On Friday, the European Commission published new information explaining more about how it expected financial market participants to comply with the Sustainable Finance Disclosure Regulation (SFDR).

The document came in response to a request from the European Supervisory Authorities (ESAs) for more clarity on certain parts of the regulation, which has caused chaos in the investment industry since it was introduced in 2021.

At its heart, SFDR seeks to force financial institutions to publicly explain how they are approaching sustainability topics and goals in their products, so that regulators and consumers can more easily assess the credibility and ambition of those claims.

The information released on Friday took the form of an official ‘Q&A’, which means it serves as an immediate and official steer on how to interpret the regulation.

Defining sustainable investment

“In general there are no big surprises, which is very helpful for the industry,” said Julia Vergauwen, a managing associate and ESG specialist at Linklaters, adding that, crucially, the document is “not setting stricter standards” for SFDR.

The Commission has been under pressure from some market participants and national regulators to introduce environmental standards and a definition of ‘sustainable investment’ into SFDR, to help ensure the credibility of claims being made, and to offer clarity to institutions about what they are being benchmarked against.

However, rulemakers have maintained that the function of the regulation is to mitigate greenwashing by promoting transparency, not by setting standards.

As a result, the Commission used the Q&A to say that “financial market participants must disclose the methodology they have applied to carry out their assessment of sustainable investments, including how they have determined the contribution of the investments to environmental or social objectives, how investments do not cause significant harm to any environmental or social investment objective [an assessment known as DNSH] and how investee companies meet the ‘good governance practices’ requirement”.

Vergauwen said the comments provide “long-awaited clarity on the sustainable investment concept” by telling asset managers that they are responsible for creating their own definitions and approaches and then reporting them. “This is in line with the SFDR being a disclosure regime,” she added.

Not everyone feels relieved by the Commission’s statement, though. One market observer, who asked not to be named, said: “All they’ve clarified here is that they’re not really going to clarify anything.”

“They’ve made the SFDR criteria utterly useless, because it now states in black and white that you can calculate sustainable investments any way you want, so how is anyone going to compare different funds or advise clients? This is a paper written entirely by people who are theorising behind a desk – they aren’t asking whether any of this actually works, and whether it will help achieve what we’re trying to achieve.”

Tiffany Cox, an associate on the ESG working group of law firm MacFarlanes, pointed out that, while the Commission does not attempt to set standards in the Q&A, it does “stress that managers should exercise caution when measuring the key parameters of sustainable investments.”

“Managers are therefore in a difficult position of facing pressure to set quantitative thresholds where possible […] but with no clear regulatory criteria or standards of how to set those thresholds,” she continued.

“Given the emphasis on the managers’ own methodology, managers of products that commit to making sustainable investments may wish to revisit their methodology for assessing sustainable investments to ensure they’re comfortable with the parameters they have set for assessing their contribution, DNSH and good governance,” said Cox.

Principal adverse impacts

SFDR also requires investors and financial advisors to disclose the negative effects they might have on sustainability goals – at entity level for those with more than 500 staff and, in some cases, at product level too – through a document known as a Principal Adverse Impact (PAI) statement. The deadline for the first round of reporting on PAIs is the end of June.

The Commission expects that statement to “include both a description of the adverse impacts and the procedures put in place to mitigate those impacts,” according to its Q&A.

“So it’s not going to be enough in June to just disclose the PAI numbers,” explained one source, who works at an investor membership body. “You also have to have a policy in place that demonstrates how you plan to mitigate those impacts. That may or may not have been something financial market participants were considering before, so people will be frustrated at having to change these disclosures as they’re being prepared.”

The Commission’s statement on PAI reporting echoes the sentiment expressed by the ESAs in a consultation they published on SFDR last week, which laid out their plans to revise some of the regulation’s reporting requirements.

As well as increasing and amending the metrics that market participants should use, the supervisors said they want them to go beyond simply publishing numbers by considering the sustainability impacts of portfolio companies’ value chains, and talking about the use of estimates and treatment of derivatives.

“The issues discussed in the consultation paper relating to PAI reporting emphasise the importance of providing narrative to help investors understand the data being presented, given the variation of approaches that will be taken in the market,” said Cox.

Next steps

While Friday’s Q&A will serve as instant clarification on certain topics, the ESAs’ proposals are out for public consultation until 4 July. After that, they will be finalised and presented to the European Commission – probably in October – as formal recommendations on how to revise parts of SFDR’s ‘level 2’ rules.

Meanwhile, the Commission is reviewing the ‘level 1’ legislation, which will eventually mean re-entering political negotiations with European Parliament and Council to decide what SFDR should look like in the future. A public consultation is slated for around September and the review will continue into 2024.

“The grand question is how the different regulatory workstreams fit together when it comes to timing,” said Vergauwen. “Hopefully, the industry will not be required to reshuffle things by reclassifying products or amending disclosures more than once in the course of the next two years.”

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