New ESMA supervisory briefing and ESA clarifications on the ever-changing SFDR regime

The ESMA supervisory briefing is addressed to EU regulators, such as the Luxembourg CSSF and the Central Bank of Ireland. The purpose of the supervisory briefing is to "promote common supervisory approaches and practices" and is not binding.  However, it is likely to be highly persuasive for EU regulators.

The new guidance will be applied by regulators principally at the point they review fund documents (such as prospectuses and private placement memoranda); for example when a firm applies to an EU regulator for a marketing passport or registers under one of the many EU national private placement regimes which involve some element of substantive document review.  It is also possible that some regulators will also undertake periodic thematic reviews of particular firms’ practices.  For institutional managers of funds in particular, this may signal more closer review of their funds' SFDR classification and their ESG credentials and design. We think it will be important for firms to remember that this is articulated as a non-binding guide to EU regulators, and there may be fact patterns where a firm may make a reasonable case to depart from a strict or overly narrow reading of the Supervisory Briefing.

Although not always a model of clarity, the Supervisory Briefing is, for the most part, a useful and uncontroversial guide to the many overlapping EU financial sustainability-related laws. At only 15 pages, it is worth a read by those steeped in SFDR.  

Our observations on the Supervisory Briefing and, where relevant, the ESA Clarifications are below. In relation to the ESA Clarifications, these are meant both for stakeholders and EU regulators; frustratingly, the ESAs continue to refer to the draft RTS published by the ESAs in October 2021 instead of the version adopted by the European Commission in April 2022. In this briefing, we do not comment on aspects of the ESMA Supervisory Briefing and/or the ESA Clarifications which confirm views and approaches previously taken by most of our clients.

It is welcome that in the Supervisory Briefing ESMA explicitly calls on EU regulators to take a proportionate approach to their supervision, taking into account (among other things) the risks to investor protection and the type of investors concerned. This may make it somewhat easier for institutional fund managers to navigate a path through the regulatory complexity and persisting uncertainties, which are, in some respects, exacerbated by the guidance.

Whilst the Supervisory Briefing purports not to create new policy, in places it represents a further step down the road moving SFDR from a pure disclosure regime (targeting the practice of greenwashing) to a de facto product labelling regime (as the market has interpreted it). For example, ESMA says that "administrative measures, including enforcement" may be warranted when a financial product that is categorised as Article 9 subsequently discloses that a "significant proportions of investments" are not "sustainable investments" for SFDR purposes. ESMA also leaves the door open for national regulators to impose additional requirements, including by adopting fund labels, as some countries have already done.

The clearest examples of this shift in emphasis are the sections of the Supervisory Briefing concerning "sustainable investment policy and objectives" and "investment strategy" applicable to Article 8 and 9 products (paragraphs 32 to 36 of the Supervisory Briefing).  

These sections are closely linked to (1) the notion expressed in recitals to the recently published near-final RTS, that an Article 8 product's promoted environmental or social characteristics must feature "binding elements" and (2) a concern by commentators that many funds' (at least mutual funds’) promoted E or S characteristics are hollow.

The new guidance in the Supervisory Briefing says that "A sustainable investment policy and/or objectives should be included in the fund documentation and the fund should be managed according to it". Any investment strategy which supports the sustainable investment policy and/or objectives should be disclosed to investors, with an explanation of how that strategy links with the sustainable investment policy and/or objectives. The Supervisory Briefing clarifies that the following elements of an investment policy require disclosure and linking back to the investment policy and/or objectives: investment universe (including limits and thresholds); screening criteria applied; specific ESG characteristics/themes or non-financial impacts pursued; use of benchmark/indices and relative expected tracking error (if applicable); or stewardship approach.

