SFDR RTS – the Commission asks the ESAs to prepare amendments

Many thought, just over a month ago, that by finally adopting Level 2 regulatory technical standards (RTS) under the SFDR, the European Commission (the Commission) had put this whole fraught issue to bed.

Not so - the Commission has now asked the European Supervisory Authorities (ESAs) to propose amendments to the RTS.

What's happened?

On 8 and 11 April 2022, the Commission sent two letters to the ESAs, inviting them to develop amendments to the RTS which supplement the SFDR, before the RTS themselves have yet been finalised - they're currently in the process of being scrutinised by the European Parliament (EP) and by the Council of the EU (the Council).

The letters were published by ESMA on 6 May 2022.

What are the two letters about?

The letters raise a number of issues in relation to the Level 2 RTS which the ESAs had been asked to develop, in particular, refinements to the RTS on

• a broad review of the PAI regime, taking into account the main technical issues which have emerged since the SFDR was agreed.  This would cover two main themes, (i) refining and expanding the list of adverse impact indicators, and (ii) requiring that "implementation and application efforts" take place.  This latter provision appears to refer to concrete action that firms which consider PAIs must actually take in practice to demonstrate "consideration" (see the letter of 11 April 2022).  These refinements would be significant for firms complying with the PAI regime

• disclosure of decarbonisation targets and actions pursued.  This would require Article 8 and 9 products to disclose decarbonisation targets (including intermediary targets and milestones), in pre-contractual, website and periodic disclosures (see the letter of 11 April 2022) and

• disclosure of product exposures to gas and nuclear activities (see the letter of 8 April 2022). This work would require Article 8 and 9 products to disclose their exposure to fossil gas and nuclear energy, consistent with the Complementary Climate Delegated Act (CDA). The CDA was adopted in March 2022 and is due to be finalised later this year. It covers natural gas and related technologies as transitional activities insofar as they fall under the Taxonomy Regulation (see our article on the CDA here).

The ESAs are asked to submit their draft RTS to the Commission

• by 11 April 2023 in respect of the work on PAI indicators and decarbonisation and

• by 30 September 2022 in respect of exposure to fossil gas and nuclear energy

What does Simmons think?

The proposed amendments to the RTS in respect of gas and nuclear exposure, and in respect of decarbonisation, are likely to be broadly uncontroversial. These are the types of incremental expansions to the SFDR architecture which the financial services industry might reasonably expect as the sophistication of understanding of ESG issues expands across the market.

However, the request for a significant reframing of the PAI disclosure requirements in the RTS is a controversial move by the Commission. While the PAI regime has been widely criticised, and a broader review might have been welcomed in a vacuum, the timing of the announcement (with just over 7 months until the RTS come into force) is an unwelcome surprise. This request is already causing concern in the industry (for firms which are complying with the regime), due to the substantial time, effort and money that has already been directed at compliance with the PAI regime in the RTS – and which may be obsolete within a year or two.

The breadth of the requested review is also unclear. The ESAs are simultaneously directed to both “aim at broadening” the PAI disclosure framework, while also being asked to “streamline” it. Market participants may also be concerned about the open-ended nature of the request to extend the list of mandatory indicators, as well as to “refine the content of all the indicators for adverse impacts and their respective definitions, applicable methodologies, metrics and presentation”. This hints at a potential re-working of the entire PAI regime.

Financial services firms which are concerned by this proposal may wish to engage with trade associations or industry bodies, to lobby for clarity on the scope of the review, and timing of any rule changes. It may be appropriate, for example, for the Commission to consider deferring or pausing the application of the current RTS PAI rules, if they are to be materially re-written in the next 12 months. This would also avoid confusion in the disclosures published to investors when the rules change.

The request for review also comes at a point in time where many smaller managers are carefully evaluating the perceived commercial benefits of complying with the PAI regime in light of the MiFID suitability changes coming in August 2022. The possibility that compliance may become more difficult, or simply different, may put off certain smaller managers from opting into the regime.

What's the background to this?

On 4 February 2021, the ESAs submitted a first batch of seven draft RTS to the Commission. These were made under Articles 2a(3), 4(6) and (7), 8(3), 9(5), 10(2) and 11(4) of the SFDR.

A further batch of six draft RTS was submitted on 22 October 2021. These were made under Articles 8(4), 9(6) and 11(5) of the SFDR.

