Risk & Compliance

Level II SFDR: Principal Adverse Impacts 

Date:September 27, 2023

On 4 February 2021, European regulators (“ESAs”) published their final proposal for the delegated regulation (level II texts) to the Sustainable Finance Disclosure Regulation (SFDR). In the previous newsletter we discussed the first part of this proposal. We described then the guidance provided by the ESAs on how to implement the do no significant harm principle. 

However, the document – which runs to just under 200 pages – covers even more topics. This month, we look at the rules surrounding the inclusion of adverse impacts on sustainability factors (principal adverse impacts; PAIs). Financial institutions (hereafter: companies) that state that they consider such impacts are required to explain on their website how they do so. This standard follows from Article 4 of the SFDR. Delegated regulations are expected to colour the obligations this explanation must meet from January 2023. This will result in a particularly detailed statement. What exactly has to be reported on may vary by investment type. 

Comply or explain 

Before we discuss how PAIs should be taken into account, it is important to mention that as a company, you are not obliged to take PAIs into account. Article 4 of the SFDR is a so-called comply-or-explain article. This means that companies have two options: 

The company takes PAIs into account, and explains how it does so (comply); or 

The company does not take PAIs into account, and explains why it does not do so (explain). 

Only for companies with more than 500 employees, this option does not apply; they are required to take PAIs into account from 30 June 2021. 

The PAI statement 

If a company chooses to consider PAIs when investing, the company must explain on its website how it does so. The Level 1 text of the SFDR sets out only broadly what this explanation should comply with. However, once the Level 2 rules become applicable, the firm is required to start using a template (annexed to the delegated regulations). This template covers six components: 

  • A summary of the PAI statement; 
  • A description of the PAIs identified; 
  • A description of the policy for identifying and prioritising key PAIs; 
  • Policies related to active share ownership; 
  • References to international standards; and 
  • Historical comparison. 

The effect of the Level 2 rules 

When the Level 2 text becomes applicable, it will affect the interpretation of the entire PAI Statement. Nevertheless, we foresee the biggest impact at second section: the description of identified PAIs. The Level 1 rules (currently in force) require companies to name the most important PAIs of their investments. This is still fairly abstract. So when do you speak of a PAI? Which indicators do you look at? And when is a PAI ‘important’? 

Because companies are currently still allowed to interpret the obligations of Article 4 SFDR as they see fit, it is relatively easy to comply with this standard. For example, if your company measures the climate impact of all investments, you can indicate on your website that you consider the climate impact of investments when investing. If, on the other hand, you pay close attention to respect for human rights, you can state that. 

However, from the entry into force of the Level 2 rules, companies are no longer allowed to decide for themselves which PAIs they take into account. The Level 2 text divides PAIs into two groups: mandatory PAIs, and opt-in PAIs. The 14 mandatory PAIs must always be considered,[1] companies must then supplement these PAIs with 2 opt-in PAIs. The list of opt-in PAIs consists of several environmentally and socially related PAIs. A company must select at least one environmentally related PAI and one socially related PAI. As a result, a company’s PAI statement ultimately contains at least 16 PAIs. 

Finally, the company may supplement its PAI-statement with any other PAI. Not many companies are expected to make use of this option. 

[1] Except for investments in governments and real estate, see the paragraph ‘Distinction by type of investment’. 

Mandatory PAIs and opt-in PAIs 

The 14 mandatory PAIs are mostly environment-related: 9 of the 14 indicators cover issues such as greenhouse gas emissions, waste generation and biodiversity loss. The remaining 5 mandatory PAIs are social in nature. These include, for example, compliance with UNGPs and OECD guidelines, diversity in governance and equal pay for men and women. 

The opt-in PAIs may – as indicated in the previous paragraph – be chosen from a list of prescribed PAIs. One of the two opt-in PAIs must be related to the environment, and the other opt-in PAI must see to social factors. 

Does this sound like a lot of work? Then it might be cold comfort to know that the ESAs initially wanted financial enterprises to publish on at least 34 PAIs. So the regulators have already slightly adjusted their ambitions by adjusting this number to 16 PAIs. 

Distinction by type of investment 

Not every PAI is measurable for every type of investment. For example, how do you measure the waste production related to a government bond? Or the diversity in governance of a real estate investment? 

The ESAs also realised this – after reading the responses to the first version of the proposal. Initially, the ESAs wanted the prescribed PAIs to be applied to all types of investments. The regulators have since 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 have to be selected; for real estate, only one (environment-related) opt-in PAI has to be selected. 

In short, the ESAs have decided to accommodate the market to some extent after all, and have done so by (i) reducing the number of mandatory PAIs and (ii) differentiating by type of investment. 

Lack of data 

Despite the relaxations 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 considered) or investments in entities outside the EU. Gathering the necessary PAI data will not always be straightforward in practice. 

In such cases, can you say: ‘I tried my best, but still failed to identify and analyse the PAIs of an investment’? Unfortunately, it is not that simple. Indeed, the ESAs write: 

”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.” 

Time for action 

Did your company choose to factor PAIs into investment decisions? If so, there is no need to stress immediately. Let’s first note that the delegated regulation is not yet in force at this stage. First, the European Commission has yet to adopt the ESAs’ proposal. Delegated regulation is then expected to come into force in January 2023. Until then, companies may therefore still interpret PAI screening in their own way. 

Nonetheless, we recommend that companies prepare now for the future rules. That way, you will be able to publish – in accordance with the Level 2 rules – about the PAIs of your investments in time. 

Want to know more? 

Do you have any questions following 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. For help with ESG compliance, contact us or follow our SFDR Awareness e-learning