Whilst we continue to believe that this guidance can be compatible with relatively light commitments by light-green Article 8 funds, which may not materially narrow the investable universe of assets for the fund (for example commitments to undertake additional ESG reporting; to apply ESG scoring systems without minimum thresholds; for debt funds, to encourage borrowers to consider ESG more systematically; for residential property funds, to undertake tenant engagement surveys), managers adopting such features for their products should not be surprised if they start to be challenged by regulators about the meaningfulness of such features. Such interventions by regulators could impact fundraising timetables.  As mentioned above, firms may nevertheless assert in response to any regulator query that based on, for example, the nature or the strategy or the location of the underlying assets, such commitments remain credible and supportable, especially as part of an evolving ESG programme.  In any case, whatever is promised must be done in practice (in this sense a fund's commitment must be "binding") and should be very clearly disclosed to investors who understand the impact of that disclosure and are therefore not misled by the Article 8 designation.

Stepping back from the detail, there is clearly a fundamental tension here with earlier statements in past ESA Q&A that the bar for "promoting" an E or S characteristic – and so for a product to qualify as an Article 8 product (even inadvertently) – was very low.

The Supervisory Briefing re-iterates that a product's website disclosures must be in all official languages of the EU member states in which the product is sold and regulators are urged to verify compliance with these requirements. This is one area where we hope that EU regulators adopt a proportionate approach, particularly where the recipients of such materials are sophisticated and institutional.  

The guidance on websites also puts additional pressure on the practice preferred by many private fund managers currently, which is to make disclosures accessible in full only to their investors on password-protected data sites, for fear of breaching other global securities offering laws or confidentiality obligations (for example in limited partnership agreements). This is likely to be a point on which trade associations representing institutional managers will wish to continue to engage forcefully with the EU authorities and regulators.

The Supervisory Briefing also addresses the topic of fund names. While not entirely clear, the Supervisory Briefing seems (perhaps not unreasonably) to indicate that only Article 8+ funds (i.e., those funds which commit to making at least one "sustainable investments" as defined in Article 2(17) SFDR) and Article 9 funds may use the word "sustainable" in their name. Firms have been cautious when using the term "sustainable" for fear of confusion with the multi-pronged, complicated and uncertain defined term used in the SFDR.

By contrast, the use of the terms "impact", "impact investing" or any other impact-related wording is intended to be used only by products whose investments are made with the intention to generate positive, measurable social and environmental impact alongside a financial return.

The Supervisory Briefing also foresees that depositaries have a role in monitoring ESG-related investment restrictions when receiving instructions coming from the management company or the investment manager.

Both the Supervisory Briefing and the ESA Clarifications make comments in this regard.

In the Supervisory Briefing, ESMA observes that "NCAs could reasonably expect that... Article 9 [products] would [consider and] disclose the Principal Adverse Impacts of investment decisions [at product level pursuant to] Article 7 SFDR, even though it is not mandatory."  This is because of the dual use of the PAI indicators under SFDR: first, under the formal PAI regime, and, second, as a tool to define the "do no significant harm" (DNSH) element of the definition of "sustainable investment" in SFDR.  In other words, if the manager is collating (at least many or most of) the PAI indicators for DNSH purposes, it might as well use them for their core purpose.  

Clients launching Article 8+ mid-green funds might go through a similar thought process, although they may only collect PAIs for their "sustainable investments" and, perhaps for that reason, ESMA does not specifically mention Article 8+ funds in this part of the guidance.

The ESA Clarifications provide additional colour and explain there are three ways in which it is possible to use the PAI indicators: (1) as part of the DNSH embedded within the SFDR definition of sustainable investment; (2) firm and product level disclosure of PAI indicators; and (3) measuring the attainment of E or S objectives for Article 8 products and sustainable investment objectives for Article 9 products. 

As part of (1), the ESA Clarifications arguably go further than the Supervisory Briefing where the ESAs make the point that the use of the PAI indicators in Table 1 Annex 1 of the RTS and "relevant indicators" in Tables 2 and 3 of Annex I of the RTS is mandatory. Presumably this must mean that it is mandatory to use all those PAI indicators which are relevant. Given that the Table 1 indicators are mandatory for those reporting PAIs on the basis that these impacts are always regarded as "principal", firms will be reluctant to dismiss any particular indicator in Table 1 as not relevant in the context of DNSH. However, the ESAs say that consideration of the PAI indicators at the entity level is not required for these purposes.   