The Commission bundled all 13 draft RTS into a single draft Delegated Regulation, which it formally adopted on 6 April 2022 along with five draft annexes. The draft RTS are now being considered by the EP and by the Council, either of which can propose amendments to them.

At the same time, the Commission deferred the date on which the final RTS would apply to 1 January 2023.

For a summary of the adopted RTS, see our article here.

In the meantime, in July 2021, the Commission's Strategy for Financing the Transition to a Sustainable Economy and associated annex, announced

• a review of the RTS under SFDR in order to "cater for the increased request for transparency in areas that extend beyond the environment" and

• that it intended to strengthen the disclosure and effectiveness of decarbonisation actions by financial market participants for all financial products through the SFDR RTS.

As a result, the Commission's view is that amendments need to be made to the SFDR Delegated Regulation based on new RTS or else several areas in the Delegated Regulation may not appropriately reflect the new factual and regulatory situation. It has, therefore, mandated the ESAs to prepare appropriate draft amendments.

What do the letters say?

11 April 2022 - PAI indicators and decarbonisation disclosures by financial products

Taking the Commission's letter of 11 April 2022 first:

(a) PAI indicators

The Commission's letter asks the ESAs to review the RTS with the aim of

• broadening the disclosure framework and

• addressing some key technical issues which have arisen since the SFDR was originally agreed.

These issues concern sustainability indicators in relation to adverse impacts (see Article 4(6) and (7) of the SFDR).

The ESAs, then, are invited to

• streamline the regulatory framework and develop it further

• consider extending the lists of universal indicators for PAI, along with other indicators, and

• refine the content of all the indicators for adverse impacts together with their definitions, methodologies, metrics and presentation.

A guiding principle for this work, the Commission states, should be "to reduce the risk of 'false certainty' and potential 'safeguards washing' by requiring well-substantiated evidence that investments align with the safeguards, and that implementation and application efforts do take place".

At the same time, the ESAs should ensure that the amended RTS are carefully calibrated so disclosures based on such indicators are "proportionate and feasible for financial market participants".

(b) Transparency on decarbonisation by financial products

The Commission's letter also invites the ESAs to propose amendments to RTS in the SFDR Delegated Regulation with respect to the information provided (a) in pre-contractual documents, (b) on websites and (c) in periodic reports on decarbonisation targets - this should include intermediary targets and milestones, where relevant as well as actions pursued.

The ESAs are also asked to consider whether the provisions in RTS on financial products referred to in Article 5 and 6 of the Taxonomy Regulation "sufficiently address the disclosure and information on environmentally sustainable economic activities".

What next?

The ESAs are asked to submit draft RTS in accordance with the above mandate within 12 months of receipt of the Commission's letter (which can be assumed to be on or very shortly after 11 April 2022).

8 April 2022 - Product exposures to gas and nuclear activities

In light of its adoption of the CDA on 9 March 2022, the Commission now considers it necessary to make amendments to the Delegated Regulation under the SFDR to make sure that investors receive information which reflects provisions in the CDA.

Its letter of 8 April 2022, then, invites the ESAs to propose amendments to the SFDR RTS with respect to information that should be provided in pre-contractual documents, on websites, and in periodic reports about the exposure of financial products to investments in fossil gas and nuclear energy activities.

The Commission's mandate covers, in particular:

• pre-contractual and periodic documents or information referred to in Article 6(3) and Article 11(2) of the SFDR and

• the product disclosures to be made on websites referred to in Article 10(1) SFDR

for Article 8 and Article 9 products under the SFDR.

The amendments are intended to ensure that, where a disclosure is made about the degree to which an investment is in an environmentally sustainable economic (i.e., a taxonomy-aligned) activity, this disclosure provides full transparency about investments in sectors and sub-sectors of the economy covered by the CDA and, in particular, about the proportion such investments represent within all investments and in environmentally sustainable economic activities.

Further, the amendments that the ESAs are asked to prepare should ensure full transparency on the proportion of investments in sectors and sub-sectors of the economy that derive revenue from the activities listed in Template 1 of Annex III to the CDA (which forms a new Annex XII of the Disclosures Delegated Regulation made under the Taxonomy Regulation).

What next?

The Commission has asked the ESAs to submit their proposed amendments by 30 September 2022.