What has been published?
Following on from their queries submitted in May (see questions and answers), the European Supervisory Authorities have submitted an additional eight questions to the Commission on the interpretation of the SFDR. A run-through of the questions is found below.
What is the potential impact of the questions?
Many of these questions relate to quite fundamental issues, and given SFDR has applied since March 2021 and the Level 2 standards under the SFDR RTS will apply from January 2023, market participants have already come to views on most of them.
Answers provided by the Commission could, depending on their content, require significant changes in approach from market participants if the responses cut across those existing interpretations.
Do we know when we can expect answers?
As yet no indication has been given as to when Commission’s answers on these particular questions will be published. Contacts at the Commission have explained that responses normally take a couple of months as detailed internal procedures need to be followed.
Market participants are currently working to prepare and finalise pre-contractual disclosures in time for the Level 2 standards coming into effect in January, taking into account deadlines for submission to regulators for approval for public/authorised funds.
Potential impact / concern
Q1 is about the definition of “sustainable investment” in Article 2(17) SFDR and asks whether it applies to investments in funding instruments that do not specify the use of proceeds, such as the general equity or debt of an investee company?
The example looks at whether an entire holding can be considered a “sustainable investment” where the investee company does no significant harm to E or S objectives and reports that 20% of its economic activities contribute to E or S objectives, or whether only 20% meets the definition.
The general view in the market is that it is possible to be a “sustainable investment” without a specific use of proceeds. In addition, this assessment is generally done at the investment level (so the entire holding would be considered a “sustainable investment”). A contrary view from the Commission could upend this approach, and also make it very difficult for products to fall within Article 9 of SFDR. This is because guidance has indicated that 100% of an Article 9 product’s investments should be sustainable investments (bar certain hedging or liquidity instruments), and so if individual economic activities underlying an investment holding must be considered separately it may be very hard to find investments that are 100% sustainable investments.
Q2 asks how “investment in an economic activity that contributes to an environmental objective” or “investment in an economic activity that contributes to a social objective” in Article 2(17) SFDR should be interpreted.
In particular, the following examples are given, asking whether they contribute to E or S objectives:
The ability of transition plans and commitments/strategies aimed at reducing E or S harm to (of themselves) make an economic activity contribute to an E or S objective is also raised.
As above, the answer could disrupt existing views that have been taken on what investments can count as a “sustainable investment”, and at what level that assessment should be undertaken.
Q3 asks whether it is correct to consider that financial products that have an Article 9(3) objective of reduction in carbon emissions can be either products with a passive or active investment strategy?
If financial products with an active investment strategy can be financial products that have reduction in carbon emissions as their objective under Article 9(3) SFDR, are there any specific requirements they should meet when they have designated an index as a reference benchmark?
This could affect the disclosures and approach of products that have the objective of a reduction in carbon emissions, as Article 9(3) has historically raised questions given part of the requirements around reference benchmarks appear more geared towards passive funds which track a benchmark.
Q4 asks whether a financial product can “promote” carbon emissions reduction as an “environmental characteristic”, as opposed to having it as an “objective”?
Given some Article 8 funds do include the reduction of carbon emissions as an environmental characteristic rather than an “objective” today, an answer which indicates that any fund which targets carbon emissions reductions as a feature is also required to disclose the information required under Art. 9(3) SFDR (for products which have carbon emissions reduction as their objective) could be disruptive to those existing funds and their intended to approach to compliance with the Level 2 disclosure requirements from January.
Q5 asks whether a financial product with a passive investment strategy which designates as a reference benchmark either a Paris Aligned Benchmark or (from 1 January 2023) a Climate Transition Benchmark can automatically be deemed to fulfil the conditions of Article 9(3) SFDR in conjunction with Article 2(17) SFDR?
Can financial products with an active investment strategy focused on carbon emissions reduction be deemed to satisfy the conditions of Article 9(3) SFDR in conjunction with Article 2(17) SFDR where they apply the same requirements (regarding portfolio composition, etc.) as those applied by PAB and CTB pursuant to BMR framework and in particular Delegated Regulation 2020/1818?
Similar to question 3 this raises the issue of how Article 9(3) applies (if at all) to active funds, and is a longstanding question as to whether funds tracking low carbon benchmarks have to apply SFDR criteria on top of the low carbon benchmark requirements. The Commission’s answer could impact the design of such funds.
Q6 asks what is the meaning of “consider” in Article 7(1)(a) SFDR? Could “consideration” of principal adverse impacts by a financial product mean that a financial product only discloses the relevant principal adverse impacts of the investments, for example total greenhouse gas emissions, or does “consideration” require action taken by the financial market participant to address the principal adverse impacts of the product’s investments, such as engagement with investee companies, and are there any minimum criteria for such actions?
The general position has been to do more than reporting considering the regulation also asks on an ex post basis what has been done to limit adverse impacts.
Q7 looks at who’s included in “the average number of 500 employees”. Should it be understood to include workers who are assigned to the FMP even though they are employed by a third party that invoices their services back to the FMP, e.g. interim workers or workers that are employed by other organisations within a group for instance as part of shared service centres?
Can the exemption in Article 23(5) of the Accounting Directive (which grants Member States the right to exempt parent companies that are themselves the subsidiary of a larger group from drawing up consolidated financial statements and a consolidated management report under that Directive) apply to a “parent undertakings of a large group” referred to in Article 4(4) SFDR?
This could be relevant to firms that are on the borderline of 500 employees or potentially subject to the Accounting Directive exemption when it comes to mandatory Article 4 SFDR disclosures.
Q8 asks whether the frequency of periodic disclosure for portfolio management services should be annual or quarterly, citing some discrepancy between the article and the recital.
The ESAs have identified one of the inconsistencies between the envisaged approach of SFDR disclosures and MiFID II portfolio management reporting requirements. For firms that have gone with the approach seemingly envisaged under the SFDR requirements of annual disclosure, then a change to quarterly disclosures could be problematic. It is also worth noting that under the MiFID Quick Fix, professional clients have been exempted from portfolio management reporting unless they opt in. This inconsistency has not been flagged by the ESAs in their question, even though it is also quite a fundamental point regarding how SFDR disclosures interact with MiFID II reporting.