Sustainable Finance Disclosure Regulation: draft Regulatory Technical Standards

The recitals to the RTS are notable for the insight they give into the thinking of the ESAs on some of the known unknowns under SFDR.  Many such areas of uncertainty were flagged by the ESAs in their letter of 7 January to the European Commission expressly seeking guidance.  Such guidance is hotly anticipated but it is not clear whether it will come before 10 March.  The recitals to the RTS beg some of the questions posed to the European Commission and it remains to be seen how the final RTS and Commission guidance will be squared.  Some of the recitals are inconsistent with preferred industry positions on these points of uncertainty.  Others are arguably at odds with the primary legislation itself and may represent overreach by the ESAs. 

The RTS set detailed rules on the following topics:

• Article 4 SFDR Principal Adverse Impact (PAI) reporting.  
  
  
• Article 8 SFDR ("light green") and Article 9 SFDR ("dark green") product pre-contractual disclosure requirements, including templates.
  
  
• Article 10 SFDR website disclosures for Article 8 and Article 9 products.
  
  
• Article 11 SFDR periodic disclosures for Article 8 and Article 9 products, including templates.
  
  
• What it means to “do no significant harm” within the meaning of Article 2(17) SFDR – the definition of "sustainable investment”. This is of broad relevance but, in particular, by this means, the RTS arguably divide the Article 8 category in two, setting up a new category of "mid-green" or "Article 8+" product. 

Significantly, the RTS suggest that various disclosures and statements required by SFDR (including website disclosures) must be published not only in English but also in the official language of each relevant EU Member State.  If this requirement is reflected in the made law, it may add significantly to costs of compliance, and pose practical challenges. 

Many firms (those below the 500-employee threshold) need to decide whether to opt in to PAI reporting at firm level under Article 4 (and then, at product level, under Article 7).  Those firms have been waiting for this final draft RTS to help them to assess whether this is feasible given the data available to them about the impacts of their portfolio companies.   Many had been concerned that the requirements imposed by the ESA consultation draft issued last year would be too burdensome.  Consistent with rumours which had been circulating, the draft RTS reduce the burden compared to the consultation proposals in relation to reporting on the principal adverse impacts of investment decisions on the environment or society under Articles 4 and 7 SFDR.

The number of indicators has been reduced from 32 mandatory plus 2 optional plus any others considered "principal" in context (as consulted upon) to 14 mandatory plus 2 optional plus any others considered principal.  The optional pick list is longer, and there are now dedicated indicators for investment into: (a) companies; (b) sovereigns and supranationals; and (c) real estate assets. 

The RTS also stress the significance of narrative reporting: firms must disclose their actions taken and planned, or targets set, to avoid or reduce the PAIs identified over time.  Other narrative disclosures include reference to engagement policies (whether those under the Shareholder Rights Directive or otherwise); a description of how those engagement policies adapt where there is no reduction in PAIs over one reference period; and descriptions of adherence to responsible business codes, internationally recognised standards for due diligence and reporting; and, where relevant, the degree of alignment with the objectives of the Paris Agreement.  Unlike the position for reporting for Article 8 and 9 products, the first RTS-compliant PAI reports will be due in 2023 in respect of the 2022 reporting period.  There are also detailed data-cut rules and a requirement for a five-year historical comparison, which has been reduced from ten.   

These changes may affect the decisions of firms hovering over whether to opt-in, in those many cases where comply or explain is an option. 

The mandatory indicators are as follows:

Environmental indicators

1. Greenhouse gas emissions (Scope 1, 2 and (from 1/1/2023) Scope 3)
2. Carbon footprint
3. GHG intensity of investee companies
4. Exposure to companies active in the fossil fuel sector
5. Share of non-renewable energy consumption and production
6. Energy consumption intensity per high impact climate sector
7. Activities negatively affecting biodiversity-sensitive areas
8. Emissions to water
9. Hazardous waste ratio

Social indicators

10. Violations of UN Global Compact principles and Organisation for Economic Cooperation and Development (OECD) Guidelines for Multinational Enterprises
11. Lack of processes and compliance mechanisms to monitor compliance with UN Global Compact principles and OECD Guidelines for Multinational Enterprises
12. Unadjusted gender pay gap
13. Board gender diversity
14. Exposure to controversial weapons (anti-personnel mines, cluster munitions, chemical weapons and biological weapons)
    
    

The RTS provisions concerning Scope 3 greenhouse gas emissions will come into force later, most likely on 1 January 2023.

In three respects, it seems that the ESAs may have reached positions which are not necessarily supported by the text of the primary legislation already in force. 

Article 7 = Article 8?

First, the ESAs could be taken to suggest in recital 19 to the RTS that a product which falls within Article 7 SFDR because the financial market participant considers the principal adverse impacts (externalities) of its investment decisions on environmental or social factors (either on a mandatory or voluntary opt-in basis) necessarily also falls within Article 8 SFDR on the basis that giving such consideration is "[o]ne of the ways in which financial products can promote environmental or social characteristics".  We do not believe that an Article 7 product ought necessarily to be an Article 8 product.  The primary legislation sets up these two categories independently of each other.  It is to be hoped that the European Commission guidance provides some assistance here, and that perhaps the RTS will be adapted to conform to it.

