On 2 June 2022, the European Supervisory Authorities (ESAs) issued a joint statement providing clarifications on their reports for the draft SFDR RTS. However, unhelpfully they state that the statement does NOT refer to the SFDR RTS adopted by the Commission in April and which is going through the scrutiny period but rather to the versions of the RTS that the ESAs had consulted on and included in their Feb 2021 and Oct 2021 Final Reports. Hence, there may be inconsistencies between this latest ESA guidance, and the latest version of the RTS. However, there are still some important points to note:

Do not significant harm (DNSH)

  • The paper confirms that the use of PAI indicators is mandatory to demonstrate that an investment qualifies as a sustainable investment. The PAI indicators that should be used are the ones in Table 1 of Annex 1 and any relevant indicators in Tables 2 and 3 of Annex I. The ESAs acknowledge that the RTS does not specify exactly how the PAI indicators should be used and that in their view “financial market participants can determine whether the indicators have been respected” for the purposes of the DNSH state. However the ESAs have stated that “best practice could be to disclose DNSH for sustainable investment [by extracting the relevant indicators]… and show the impact of the sustainable investments against those indicators, proving through appropriate values… that the sustainable investments do not significantly harm any environmental or social objectives” and indicated that firms could have regard to the metrics for DNSH under the Taxonomy Regulation.

  • Overall, this is a helpful development as it seems that the ESAs consider that FMPs can determine how the PAIs should be used, and also potentially opens the door for a qualitative DNSH assessment for some or more PAI indicators – provided the FMP can demonstrate “through appropriate values” that significant harm is avoided.

  • On the requirements for sustainable investments demonstrating DNSH to show “whether the investments are aligned with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights, including the principles and rights set out in the eight fundamental conventions identified in the Declaration of the International Labour Organisation on Fundamental Principles and Rights at Work and the International Bill of Human Rights”, the ESAs do not provide much additional clarification, as they simply state it was intended to bring the DNSH disclosures under SFDR in line with the minimum safeguards under the Taxonomy requirements.

  • The ESAs essentially agree with earlier Commission guidance that use of PAIs for the DNSH is separate from the general PAI disclosure obligations under Articles 4 and 7 of SFDR.

  • They also reiterate that the DNSH tests under the Taxonomy and under SFDR are separate and should apply cumulatively for SFDR sustainable investments that are Taxonomy-aligned.

Measuring and disclosing attainment of E/S characteristics and SI objectives

  • The paper confirms that “sustainability indicators” (i.e. indicators used to measure the environmental or social characteristics or the overall sustainable impact of Art 8/9 products) are not the same as the PAI indicators in the SFDR RTS, but that there is some overlap between the two concepts as the PAI indicators can also be used as sustainability indicators to measure the attainment of the E/S characteristics or objectives of Art 8/9 products. They also clarify that PAI indicators can be used as “sustainability indicators” even when PAIs are not considered at an entity level (under Article 4) or product level (under Article 7). We don't expect that any of these observations will be particularly surprising to the market.

  • In the top 15 holdings of the financial product that are disclosed in periodic reports, the ESAs consider that the country identified should be the country in which the investment is made or the investee company is headquartered or where a financial product is domiciled – and that in the case of fund investments etc. the country where the fund is domiciled should be included (i.e. there is no requirement to look through).

Article 9 products

  • The paper reiterates the view that “financial products that have sustainable investment as an objective should only make sustainable investments” but goes on to state that “disclosures are still required on the amount and purpose of any remaining assets to demonstrate how those do not prevent the financial product from attaining its sustainable investment objective” and those remaining assets environmental or social safeguards should be considered.

  • Whilst this might seem to indicate some flexibility for Article 9 products to have non-sustainable investment positions - given all the strict EU feedback on this point since July last year, we think this “remaining assets” bucket should be interpreted still as being very much limited to cash, hedging instruments and positions required by sectoral rules.

Principal adverse impact (PAI) calculations

  • The paper re-confirms the position in the rules that the entity-level PAI calculations should be based on, at least, the average of four calculations made on 31 March, 30 June, 30 September, and 31 December of a calendar year reference period. The ESAs however have helpfully acknowledged that in some cases data for certain PAI indicators may only be available on an annual basis (e.g. GHG emissions) and so the same GHG emissions figure can be used for the 4 quarterly calculations (and the difference each quarter will therefore be the level / value of the holding in such investments). However, the worked example also suggests that if further information is made available regarding the company’s emissions during that year, that should be considered.

