On 14 April 2023, the European Commission published its long awaited responses to the questions the European Supervisory Authorities (“ESAs”) had raised previously on SFDR (see our earlier blogpost) – in particular regarding the “sustainable investments” test and the compliance requirements for Article 9(3) funds that track EU Paris Aligned Benchmarks (“PABs”) / Climate Transition Benchmarks (“CTBs”).
Overall the responses are helpful for the industry (as they have not resulted in a tightening of standards as had been feared) and appear to be in line with the SFDR’s policy aim as a disclosure regime. The Commission has also very helpfully back tracked on previous guidance that Article 9(3) funds tracking EU PABs/CTBs must additionally comply with the Article 2(17) sustainable investment requirements – as they have now confirmed that passively tracking an EU PAB/CTB will be sufficient for the fund to be treated as an Article 9 product. This is a welcome change of position, but quite late in the day for the industry.
Sustainable Investments test – defining positive E/S contribution
By way of recap, under the SFDR rules, a sustainable investment is one that (i) makes a positive environmental or social contribution; (ii) does no significant harm to other environmental and social objectives (“DNSH”); and (iii) demonstrates good governance. The ESAs had asked the Commission a number of questions regarding the positive environmental / social contribution limb of the test – in particular, the ESAs had asked if the following would meet that limb:
- sustainable activities – i.e. activities that are sustainable by their nature (e.g. renewable energy);
- sustainable behaviours – i.e. activities that are not sustainable in themselves, but are conducted by investee companies in a sustainable manner (e.g. manufacturing a product in a more sustainable manner than peers); and
- transitioning activities / companies.
In the absence of specific guidance, firms had been using some or all of the above approaches to classify investments as “sustainable investments” in the market and the concern had been that the Commission would potentially restrict this limb of the test in particular regarding (b) and (c), which would have then resulted in firms having to reclassify investments and Article 9/8+ products under SFDR. However, very helpfully, the Commission have not taken that approach and have instead acknowledged that the SFDR “does not set out minimum requirements that qualify concepts such as contribution, do no significant harm, or good governance, i.e. the key parameters of a ‘sustainable investment’. Financial market participants must carry out their own assessment for each investment and disclose their underlying assumptions”. The Commission do however go on to state that “This policy choice 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’.”
With respect to transitioning bucket, the Q&A does state that sustainable investments must comply with the DNSH test as well and that therefore “referring to a transition plan aiming to achieve that the whole investment does not significantly harm any environmental and social objectives in the future could for instance not be considered as sufficient” – accordingly, if FMPs can demonstrate that transitioning assets meet the DNSH and good governance tests today (rather than in future), this would suggest that transitioning assets can also qualify as sustainable investments.
Sustainable Investments test – revenue vs. company / investment level test
The other question on the sustainable investments topic that the ESAs had asked for clarity on was whether a revenue / economic activity based test (similar to the EU Taxonomy approach) should be applied to measure sustainable investments within a portfolio (rather than a company or investment level test). By way of example, if a manager invests in a company with a 20% renewable energy business, the question was whether 100% of the company should be seen as a sustainable investment (noting that the other limbs of the “sustainable investment” test apply to the whole company) or just 20%? This was a potentially significant question for Article 9 products, as they must have 100% sustainable investments (subject to certain exceptions) and so a revenue / economic activity based calculation would have meant that they are potentially unable to meet the 100% Article 9 requirement and would have had to downgrade.
Helpfully, the Commission have again confirmed that the Article 2(17) sustainable investment definition “does not prescribe any specific approach to determine the contribution of an investment to environmental or social objectives. Financial market participants must disclose the methodology they have applied to carry out their assessment of sustainable investments” and that “the notion of sustainable investment can therefore also be measured at the level of a company and not only at the level of a specific activity”. Accordingly, there is no need to do a revenue level attribution in the calculation (i.e. 20% in our example above).
Article 9(3) funds tracking EU PABs / CTBs
The Commission has made two helpful clarifications here:
- Article 9(3) funds that passively track EU PABs/CTBs don’t need to additionally ensure compliance with the Article 2(17) sustainable investments test – i.e. just tracking an EU PAB or CTB is sufficient to be an Article 9 fund. This view back tracks from previous guidance given by the EU authorities on this point (as they had previously stated that Article 2(17) must be applied on top – which had even resulted in certain FMPs downgrading their funds to Article 8) and we expect will be welcomed by the industry although some will likely think that this guidance has come too late.
- Funds with a carbon reduction objective under Article 9(3) can be actively managed and don’t have to passively track EU PABs/CTBs (“The SFDR is a transparency regulation, it does not prescribe the use of Paris-Aligned Benchmarks (‘PAB’) or Climate Transition Benchmarks (‘CTB’) nor the use of any other specific type of index”). Note: such actively managed funds would however have to comply with the Article 2(17) SFDR sustainable investments test.
Can Article 8 funds promote carbon emissions reduction as a characteristic without becoming an Article 9(3) fund?
Helpfully the Commission’s view is yes – but the FMP must ensure that its disclosures and marketing materials for the product do not mislead investors into thinking that the product gas a carbon emissions reduction objective. The expectation therefore seems to be that any funds with a carbon reduction “objective” must only be Article 9 funds which either track an EU PAB/CTB, or are actively managed and comply with the SFDR sustainable investments test as well.
Considering PAIs at product level – is disclosure of PAIs sufficient?
The ESAs had basically asked the Commission to clarify whether a product could claim to “consider” Principal Adverse Impacts (“PAIs”) just by disclosing PAI metrics at product level (e.g. publishing GHG emission figures at product level). The Commission have confirmed that disclosure of PAI metrics is not sufficient and that firms must also additionally disclose the policies and procedures they have put in place to mitigate the PAIs. FMPs should therefore be incorporating mitigation of PAIs in their investment framework (e.g. engagement, due diligence, investment screens etc.) in order to say that PAIs are considered at product level – disclosure of PAI figures by itself will not be enough.
500 employee threshold for entity level PAI disclosures
The Commission was asked to clarify how interim workers or workers employed by shared-service centres should be counted for the purposes of the 500-employee threshold for mandatory entity level PAI disclosures. The Commission states that since SFDR does not contain a definition it must be determined by reference to the definition of employee set out in the applicable national law.
The Commission was also asked whether the exemption in Article 23(5) of the Accounting Directive from drawing up consolidated financial statements and management reports for parent companies which are also subsidiaries of a larger group would apply to the entity level PAI disclosures for “parent undertakings of a large group”. The Commission clarifies that this exemption is not relevant to SFDR.
Periodic reporting for portfolio management
The ESAs queried how frequently SFDR periodic reports should be provided in a portfolio management context given that, by default, MiFID portfolio management reporting should be provided quarterly whilst Recital 21 of SFDR suggested SFDR periodic reports should only be provided annually. The Commission helpfully confirmed the existing market view that SFDR periodic reports should just be provided annually, and suggested it should be in “every fourth report”, seemingly providing flexibility for portfolio managers to choose the exact cycle of reporting. However, the Commission does not address the fact that, depending on the circumstances, MiFID portfolio management reports might not be provided on a quarterly basis (or indeed at all if an exemption applies). Hence it is still somewhat unclear how the periodic reporting obligations under SFDR would apply in those circumstances.
