The European Supervisory Authorities have issued their 2023 annual report on the extent of voluntary disclosure of principal adverse impacts (PAI) of investment decisions on sustainability factors under the Sustainable Finance Disclosure Regulation. The report considers (i) the explanations for not considering PAI, (ii) disclosures on due diligence and Paris alignment, and (iii) accessibility of PAI disclosures as main areas of improvement.
What is the ESAs’ 2023 PAI Report?
On 28 September 2023, the European Supervisory Authorities (ESAs) issued their second report on the extent of voluntary disclosure of principal adverse impacts (PAI) under the Sustainable Finance Disclosure Regulation (SFDR) (2023 PAI Report). PAI are meant to capture and disclose negative externalities caused by investments using a pre-defined set of indicators from the Commission Delegated Regulation (EU) 2022/1288 containing the SFDR level 2 provisions (SFDR Regulatory Technical Standards (SFDR RTS)). PAI can be considered under SFDR at financial market participant (FMP) level (Article 4 of the SFDR) and at financial product level (Article 7 of the SFDR).
Article 18 of the SFDR requires the ESAs to take stock of the extent of voluntary disclosures each year. They must do so with the support of the National Competent Authorities (NCAs) and submit an annual report on the result of this stocktaking exercise to the European Commission (Commission).
This year’s report follows the first report, which was issued on 18 July 2022. It contains a summary of the ESAs’ main findings, examples of good and bad practice, recommendations to the Commission and a more detailed description of responses from NCAs to the questions asked during the stocktaking exercise.
What are the main findings of the 2023 PAI Report?
The 2023 PAI Report identifies the following main areas of improvement:
- Explanations for not considering PAI;
- Disclosures on due diligence and alignment with the Paris Climate Agreement; and
- Availability and accessibility of PAI disclosures.
Explanations for not considering PAI
SFDR permits FMPs not to consider PAI, in the case of Article 4 of the SFDR, only if the FMP and its subsidiaries have less than 500 employees. If PAI are not considered, the FMP must explain and indicate when it intends to consider PAI.
According to the ESAs, the explanations disclosed by many FMPs are not sufficient. It appears that many FMPs only refer to the 500-employee threshold, which is not an explanation but a precondition to opting out of the PAI regime. Other FMPs make ambiguous claims about data availability and comparability or the lack of legal clarity. As to lack of legal clarity, the ESAs refer to the “numerous clarifications” they have published on the PAI regime and simply call this out as bad practice.
According to the ESAs, FMPs should give more detailed and specific explanations as to why they have chosen not to consider PAI (noting that such explanations must extend to all adverse impacts, not only to PAI, as explained by the Commission in Question IV.1 of the consolidated SFDR FAQ). Moreover, the ESAs consider it best practice to indicate a target date by which the FMP intends to start considering PAI indicators.
Disclosures on due diligence and Paris alignment
Disclosures on PAI consideration under Article 4 of the SFDR should include information on the:
- FMP’s due diligence policies in relation to PAI (Article 7(1) of the SFDR RTS); and
- Adherence to international standards including, where relevant, the degree of Paris alignment (Article 9 of the SFDR RTS).
The ESAs note that while many FMPs mention their participation in sustainability-related international organisations and initiatives like the Principles for Responsible Investment or the Net-Zero Asset Owner alliance, there is little to no information on what this means in practice in relation to PAI consideration and the degree of Paris alignment. In the ESAs’ view, disclosures on Paris alignment need to include information on indicators measuring the decarbonisation path of investments. They do not consider it sufficient to merely refer to coal exclusion policies, contributions to the UN Sustainable Development Goals or to one’s status as a signatory to the UN Global Compact.
Availability and accessibility of PAI disclosures
The ESAs also find that PAI disclosures, in particular, at FMP level under Article 4 of the SFDR, are in many instances difficult to locate and access. It appears that NCAs often had to use search engines to find PAI disclosures since they were included in other documentation (eg, responsible investment policies) or hidden in sections with non-intuitive titles (eg, “downloads”, “legal reports”, “corporate information” or “required information”).
The ESAs make it clear that PAI disclosures at FMP level under Article 4 of the SFDR must be made on a website and that PAI disclosures should generally be easily accessible, clear and intuitive for the investor to find.
What do the ESAs recommend to the Commission?
On the basis of the findings above, the ESAs recommend the following:
- To consider replacing the 500-employee threshold with a threshold based on the size of the FMP’s investments since the size of investments is a better reflection of the adverse impact potential as compared to the number of employees;
- To consider detaching the PAI consideration at financial product level under Article 7 of the SFDR from the PAI consideration at FMP level under Article 4 of the SFDR, thus permitting FMPs not considering PAI at FMP level (ie, across all of their financial products) to consider PAI for some of their financial products; and
- To consider extending the review period under Article 18 of the SFDR to three years instead of one to permit a more meaningful stocktake and to adequately monitor current developments.
The ESAs also note that they expect adequate follow-up supervisory actions from NCAs where non-compliance of FMPs with regulatory provisions has been detected. NCAs should consider the use of enforcement tools, which demonstrates that the regulatory leniency period is over.
Interestingly, the ESAs also note that the NCAs’ responses to the stocktaking exercise demonstrated a lack of regulatory expertise and understanding of some of the central concepts of the PAI regime. For example, NCAs seem to have confused the difference between “considering PAI” under Article 4 and 7 of the SFDR (requiring disclosure of PAI data and how PAI are addressed) and “taking into account PAI” as part of the do not significantly harm (DNSH) test for sustainable investments (requiring actively filtering out any investments which cause harm as established based on the PAI indicators).
Moreover, responses from NCAs included terms such as “ESG risk”, “ESG criteria” or “sustainable investment goals” which are not technical terms under the SFDR and, in respect of risks, are not relevant for the PAI regime focusing on negative externalities.
How does the 2023 PAI Report fit into the broader EU Sustainable Finance landscape?
The 2023 PAI Report adds to a series of consultations run by the ESAs and the Commission on the review of the SFDR and the SFDR RTS:
- From 12 April to 4 July 2023, the ESAs consulted on various amendments to the SFDR RTS (including, among other things, new social PAI indicators and additional disclosures on greenhouse gas emission reduction strategies and the DNSH principle for sustainable investments). For background, see here.
- On 14 September 2023, the Commission launched two new consultations to seek feedback on the review of the SFDR (including, among other things, questions on the functioning and improvement of the current PAI disclosures). Read more about the consultations in our blog here.
Consequently, we expect the SFDR and SFDR RTS to undergo a number of changes in the coming years, which will require FMPs to review and adapt their existing SFDR disclosures and related procedures in the medium term. However, these changes also contain the potential for significant improvements of this sometimes cumbersome and difficult to handle legal framework. Although the ESAs make it clear that, in their view, the lack of legal clarity is not a reason for not considering PAI, they also concede that even the NCAs do not yet properly understand the PAI regime and SFDR more broadly. It is, therefore, understandable that FMPs struggle with the same challenges.
More details on the overall EU Sustainable Finance timeline can be found here.
For further information, please contact:
Heike Schmitz, Partner, Herbert Smith Freehills
heike.schmitz@hsf.com
