It is worth noting that the ESAs confirmed that the clarifications relate to their February and October 2021 versions of the RTS and not the version adopted by the European Commission on 6 April 2022. As a result, there may be some differences between the clarifications and the latest version of the RTS that is currently undergoing scrutiny by the European Council and Parliament. In any event, the ESAs statement contains a lot of information, including some of the key concepts such as PAIs and DNSH, summaries of which are contained below.
Sustainability and ‘Principal Adverse Impact’ (“PAI”) indicators
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The ESAs have confirmed that sustainability indicators are different to PAI indicators but recognise that there may be some overlap between the two. That is, the sustainability indicator disclosure requirements in Articles 10 and 11 of the SFDR relate to those indicators that are used for measuring the attainment of the E or S characteristics or the overall impact of the financial product and not the PAI indicators referred to in Article 4.
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The ESAs have however clarified that it is possible to use the PAI indicators for measuring purposes, for example, by showing improvements of the investments against those indicators over time.
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Ultimately, the ESAs confirm that the PAI indicators have three possible uses:
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Disclosure of Do No Significant Harm for sustainable investments under Article 2(17) SFDR;
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Disclosure of PAI consideration under Article 7 SFDR; and
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Measurement of the attainment of environmental or social characteristics and the sustainability-related impact (Articles 10(1)(b), 11(1)(a) and 11(1)(b) SFDR).
These clarifications do not appear to be too controversial and are ultimately in line with the views adopted by the market. Nonetheless, it is helpful to have this further guidance from the ESAs.
‘Do no significant harm’ (“DNSH”) disclosures
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The ESAs acknowledged the difficulties and lack of guidance to date regarding the difference between consideration of the PAIs and DNSH disclosures, both of which require the use of the same adverse impact indicators in Annex I.
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The ESAs note that the DNSH disclosures should not be mistaken with the disclosures required by Articles 4 and 7 SFDR which contain references to how the financial market participant (“FMP”) or financial product considers the principal adverse impacts of its investments. For disclosures under Article 4 SFDR, that consideration is done by the publication of a statement on the principal adverse impacts of investment decisions on sustainability factors with reference to the indicators in Annex I.
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The ESAs explicitly outline that there is no direct link between the two types of disclosures and both apply independently; a financial product making sustainable investments must make DNSH disclosures, whereas the PAI disclosures at the financial product level referred to in Article 7 SFDR apply separately under that Article.
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The guidance continues to note that the DNSH principle under the Taxonomy Regulations (TR) is not applied in the same way as it is under Article 2(17) SFDR, both DNSH tests are separate but should apply cumulatively for SFDR sustainable investments that are taxonomy aligned.
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The ESAs also noted that their final reports did not specify how the PAI indicators should be used for DNSH disclosures or financial product disclosures. The ESA’s clarification on DNSH provides that “best practice could be to disclose DNSH for sustainable investment by extracting the indicators from Table 1 of Annex I, and any additional relevant indicators from Table 2 and 3 of Annex I, and show the impact of the sustainable investments against those indicators, proving through appropriate values (e.g. where feasible in compliance with the Climate Delegated Act and the Complementary Climate Delegated Act) that the sustainable investments do not significantly harm any environmental or social objectives”.
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These clarifications helpfully distinguish between the two types of disclosures and provide welcomed guidance on best practice for the SFDR DNSH test. Importantly, these clarifications could be potentially relied on for performing qualitative DNSH tests for certain PAI indicators instead of applying quantitative thresholds, particularly while we are in this transition period and still waiting for good quality ESG data to become more readily available.
Taxonomy-related financial product disclosures
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The ESAs clarified that commitments on the “minimum proportion” of Taxonomy-aligned investments are intended to be a binding commitment to ensure transparency to end-investors on the taxonomy-related ambitions of the product. Failing to respect such commitments will be met with the same penalties for failure to comply with other binding product commitments.
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The ESAs stated that the pre-contractual disclosure of the Taxonomy-alignment of a financial product is designed to favour the measurement of the non-financial investee undertakings’ Taxonomy-contribution by turnover. However, the ESAs appear to introduce an element of flexibility by clarifying that if a more representative calculation of the taxonomy-alignment is given by using capital expenditure or operating expenditure, then these calculations may be used instead (provided they are justified) in pre-contractual disclosure.
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The ESAs also clarified that in respect of periodic reporting, the Taxonomy-alignment of the aggregated investments should be represented in the form of a bar chart, and be expressed by turnover, capital expenditure and operating expenditure.