  • The ESAs have given further guidance on getting PAI data on indirect investments (e.g. investments in holding companies, collective investment undertakings or special purpose vehicles) – the ESAs expect firms to do the calculation on a look through basis, however there seems to be some welcome understanding that this data may not be easily available or capable of being reliably estimated and so the ESAs have said that in such cases firms should disclose “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”.

  • The ESAs also explain that where FMPs invest in the different asset classes of real estate and investee companies, the PAIs should be disclosed by type of exposure aggregated at the entity level (i.e. each type of exposure should be kept separate). Hence, for example, the denominator of indicator 17 of Table 1 should be all investments in real estate assets. Although the same clarification is not given with respect to sovereign, supranational etc. investments, we expect that the same principle should apply.

  • Clarifications have also been given on the calculation of certain PAIs – some key clarifications include:

    • On indicator 6 of Table 1 (energy consumption intensity per high impact climate sector) – the ESAs clarify the calculation is restricted to the energy consumption of companies for high impact climate sectors only, not the general entity-level energy consumption intensity of a company.

    • For indicator 8 of Table 1 (emissions to water) the ESAs say this should be expressed as a weighted average (which is defined in the Annex) of the priority substances referred to in the definition of “emissions to water” in Annex I.

    • PAIs requiring averages or average ratios (e.g. indicators 12 and 13 of Table 1) “are intended to be expressed weighted by the individual size of each investments”.

    • The ESAs explain that indicator 18 of Table 1 (exposure to energy-inefficient real estate assets) is to be calculated by reference to the “inefficient real estate assets” formula in Annex I, and that the relevant inputs (NZEB, PED and EPC) were chosen to be consistent with the Taxonomy screening criteria.

    • The ESAs state that indicator 14 of Table 3 (number of identified cases of severe human rights issues and incidents) is “intended to capture exposure to investee companies connected to cases and incidents related to severe human rights issues” (although this doesn’t provide much in terms of clarification). However, they suggest these could be considered against the Charter of Fundamental Rights of the EU, or the European Convention for the Protection of Human Rights and Fundamental Freedoms.

    • The quantitative social and employee indicators in Table 3 (indicators 3, 7 and 14) should be expressed as a weighted average. However, because they are not expressed “per million EUR invested” the value should be expressed in absolute numbers instead of as a relative expression.

    • The ESAs view NACE codes as being sufficient to “identify some investments for some indicators”. The concrete examples they give are indicator 9 in Table 2 concerning pesticides and indicator 8 in Table 1 on emissions to water.

    • Non-cooperative tax jurisdictions referred to in indicator 22 in Table 3 should be understood as referring to the EU list of non-cooperative jurisdictions maintained by the EU Council.

Taxonomy commitments

  • The ESAs state that disclosures of “minimum proportions” of Taxonomy-aligned investments in pre-contractual disclosures should be viewed as “binding commitments” and that penalties for failure to comply would be the same as for failing to comply with other binding product commitments under the relevant sectoral legislation.

  • The ESAs reiterate their previous guidance that the pre-contractual disclosures are intended to favour the measurement of non-financial investee undertakings’ Taxonomy-contribution by turnover, but CapEx or OpEx may be used instead where this is more representative, and their use should be justified.

  • The ESAs think that since the Taxonomy-alignment disclosures require a breakdown of the proportion of each of the environmental objectives which the sustainable investment contributed to, financial products should be able to demonstrate contribution to each of the Taxonomy environmental objectives separately.

  • Where a SFDR financial product A invests in another SFDR financial product B that makes Taxonomy alignment disclosures, the ESAs think the first product A’s disclosures should be based on the market value of the proportion of Taxonomy-aligned investments of the latter product B. This is a potentially helpful statement as it confirms that the FMP of product A can just rely on Taxonomy alignment assessments made by the FMP of product B (noting that different firms in the market are taking different approaches to determining Taxonomy alignment, with some more comfortable with using third-party data providers, differing estimation methodologies etc.)

Financial products with investment options

  • The ESAs say that for multi-option products and other financial products with underlying investment options, pre-contractual and periodic disclosure requirements set out the instructions to disclose at a financial product level a list of investment options that qualify as Art. 8 or 9 SFDR products, or that have sustainable investment as their objective and are not a financial product under SFDR. The ESAs clarify that website disclosures should include similar information.

  • However, remaining disclosures should be made at the underlying investment option level. Hence the sustainability information should be included for each investment option that qualifies as an Art. 8 or 9 SFDR product, and the information should be grouped from letter (a) to (l) so that investors can find the disclosures related to a specific underlying investment option.