Interestingly:

• In the context of PAI entity-level disclosures, the ESA Clarifications make certain comments in relation to the inclusion of direct and indirect investments and the ability of firms to use "look through" to evaluate the impact of underlying assets. Here, the ESAs state that, where such information is not available, details of the best efforts used to obtain this information either directly, through carrying out research, using third party data providers or making reasonable assumptions should be disclosed. It is not clear whether the ESAs envisage making similar disclosures where PAI data is used in the other contexts listed above.
  
  
• The ESA Clarifications confirm that firms are able to set their own significant harm thresholds for the purposes of DNSH, although they are expected to at least have regard to the Taxonomy thresholds for environmental harm "where feasible". The ESAs say that "best practice could be" to list the harms associated with sustainable investments using the PAIs and to "prove through appropriate values" that the asset does not do significant harm.  Taken together with other comments made in the ESA Clarifications, this appears to be a partial elision of the SFDR and Taxonomy DNSH tests.

(This is separate to the possibility of firms voluntarily opting-in to the PAI regime under Article 7 SFDR on a product-by-product basis as contemplated by the relatively recent European Commission Q&A. Please refer to our earlier briefing.)

It therefore remains unclear what the PAI disclosures must look like in pre-contractual and periodic reporting templates for Article 8 and 9 products.

As a general matter, the ESA Clarifications provide numerous, granular clarifications on a variety of other points covering:

• specific PAI indicators and their underlying calculation methodologies;
• pre-contractual disclosures;
• periodic disclosures;
• product-level Taxonomy disclosures; and
• disclosures for products with investment options. 

The clarification to underlying PAI indicator calculation methodologies (concerning, e.g., energy consumption, emissions to water, gender diversity and pay gap indicators, and non-cooperative tax jurisdictions, the latter which must be determined by reference to the EU Council's list of non-cooperative jurisdictions) may be worth firms' review in order to align their internal processes with the ESAs' expectations (those internal processes could be used as part of the firm's opting-in to the PAI regime, the use of the PAI indicators to ascertain DNSH or more generally as useful proxies for negative externalities in a firm's investment programme more generally).

We comment below on certain specific aspects coming out of the clarifications. There are, however, numerous points of detail and firms may want to read the document itself.

Use of PAI indicators more generally

The ESA Clarifications:

• Confirm that the PAI indicators are distinct from sustainability indicators. However, as mentioned above, they can be used for the purposes of determining the attainment of E or S characteristics for an Article 8 fund or sustainable investment objectives for an Article 9 fund.
  
  
• Suggest that both direct and indirect investments should be included in the relevant calculations. Direct investments cover listed/unlisted equities, bonds, ABS and other types of debt. Indirect investments include investments in funds and fund-of-funds. Where the investment is for example an SPV, the firm can look through to the underlying assets to consider total adverse impacts arising.

Operation of the sustainable investment definition

The ESA Clarifications appear to indicate that the sustainable investment test for SFDR purposes is evaluated at the level of the investment rather than the constituent economic activities forming it.

Taxonomy alignment – a binding minimum commitment

The ESA Clarifications also indicate that a pre-contractual disclosure of Taxonomy-alignment should be understood as a minimum commitment that is binding; if there are any changes to the Taxonomy-alignment during the life of a product it is appropriate to consider how to update the pre-contractual disclosures. Further, where the disclosure of the Taxonomy alignment is calculated using capital expenditure or operating expenditure instead of turnover, that should be justified in the pre-contractual disclosure, including an explanation how it is appropriate for the product. Again, any changes to this, according to the ESAs, merit updates to the pre-contractual disclosures.

If you would like further information or assistance in understanding these publications or the sustainability regime more generally, please speak to your usual Travers Smith contact or any of the individuals below.