ESG – the ESAs clarify aspects of the SFDR Level 2 RTS

On 2 June 2022, following what they describe as “numerous requests for clarifications received from stakeholders and national competent authorities”, the European Supervisory Authorities (ESAs) published a document entitled “Clarifications on the ESAs’ draft RTS under SFDR” (the Clarifications).

Overall, we see the Clarifications as being broadly positive as they both confirm a number of the interpretations which we have taken to date and, in some areas, reduce the potential regulatory burden arising from the Level 2 RTS made under the SFDR.

The ESAs’ Clarifications

The aim of the Clarifications is to assist with the interpretation of the ESAs’ draft RTS under the SFDR included in the ESAs’ Final Reports of February and October 2021. Note that the Clarifications do not refer to the draft RTS and annexes which the European Commission (the Commission) subsequently adopted on 6 April 2022. This, though, makes no material difference to the analysis below.

The various requirements under the RTS (including product-specific disclosures arising from the Taxonomy Regulation) are due to apply from 1 January 2023. The Clarifications have been published now with the aim that market participants have time to gather the necessary information and make appropriate adjustments so they can comply with them from the outset.

What do the Clarifications cover?

The following sets out some of the key aspects of the guidance contained in the Clarifications.

A. Principal adverse impact (PAI) disclosure of investment decisions on sustainability factors

Uses of “sustainability indicators”

One of the key themes in the Clarification is to explain the use of the PAI indicators (in Annex I of the draft RTS) in contexts other than the entity-level PAI disclosures under Article 4 of the SFDR.

The ESAs confirm that:

• sustainability indicators for periodic reporting need not be based on the PAI indicators (although firms are able to re-use the PAI indicators, these are, in principle, different disclosures)
• product-level PAI disclosures under Article 7 do not have to use the PAI indicators
• however, the DNSH test under Article 2(17) in the definition of “sustainable investment” does require the mandatory use of PAI indicators.
• helpfully, though, using the PAI indicators for DNSH does not require a firm to comply with the PAI regime at an entity-level.

PAI calculation methodology

Paragraphs 8 to 11 of the Clarifications sets out a worked example for calculating PAI exposures on a quarterly snapshot basis, which we believe firms will find useful.

A look-through approach and investment instrument scope for PAI disclosures

Paragraph 12 of the Clarifications underlines Recital (3) of the Commission’s draft RTS in confirming that both direct and indirect exposures must be included for the calculation for PAI reporting purposes.

In our experience, though, firms have found it difficult to determine what they should include as “indirect” exposure.

The Clarifications note that indirect exposure includes exposure via funds, fund of funds, derivatives, holding companies and SPVs. Firms need to look-through the holding vehicle to the exposures of the underlying investments and consider the total adverse impacts arising from them. Firms must use best efforts to obtain this data, including directly from the relevant companies, via their own research, from third party data providers or by making reasonable assumptions.

The final reference should be noted in particular, as it expressly endorses firms’ ability to use assumptions for their PAI disclosures, as a measure of last resort.

Where an investment exclusively finances a particular green project (such as a green bond, a social bond or a project bond), the ESAs confirm that it is permissible to look only at the adverse impact of the project or type of project financed by that investment.

Disclosures for direct and indirect investments in pre-contractual and periodic disclosures

Relevant pre-contractual and periodic disclosures must be provided for a financial product which promotes environmental or social characteristics or commits to a sustainable investment objective, outlining the share of the investments of the financial product held directly and indirectly.

The proportion of the investments used to attain (a) the environmental and social characteristics promoted by the financial product or (b) the sustainable investment objective (as applicable) should be disclosed as well as the purpose of the remaining proportion of investments.

As far as this ‘remaining proportion of investments’ is concerned, the Clarifications note that environmental or social safeguards could be considered, but these must be described in such a way that end investors receive accurate information on the entirety of the investments made by the financial product.

Paragraph 19 of the Clarifications again confirms the view (included in the Commission’s Q&As of July 2021) that Article 9 products must make only sustainable investments.

