EU Sustainable Finance Disclosure Regulation

As we noted in our recent overview, the EU Sustainable Finance Disclosure Regulation (SFDR) is very much a"work in progress". Since it entered into force, it has been complemented by a more detailed Delegated Regulation. It has also been the subject of various Q&A, clarifications, supervisory statements and guidance, as well as amendments to reflect the addition of certain nuclear and gas activities to the EU Taxonomy. The high volume of clarifications, often issued late in the day, has been particularly challenging for firms.

In April 2023, further clarifications and a consultation on proposed changes to some of the requirements were published, marking a further step in the evolution of the regime. This article explores these publications and highlights their implications for firms.

On 14 April, the European Commission responded to the latest questions from the European Supervisory Authorities (ESAs) on aspects of the baseline SFDR requirements (the 'level one' text). The ESAs submitted eight questions to the Commission back in September 2022 and the responses have been much awaited by industry due to the fundamental nature of some of the questions. 

Some firms had been concerned that the responses might have communicated a significant change in the authorities' expectations, or a narrower or more prescriptive approach. Overall, they allow flexibility and are reasonably aligned with how industry has interpreted the requirements to date, but therefore do not provide the certainty of methodology that other firms are seeking. 

This lack of prescription is likely to reinforce ongoing challenges for investors when it comes to the consistency and comparability of the disclosures — particularly because the approach to defining a 'sustainable investment' can look quite different from one firm to the next. The Commission seems to recognise this possibility where it states that SFDR "gives financial market participants an increased responsibility towards the investment community and means that they should exercise caution when measuring the key parameters of a 'sustainable investment'."

Key points in the responses:

• Clarifications on the definition of sustainable investments note that:
  • The concept can be considered at the level of the investee company or specific activities (in contrast to the activity-level approach in the EU Taxonomy). 
  • There are no minimum requirements around the contribution of an activity to an environmental or social objective. 

More specifically, the Commission confirms that where activities are covered by transition plans that have a future aim to meet the 'do no significant harm' (DNSH) criteria, such activities cannot be considered sustainable. This is likely to remain a frustration for asset managers seeking to classify related products as Article 9, particularly those in private markets who view 'transition investments' as a route to deliver sustainable outcomes.

• Products that have a reduction in carbon emissions as their objective may be either active or passive. Where a Paris-Aligned Benchmark (PAB) or Climate Transition Benchmark (CTB) is not tracked, a detailed explanation should be provided on how the product is attaining its objective. Passive products that track PABs or CTBs are considered to have sustainable investments as defined by SFDR (i.e. are eligible for Article 9 status). For active strategies with a reduction objective, firms must explain why they consider the products have sustainable investment as their objective.
• Products that "promote" carbon emissions reduction may have Article 8 or 9 status depending on their characteristics, but firms should carefully consider their disclosures and ensure investors are not misled. Customer testing may therefore be useful in this context.
• Product-level Principal Adverse Impact (PAI) consideration must go beyond disclosure and include the procedures put in place to mitigate those impacts (representing new information from the Commission). Firms should therefore carefully review whether mitigating procedures are already in place.
• The definition of an employee for the purposes of the entity-level disclosure threshold should be made with reference to national law (as EU legislation, including SFDR, does not define employees). Firms therefore cannot take an EU-wide approach and will need to review the specific requirements for relevant Member States.
• MiFID portfolio management disclosures can be made only annually (rather than quarterly, as some had suggested).

On 12 April, the ESAs (the EBA, ESMA and EIOPA) published a lengthy joint consultation paper, proposing amendments to the SFDR Delegated Regulation (the Regulatory Technical Standards (RTS) or the "level two” text). Feedback to the consultation will inform the ESAs' response to the Commission's 2022 request for the ESAs to review aspects of the RTS to broaden disclosures and address known issues. 

The RTS took effect only from 1 January 2023, but the ESAs' proposals represent a significant overhaul of the existing requirements. In some areas, the ESAs have gone further than the explicit Commission mandate and propose the removal of areas of the rules considered too complex or allowing too much discretion for firms (unlike aspects of the Commission's more flexible stance set out above). The ESAs have also proposed technical adjustments to facilitate use of the templates and application of the standards.

Proposed amendments to aspects of the disclosure framework to address issues that have emerged since the introduction of SFDR cover:

•  Extension of the list of social indicators for PAIs, mainly based on the EU Sustainability Reporting Standards, which will add further considerations for firms when undertaking DNSH assessments (whose outcomes inform what may be classified as a 'sustainable investment'). The proposals include a new, specific indicator on earnings accumulated by investee companies above a certain size in non-cooperative tax jurisdictions (which is notably not an existing ESRS disclosure). 
• Refinement of the content of some other indicators for adverse impacts and their respective definitions, applicable methodologies, metrics and presentation. 
• Text relating to decarbonisation (the ESAs' preferred term is 'GHG emissions reduction') targets, including intermediate targets, the level of ambition and how the target will be achieved. 

In addition, the ESAs propose amendments relating to:

• Improvements to the DNSH disclosures in relation to the environment and society.
• Simplification of pre-contractual and periodic disclosure templates for financial products, including a new dashboard and the possibility of a layered, click-through approach. 
• Other technical adjustments affecting issues such as the treatment of derivatives, the definition of 'equivalent information', and provisions for financial products with underlying investment options. 

Firms are requested to submit feedback to the 43 questions by 4 July 2023. The ESAs will then consider the feedback and submit a final report to the Commission for endorsement and subsequent scrutiny by the European Parliament and Council. Firms are likely to support proposals for streamlining and simplification but may be averse to the more significant proposed changes.

The Q&A and consultation paper illustrate that the SFDR remains very much a work in progress and that the authorities' expectations are constantly evolving. They also underline the need for firms to have a coherent and comprehensive governance and controls framework underpinning the implementation of SFDR. This includes an effective approach to monitoring, understanding and implementing further regulatory guidance.

Firms should read the Commission's clarifications and factor them into their approach to complying with the SFDR — in particular, focusing on the new guidance on considering PAIs at product level (i.e. having mitigating procedures if not already identified), and the classification of passive products that track a PAB or CTB. 

A separate consultation by the European Commission on a wider review of the SFDR is expected in the second half of 2023, which may propose other amendments to the regime.

If you need assistance with your approach to ensuring compliance with the SFDR requirements, please get in touch.