On February 4, 2021, European regulators (ESAs) published its final proposal for the Delegated Regulation to the Sustainable Finance Disclosure Regulation (“Level 2 SFDR”). In 49 recitals, 74 articles and 5 annexes, the ESAs explain how financial market participants should implement the requirements of Level 1 SFDR.
Level 2 SFDR is an extensive and very detailed explanation and its implementation will be intense. Fortunately, you don’t have to be in a hurry. The entry into force of the delegated regulation has been postponed to January 1, 2022.
Nevertheless, it is advisable to analyse this Level 2 SFDR thoroughly. Not only does it give you direction on implementation of Level 1 SFDR requirements - that needs to be finalized by March 10, 2021-, but you can also anticipate on the implementation efforts that needs to be taken after that date.
To help you getting started Projective Group will zoom in on one topic from the Level 2 SFDR in each of the coming months. We start with a topic that is also relevant for the implementation of Level 1 SFDR: do no significant harm principle.
This do no significant harm principle (DNSH) is part of the definition given by the SFDR for the concept 'sustainable investment'. The SFDR defines a sustainable investment as:
"an investment in an economic activity that contributes to an environmental objective (...) or to a social objective (...) provided that these investments do not significantly harm any of those objectives and the investee companies follow good governance practices."
From this definition, we conclude that for an investment to qualify as sustainable, it must achieve its sustainable objective without causing significant harm to other environmental or social objectives. To illustrate, an investment in the construction of a wind farm (which would contribute to the reduction of CO2 emissions) is not sustainable if the construction comes at the expense of a protected natural area (loss of biodiversity).
Why is this DNSH-principle relevant for the implementation of the Level 1 SFDR? We just pointed out that the DNSH-principle is a component of the definition of "a sustainable investment”. The definitionof sustainable investment is relevant for the qualification of the financial products you offer.
Financial market participants should classify their financial products according to their level of sustainability: grey (article 6), light green (article 8) or dark green (article 9). A dark green product is defined in the SFDR as a product that has 'sustainable investments' as its objective. Since the DNSH-principle is a component of the definition of sustainable investment financial market participants should assess whether it complies with this principle.
And as light green products could also include a percentage of sustainable investments (nowadays referred to as 8+ products) those sustainable investments also need to comply with the DNSH-principle.
Do you offer dark green products or light green products with (some) sustainable investments? And do you wonder how to assess whether these investments comply with this DNSH-principle? Let us explain.
As the Level 1 SFDR does not specify how to assess compliance with this DNSH-principle it initially seemed that financial market participant were allowed to determine how they would interpret this principle. This turned out not to be the case. The ESAs were given the task - in the Level 2 SFDR – to provide clarity on this DNSH-principle which resulted into the following interpretation.
In order to comply with the DNSH-principle (which is one of the conditions to qualify an investment as a "sustainable ") from the Level 2 SFDR text, it must be demonstrated:
First a financial market participant must indicate how any adverse ESG impacts of the investment are taken into account. For example, is the investment related to high greenhouse gas emissions, deforestation, or workplace discrimination? Such an investment cannot qualify as 'sustainable investment.
But what exactly is meant by taking these negative impacts into account? Is it sufficient to only identify these impacts? From the DNSH-principle it follows that the investment may not significantly harm any other environmental and/or social objectives. So only identifying those negative impacts will not be sufficient to comply to this principle.
The second clarification for this DNSH-principle entails that a sustainable investment should comply with the OECD Guidelines for Multinational Enterprises and UN principles on business and human rights. For example, the principles and rights cited in the International Labor Organization (ILO) Declaration on Fundamental Principles and Rights at Work, and the principles in the International Covenant of Human Rights.
So it seems that the ESAs are of the opinion that compliance with the DNSH-principle can be substantiated by explaining how you have complied with i.) and ii.).
What to do next with this information? The Level 2 SFDR will enter into force on January 1, 2022. So you have sufficient time to implement the DNSH-principle. To avoid having to adjust your product qualification at the last minute , Charco & Dique (now Projective Group) recommends thorough preparation by assessing from now on whether the investments you consider to be "sustainable" also meets the DNSH-principle as explained in the SFDR Level 2.
Do you have any questions following the above information? Could you use support in mapping out and implementing 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 our help with SFDR compliance, or follow our SFDR Awareness e-learning.