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The ESAs are of the view that since disclosure requires a breakdown of the proportion of each of the environmental objectives set out in Article 9 of the Taxonomy Regulation, financial products should be able to demonstrate its contribution to all environmental objectives separately.
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In the case of a financial product investing in another financial product (e.g., A investing in B) the ESAs believe that the Taxonomy-alignment calculation of A should be based on the market value of the proportion of the taxonomy-aligned investments of B.
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Where products do not purport to be Taxonomy-aligned, 0% Taxonomy alignment should be disclosed.
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We are seeing a renewed focus by FMPs on compliance with the Taxonomy Regulation. There has been some disappointment expressed about having to disclose 0% Taxonomy-alignment at this early stage however FMPs should be able to justify this to their investors, particularly if this approach is applied consistently across the market.
Pre-contractual product disclosures
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The ESAs clarify that where changes to the financial product result in a need to update any pre-contractual disclosure (including any environmental and social commitments), FMP’s should consult the relevant sectoral legislation referred to in Article 6(3) of the SFDR to determine the process for amending pre-contractual disclosures.
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The ESAs pointed out that where disclosures of the Taxonomy-alignment of a financial product is calculated for non-financial investee undertakings using capital or operating expenditure instead of turnover, this should be justified in the pre-contractual disclosure.
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Where a change in strategy requires a need to amend the Taxonomy-alignment KPI, historical comparisons in the periodic reports should be supported by a statement that the Taxonomy-alignment KPI in the pre-contractual disclosure has changed and the reasons for such change.
Periodic financial product disclosures
Further PAI guidance and calculation methodology
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The guidance clarifies that the calculation methodology for the disclosure of the principal adverse impact of investment decisions on sustainability factors is set out in Chapter II of the RTS empowered by Article 4(6)-(7) SFDR, whereas the periodic disclosures for financial products are governed by the sectoral legislation set out in Article 11(2) SFDR.
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The ESA’s helpfully acknowledged that an investees company’s emissions may change throughout a reference period (e.g. GHG emissions), and in these cases for the purposes of PAI on investment decisions on sustainability factors, the assessment of the impact should be based on, at least, the average of four quarterly calculations. The guidance contains a helpful worked example.
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The ESAs also confirm that the calculations to be made as part of the reporting on PAI of investment decisions should consider all investments (both indirect and direct).
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The guidance clarifies that when the investee company is a holding company or special purpose vehicle, information about the adverse impacts of those investment decisions of those companies could look through to the individual underlying investments of those companies and consider the total adverse impacts arising from them. Where such information is not available, the section should “contain details of the best efforts used to obtain the information either directly from investee companies, or by carrying out additional research, cooperating with third-party data providers or external experts or making reasonable assumptions”.
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Whereas, when an investment exclusively finances a project or type of project (e.g. investment in a green bond) the assessment of the adverse impacts of the investment decisions could be limited to the adverse impacts of the project or type of project funded by the instrument.
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In relation to multi-asset investments in real estate and investee companies, the ESAs explain that PAI should be disclosed by the type of exposure aggregated at an entity level, meaning that each type of exposure should be kept separate.
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The ESAs have also provided clarity on the below points:
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Indicator 13 in Table 3 of Annex 1 concerning the identification of severe human rights issues and cases, this indicator is “intended to capture exposure to investee companies connected to cases and incidents related to severe human rights issues”. They suggest these could be considered against the Charter of Fundamental Rights of the European Union and the European Convention for the Protection of Human Rights and Fundamental Freedoms.
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With regards to the quantitative social and employee indicators in Table 3 (indicators 3, 7 and 14), the value impact should be expressed in absolute numbers instead of relative expression.
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The ESAs are of the view that NACE codes are “sufficient to identify some investments for some indicators”. For example, indicator 9 in Table 2 of Annex I concerning pesticides.
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With regards to non-cooperative tax jurisdictions referred to in indicator 22 in Table 3 of Annex I, reference to non-cooperative tax jurisdictions should be understood to refer to the EU list of non-cooperative jurisdictions maintained and updated by the EU Council.
Next steps
Overall, the ESAs clarifications have been welcomed by the industry, particularly as there has been very little to no guidance provided on the PAIs and DNSH test to date. We hope that in the spirit of transparency, the ESAs and EC continue their efforts to provide further guidance on these and other SFDR and Taxonomy-related topics, especially in the lead-up to the RTS coming into effect on 1 January 2023.
Authored by Rita Hunter, Simi Malhi, Paida Manhambara and Aliya Padhani.
