ESAs propose changes to SFDR Regulatory Technical Standards

Social PAI indicators

The ESAs have proposed extending the list of PAI indicators (currently set out in Tables 1, 2 and 3 of Annex I to the SFDR RTS) to include new mandatory and optional social PAI indicators.  The proposed indicators are based, for the most part, on those set out in the draft European Sustainability Reporting Standards (ESRS).  The ESAs hope that this will provide an element of harmonisation, particularly with the Corporate Sustainability Reporting Directive, and therefore avoid some of the current data challenges experienced by firms.

The new mandatory social indicators would be: 

• Amount of accumulated earnings in non-cooperative tax jurisdictions (for undertakings whose turnover exceeds €750 million).
  
  
• Exposure to companies involved in the cultivation and production of tobacco.
  
  
• Interference in the formation of trade unions or election of worker representatives.
  
  
• Share of employees of investee companies earning less than the adequate wage.

The new optional indicators would be:

• Excessive use of non-guaranteed-hour employees in investee companies.
  
  
• Excessive use of temporary contract employees in investee companies.
  
  
• Excessive use of non-employee workers in investee companies.
  
  
• Insufficient employment of persons with disabilities within the workforce.
  
  
• Lack of remediation mechanisms for communities affected by the operations of the investee companies.
  
  
• Lack of remediation handling mechanisms for consumers/end-users of the investee company.

The ESAs also seek views on whether a social PAI indicator should apply to investments in real estate assets (through the entity managing the asset) and whether the current definition of an "inefficient real estate asset" ought to be revised in line with the relevant EU Taxonomy criteria.

Finally, the ESAs have also proposed some tweaks to the wording of a number of current PAI indicators to make them more user-friendly and consistent with other sustainable finance legislation.  Although potentially helpful in the longer term, firms will nevertheless need to assess the impact of the proposed changes carefully, to see whether the proposals affect the content and scope of their existing disclosures and processes to collate PAI indicator data (for example, the ESAs have proposed replacing the references to the UN Global Compact principles in certain PAI indicators with the UN Guiding Principles on Business and Human Rights).

Clarifications to existing PAI indicator metrics

The ESAs have also suggested a number of changes to the existing metrics and PAI indicators.  Many of these are intended to provide clarity on existing points of uncertainty. 

The proposed changes include:

• New formulae for certain PAI indicators.
  
  
• A requirement to provide information on the share of investments for which the FMP relies on information from investee companies – this was previously recommended as "good practice".
  
  
• Clarification that, except in the case of Scope 3 GHG emissions, the contribution of investee companies’ value chains is only required to be included in PAIs where the investee company is reporting impacts in its value chain under the sustainability provisions of the EU Accounting Directive or where that information is readily available (e.g. in public reports).
  
  
• Inclusion of an exposure equivalent to that of the assets underlying any derivatives in the numerator of the PAI indicator. This is intended to prevent firms from using derivatives to avoid PAI reporting.  However, this would not apply where firms can show that a derivative does not ultimately result in a physical investment in the underlying security. The ESAs also propose to clarify how firms should perform netting - with adverse impacts to be netted at the level of an individual counterpart without going below zero.

The ESAs also ask for views on whether the denominator of the PAI indicator should be based on all investments made by a firm or just those in a particular type of asset (e.g., sovereigns) or real estate.  The ESAs suggest that the latter approach could result in a more tailored focus for investors but may affect comparability.

The ESAs have also proposed new financial product templates in Annexes II – V of the SFDR RTS and changes to the website disclosures. Many of these are connected to increasing transparency on DNSH disclosures and GHG emissions disclosures (please see below) but there are also a number of more general changes to the language, layout and structure - ostensibly to reduce their length and complexity.  These proposals will also be subject to consumer testing. 

The key changes include a new "dashboard" of key information in the pre-contractual and periodic disclosures as well as the use of simpler, less-technical language.  As with the proposals for Annex I, the changes, if adopted, are likely to require firms to reconsider and potentially rework their existing disclosures. 

The ESAs have voiced concerns that firms' current discretion in assessing the "sustainability" of an investment under the SFDR's definition of "sustainable investment" and in complying with the principle of DNSH may affect investors' ability to compare financial products and potentially lead to greenwashing.  The ESAs have also noted the inconsistency between the SFDR DNSH principle and the DNSH principle in the EU Taxonomy which, in the ESAs view, potentially leads to anomalous results.

Although the ESAs feel that those inconsistencies would need to be addressed by the EU legislators (possibly based on a single taxonomy-based system for DNSH), the ESAs are considering proposing more prescriptive disclosure requirements including a requirement to publish the quantitative thresholds used by firms when assessing DNSH with reference to the PAI indicators.   This could potentially be complemented by the introduction of an optional "safe harbour" which would allow a firm to conclude that a particular investment passes the environmental DNSH SFDR test where it is Taxonomy-aligned.

The ESAs have proposed changes to the SFDR RTS which would introduce new requirements to disclose information on GHG emission reduction targets. These proposals will likely only impact a limited number of products (namely Article 9(3) funds and those Article 8 products which have a GHG emission reduction target).  The ESAs have also proposed the inclusion of new definitions of "greenhouse gas (GHG) emissions", "financed GHG emissions", "GHG removals and storage" and "carbon credits".

The ESAs' proposals are wide-ranging and affect the template pre-contractual and periodic disclosures as well as the website disclosure requirements.  For example, the ESAs proposed changes to the template pre-contractual disclosures for Article 8 and 9 funds include new questions relating to whether a product has a GHG emission reduction target and, if so, additional supplemental questions have been added requiring further disclosure relating to the target including any intermediate targets and whether the target aims to limit global warming to 1.5 degrees Celsius.  The ESAs have also proposed consequential changes to the template periodic disclosures, including the addition of questions on how much progress towards a product's GHG emission reduction target was achieved. 

Finally, the ESAs have proposed a number of ancillary changes to reflect the technical issues that have been raised since the initial adoption of the SFDR RTS.   These include:

• The ability to display the pre-contractual and periodic disclosures as being extendable where delivered electronically (whereby the answers to each question would open when clicked upon by investors).
  
  
• Replacement of the concept of "equivalent information" to be used where information on Taxonomy-alignment is not available from investee companies with the concept of "estimates". The ESAs also ask for feedback on what could be accepted as an "estimate".
  
  
• Additional clarifications for financial products with investment options such as insurance-based investment products that offer a choice of options and certain pension products including, in many cases, the ability to cross-reference to the disclosures made in respect of those underlying options.

Firms should continue to monitor developments in the EU sustainable finance landscape closely. The ESAs' proposals are one piece of an evolving tapestry.

If you would like further information or assistance in understanding the ESAs' proposals, please speak to your usual Travers Smith contact or any of the individuals below.