Further guidance on the adverse impact indicators in Tables 1-3 of Annex I

Paragraphs 20 to 30 of the Clarifications set out some detailed considerations of the calculation methodology for specific PAI indicators as well as providing more guidance on some of the specific terms used, which we consider to be useful.

B. Pre-contractual and periodic disclosures for Article 8/9 products

Where a firm’s minimum commitment disclosures change, the firm should update its pre-contractual disclosures. When and how this is done should be determined by relevant sectoral legislation for the product (eg, the requirements for updating pre-contractual disclosures as specified in MiFID, UCITS, AIFMD, as applicable).

The Clarifications re-iterate that periodic disclosures published after 1 January 2023 will need to comply with the RTS, and that disclosures published during 2022 need to comply with Article 11 SFDR on a principles-based basis.

This helps resolve a source of uncertainty within the industry as to whether it is the reference period that matters, or the date of publication.

C. Taxonomy-related disclosures

Firms are required to disclose the “minimum proportion” of taxonomy-aligned investments in their pre-contractual financial product disclosures.

The Clarifications state (at paragraph 37) that the ESAs regard commitments on the “minimum proportion” of Taxonomy-aligned investments as binding commitments, and that a failure to respect them would be subject to penalties under relevant sectoral legislation.

The Clarifications also include detailed comments on use of KPIs under Taxonomy disclosure calculations, intended to provide guidance on how environmentally sustainable economic activities related to climate change adaptation can be counted.

The pre-contractual disclosure of the Taxonomy-alignment of a financial product in the ESAs’ draft RTS is designed to favour the measurement of the non-financial investee undertakings Taxonomy-contribution by turnover. But the use of either capital expenditure or operating expenditure can be justified if this gives a more representative calculation of the taxonomy-alignment. All three measurements should be disclosed in periodic disclosures.

For the avoidance of doubt:

• only economic activities which comply with Article 3 of the Taxonomy Regulation may count towards the representation of taxonomy-aligned activities funded by a financial product
• in periodic reports, the taxonomy-alignment of aggregated investments should be represented as a bar chart, expressed by turnover, capital expenditure and operating expenditure
• disclosures require a breakdown of the proportion of each of the environmental objectives set out in Article 9 of the Taxonomy Regulation to which the sustainable investments contributed
• as such, in its periodic reports, a financial product should be able to demonstrate the contribution of its investments to both climate change mitigation and adaptation (and to the other four environmental objectives in Article 9 of the Taxonomy Regulation once these apply).

D. DNSH disclosures

As mentioned above, the Clarifications confirm that DNSH should not be seen as the same as disclosures to be made under Articles 4 and 7 of the SFDR.

Rather, DNSH requires firms to determine for themselves whether or not PAI indicators have been respected, when judging significant harm to an environmental or social objective. ie, firms must comply with DNSH by setting their own subjective thresholds of significant harm, as against the PAI indicators.

The ESAs acknowledge that their final reports of February and October 2021 did not specify exactly how PAI indicators should be used for DNSH disclosures. As a result, the Clarifications note that, for DNSH disclosures, best practice will be to extract the PAI indicators and to show the impact of investments against those indicators, using appropriate values.

Note that taxonomy-aligned investments must also separately meet the DNSH test under the SFDR (in other words, meeting the Taxonomy’s separate DNSH test is not sufficient for the SFDR).

E. Disclosures for financial products with investment options

For multi-option products and other financial products which have underlying investment options, pre-contractual and periodic disclosure requirements must disclose at a product level a list of the investment options that qualify as an Article 8 or Article 9 product under the SFDR or have sustainable investment as their objective and are not an SFDR defined financial product.

Website disclosures for multi-option Article 8 or Article 9 products should include disclosure of the following items:

• a list of the investment options that qualify as an Article 8 or Article 9 product and
• a summary for each underlying investment option that qualifies as an Article 8 or Article 9 product or that has a sustainable investment as its objective but is not a financial product under the SFDR definition.

Remaining disclosure requirements should be disclosed at the underlying investment option level.