related. They relate for example to compliance with the UNGPs and OECD board diversity and equal pay for men and women.
The opt-in PAIs must be chosen from a prescribed list of PAIs in Annex I. One opt-in PAI must be related to the environmental factors, and the other opt-in PAI must relate to social factors.
Does this sound like a lot of work? Then it may be reassuring to know that the original intent of the ESAs was for companies to publish about at least 34 PAIs. Therefore, the regulators have slightly adjusted their ambitions by reducing the number of PAIs from 34 to “only” 16.
Not every PAI is measurable for every type of investment. For example, how do you measure waste generation related to a government bond? Or board diversity in a real estate investment?
The ESAs also realized this, after reading the feedback of companies to the first version of the Level 2 SFDR proposal. Initially, the ESAs wanted the prescribed PAIs to be applied to all types of investments but have since the received feedback changed their minds. For investments in sovereigns and supranationals or real estate, there are not 14 mandatory indicators, but only 2. Note that opt-in PAIs must also be added for these investments. For sovereigns and supranationals, two opt-in PAIs must be selected; for real estate, only one environment-related opt-in PAI needs to be selected.
In short, the ESAs decided to accommodate the market somewhat after all by (i) reducing the number of mandatory PAIs and (ii) differentiating per type of investment.
Despite the easements from the first proposal described above, PAI screening will be quite complicated for many investments. Think of investments in funds-of-funds (where the ESAs require the underlying investments to be taken into account) or investments in entities outside the EU. Gathering the necessary PAI data will not always be an easy job.
In such cases, are you able to say, “I tried my very best, but failed to identify and analyze the PAIs of an investment”? Unfortunately, it is not that simple as the ESAs are of the opinion that:
‘’Financial market participants should identify principal adverse impacts on sustainability factors through all reasonable means available. For example, they may employ external market research providers, internal financial analysts and specialists in the area of sustainable investments, undertake specifically commissioned studies, use publicly available information or shared information from peer networks or collaborative initiatives. Financial market participants may also engage directly with the management of investee companies to better understand the risk of adverse impacts on sustainability factors. Direct engagement may be particularly necessary in situations where there is an insufficient level of data available.’’
Does your company take PAIs into account for its investment decisions? If so, you don't need to stress immediately. Let's start by saying that level 2 SFDR is not yet in force. First, the European Commission has yet to adopt the ESAs' proposal. Level 2 SFDR is then expected to take effect in January 2022. So, until then, companies may still interpret PAI screening in their own way.
Nevertheless, we recommend companies to start preparing for the upcoming level 2 SFDR. That way you will be able to publish - in accordance with the Level 2 SFDR- about the PAIs of your investments in time.
Do you have questions in response to the above information? Could you use support in identifying or implementing (upcoming) ESG regulations, such as the SFDR? We would be happy to tell you more about ESG regulations for the financial sector, and their impact on your company. Read more about how we can support your company with ESG matters or contact us.