Article 9 = Article 7?

Second, in the same recital, it is ambiguous whether the ESAs are suggesting that an Article 9 product (one which has sustainable investment as its objective) must necessarily also fall within Article 7 and its manager within Article 4 (both concerning PAI reporting).  We think this cannot be the intention.  In particular, a financial market participant which (where allowed the choice, not open to the largest firms) opts out of PAI reporting at firm level is not permitted by SFDR to opt-in at product level.  So, we think the ESAs must mean instead that the manager of an Article 9 product will be obliged merely to have regard to PAI indicators in order to determine whether particular investments are "sustainable investments"on the basis that they "do no significant harm" (or are disqualified on this basis), which is to be determined by reference to PAI indicators, and this will show up in their periodic reporting under Article 11 SFDR.  This is very different from having to gather data and report periodically against the PAI indicators pursuant to Articles 4 or 7.

Article 9 threshold

We had thought that it should be fairly clear whether a product falls within Article 9 or not.  It will if it has "sustainable investment [as defined] as [one of] its objective[s]".  In other words, an Article 9 product is one which (at least for a material proportion of its capital deployed) targets making a measurable contribution to an environmental or social objective (likely in addition to financial return, a so-called "double bottom line").  If it has such an objective, it will necessarily have bespoke or standardised "sustainability indicators" against which its performance will be capable of being assessed.  The ESAs asked the European Commission in their letter for guidance as to whether an Article 9 product must invest only in sustainable investments and, if not, whether a minimum proportion of sustainable investments is required.  We don't see any possible basis in the law to support these suggestions – although we acknowledge that there will need to be meaningful investment in sustainable investments if the fund is to pursue the relevant sustainability objective.  Trade associations have made the same points to the European Commission.  However, recital 23 suggests that Article 9 products are "expected to make only sustainable investments".  In our view, this is arguably purporting to amend the scope of the primary legislation by means of a recital to a delegated act.

Under EU law, recitals cannot override an unambiguous operative provision of law but they are important to "purposive" interpretation.

There are a small number of clear developments which will be unwelcome to industry because they may create compliance burdens which might put firms off launching light-green or dark-green products, which might otherwise help to tackle the climate emergency and other pressing societal challenges.  

Periodic reporting in 2022 concerning 2021

First, it appears that the ESAs contemplate that periodic reporting under Article 11 SFDR (required for Article 8 and Article 9 products) must begin during 2022 (at the point at which annual reports would otherwise be required in that year) and therefore presumably covering the period 10 March 2021 to 31 December 2021.  This will disappoint some firms who had assumed that the first reporting would be during 2023 in respect of 2022; it will set up practical compliance challenges for any firms with such light green or dark green products, who must begin gathering data in less than a month's time.  This may put off some firms considering whether to launch Article 8 or Article 9 products.  By contrast, the first RTS-compliant PAI reports will be due in 2023 in respect of the 2022 reporting period.

Translations

Second, there is a requirement (flagged in our overview) to make available the following disclosures not only in English (for products marketed in more than one Member State) but also in "a language of all the Member States where that financial market participant's financial products are marketed" (apparently whether or not the product is marketed pursuant to a single market passport):

• Summaries of website disclosures concerning PAIs pursuant to Article 5(2) of the RTS.
  
  
• Summaries of website disclosures required of Article 8 and Article 9 products (Article 10 SFDR and Articles 33(2) and 46(2) of the RTS). These must be summaries which cannot exceed the length of two sides of A4 paper.

Fund-of-funds will find it hard to consider PAIs

Third, it appears that fund-of-funds managers may not be able to elect into Article 4 and 7 SFDR PAI reporting initially, unless all of their underlying funds are undertaking PAI reporting themselves.  Recital 4 to the RTS provides that where financial market participants do not have sufficient information about the adverse impacts of investment decisions on a look-through basis, they "cannot be considered to take into account the principal adverse impacts of their investment decisions on sustainability factors". 

There have been some concerns about private funds making public website disclosures pursuant to Article 10 SFDR in relation to Article 8 and Article 9 products.  Some trade associations have argued that this obligation ought not to apply to products where information is not otherwise made available to the public or to retail investors.  For example, such publication could be in tension with global securities offering laws.  The ESAs do not address this point specifically.  However, they do make some remarks about confidentiality (presumably directed at segregated investment management mandates), which have a bearing, and firms will wish to consider these carefully.  In their letter to the European Commission, the ESAs asked: "If the disclosure requirements of SFDR apply at the portfolio level, how is it possible to maintain confidentiality obligations to the client in view of the disclosures required, especially the website disclosures required by Article 10 SFDR?".   In the draft RTS, the ESAs suggest that, when making public disclosures "financial market participants should comply with national and Union law governing the protection of confidentiality of information, including the protection of undisclosed know-how and business information and the processing of personal data.”

The draft RTS provide for more flexibility in relation to the manner in which they gather PAI data. They should do so "through all reasonable means available", which might include: employing external market research providers, internal financial analysts and specialists in the area of sustainable investments; undertaking specifically commissioned studies; or using publicly available information or shared information from peer networks or collaborative initiatives. It seems to be assumed to be the exception (as opposed to the rule) that financial market participants will engage directly with the management of investee companies, although in many private markets we expect this to be the norm.

As noted above, the draft RTS beg some of the questions which are on the desks of the European Commission, who are expected to publish guidance.  It is therefore unclear whether the ESAs have decided to adopt their own position, or whether the relevant sections of the RTS will be changed, depending on the European Commission's response.

Article 8 threshold

In particular, is the mere existence of a norms-based or industry-standard screen sufficient to make a product engage Article 8?  That remains unclear.  Recital 18 could be read to suggest that specific sectoral exclusions are a means of promoting environmental or social characteristics, whereas Recital 25 could be read in many ways, including that a product is only within Article 8 if such exclusion strategies are "showcased as material".  This sits oddly with Recital 22 which provides that where environmental or social characteristics are "promoted" in the product name, marketing material or pre-contractual information then that product should comply with the disclosure requirements of the RTS (i.e. no reference to materiality).  In other words, must concerns about greenwashing be cured by subjecting a product to Article 8 or can it be addressed by using the Article 6/8 boundary to force financial market participants to be clearer in their claims?  In our view, these recitals only add to the confusion, and could be read in support of either side of this debate. Given a core purpose of the regime is to help investors distinguish "green" products from other products, we think it would be unhelpful for private fund products to be classified as light green solely on the basis of using industry standard screens which are not intended to make the product "green".  

A new category of mid-green product?

The draft RTS contemplate the concept of an Article 8 product that commits to make a sustainable investment.  Does this in effect create a new category of an Article 8+ product?  Such products will likely need to be particularly mindful of recital 21 to the RTS which provides that firms need to be fully transparent as regards the allocation of underlying investments, i.e. those which are sustainable investments, versus other investments (including those held for diversification, liquidity and hedging etc).

Do no significant harm (DNSH)

Products must (in our view) have regard to PAI indicators when measuring DNSH where they have made or committed to make "sustainable investments".  This will catch Article 9, Article 8+ products, but not other Article 8 products which have not committed to make a sustainable investment.  Such products must also explain whether the sustainable investment is aligned with certain international standards namely the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights.

Good governance

Recital 27 provides that both Article 8 and Article 9 products should "include information on the  policy of the financial market participant to assess good governance practices of investee companies".  Draft RTS Articles 15 and 22 require that to be included in pre-contractual disclosures.  Draft RTS Articles 36 and 49 require website disclosures to include fuller details of the policy to assess good governance “including with respect to sound management structures, employee relations, remuneration of staff and tax compliance”.  There is no further elaboration in the RTS as to how this impacts products investing in asset classes where this requirement will prove to be difficult (e.g. certain types of credit and non-control investment strategies).

Templates

The RTS contain revised templates for pre-contractual (e.g. AIFMD Article 23) and periodic (e.g. AIFMD Article 22 annual report) disclosures in respect of Article 8 and Article 9 products (Annex II - V, beginning on page 82 of the document).

The revised templates will need to be used from January 2022 and will, we think, need to be trailed in a short summary in the front-end of the relevant disclosure or report, with the templates scheduled to the document. 

The templates take a very much "one-size fits all" approach, not distinguishing between information which a retail investor could digest or an institutional investor would find useful.  This, the ESAs expressly acknowledge, is a problem: they say that this is a sub-optimal situation leaving the disclosures "unfit for purpose for both types of documents", but their hands are bound by the primary legislation.

When populating these templates, firms will need to have regard to the granular rules in the relevant part of the RTS (in terms of substance, presentation and data cut) in order to ensure that all relevant disclosure requirements are addressed.  Certain data metrics need to be given on a year-on-year basis so as to give five years' worth of data (although these do not look back beyond the first SFDR reporting period).

Firms with, for example, live in-scope Article 8 or 9 funds should check these detailed requirements and identify any red-flags, important ambiguities or items requiring significant data lifts at an early stage in order to avoid any surprises.

Firms with so-called "Article 9(3) products" (those which have a reduction in carbon emissions as an investment objective) should note specific disclosure requirements as to alignment with, and achievement of the objectives of, the Paris Agreement via a specified benchmark or, if none is available, what other steps are taken and the extent to which they are consistent with underlying detailed methodological requirements set out in separate EU legislation.   

We await European Commission guidance with bated breath!

Developments in relation to SFDR are fast moving.  This client briefing assumes a certain familiarity with the concepts and it does not cover all of the issues our clients currently face.  If you would like to discuss the implications of the draft RTS for your particular SFDR implementation project, please contact your usual contact or any of the lawyers below.