New Q&As on Sustainable Finance Disclosure Regulation (SFDR) adopted by the European Commission (EC)

The European Securities Authorities (ESAs) issued a series of questions to the EC in relation to the interpretation of SFDR in September 2022. The EC published its answers to these questions on 14 April 2023. These questions were raised by the ESAs for clarification in anticipation of the implementation of the Commission Delegated Regulation (EU) 2022/1288 supplementing the SFDR by 31 December 2022. While it has taken seven months for the EC to provide these answers, we expect the additional clarification they provide will be broadly welcomed by asset managers.

At a high level, the Q&As cover the definition of "sustainable investments", what it means to "consider" principal adverse impacts (PAIs), the definition of Article 9(3) financial products, the timing of periodic reports for portfolio management services and the 500 employee test for mandatory PAI compliance.

For consistency, the EC also updated answers adopted previously, on 6 July 2021 and 13 May 2022.

We have summarised the Q&As as follows:

1. How does the definition of "sustainable investment" in Article 2(17) of SFDR apply to investments in funding instruments that do not specify the use of proceeds, such as general equity or debt of an investee company?

The EC response provides that SFDR does not prescribe any specific approach to determine the contribution of an investment to environmental or social objectives. Rather financial market participants (FMPs) must disclose the methodology they have applied to carry out their assessment of sustainable investments, including how they determine the contribution of those investments to environmental or social objectives, do not cause significant harm to any environmental or social objective and how investee companies meet the good governance practices requirements.

The EC goes on to state that SFDR does not limit sustainable investments to funding instruments which specify the use of proceeds so that general equity or debt of the investee companies could qualify as "sustainable investments". In addition, the EC notes that products disclosing under Article 9(3) of SFDR tracking a Paris Aligned Benchmark (PAB) or a Climate Transition Benchmark (CTB), which are often based on portfolios of shares or bonds of investee companies, are deemed to make sustainable investments.

The EC concludes on this basis, that the notion of sustainable investment can be measured at the level of the company and not only at the level of the specific activity.

Asset managers may welcome this clarification which allows firms to retain discretion to apply their own assessment methodology as to what is a sustainable investment. In addition, asset managers who we have reclassified some Article 9(3) products to Article 8 may now be in a position to consider reclassifying those products to disclose under Article 9(3) where they track PAB or CTB indices.

2. How should "investment in an economic activity that contributes to an environmental objective" or "investment in an economic activity that contributes to a social objective" under Article 2(17) of SFDR be interpreted?

The EC responded that SFDR does not set out minimum requirements that qualify concepts such as contribution, no significant harm or good governance, besides the need for FMPs to carry out their own assessment for each investment and disclose the underlying assumptions. Noting that this places responsibility on the investment community, the EC recommended that they should "exercise caution" measuring the key parameters of a "sustainable investment".

The EC went on to note that sustainable investments are required to not significantly harm any of the objectives referred to in Article 2(17) and therefore, referring to a transition plan aiming to achieve that the whole investment does not significantly harm any of those objectives in the future, could for instance not be considered as sufficient.

We expect that asset managers will welcome this further flexible approach in relation to assessing contribution to an environmental or social objective. The warning that this approach places responsibility on the FMP, which should "exercise caution" will be a reminder to asset managers to be aware of the greenwashing risks associated with this approach.

It should also be noted that the EC's response in relation to investee companies which have a transition plan aimed at mitigating harm to environmental or social objectives may not itself be sufficient to qualify as a sustainable investment.

3. Referring to the EC's Q&A answer regarding Article 9(3) of SFDR in July 2021, is it correct to consider that financial products that have an Article 9(3) objective of reduction in carbon emissions can either be products with a passive or active investment strategy?

The EC responded that Article 9(3) is neutral in terms of product design and SFDR is a transparency regulation, which does not prescribe the use of a PAB or CTB index. The EC noted that where no PAB or CTB index is passively tracked, the SFDR requires detail of how the continued effort of attaining the objective of reducing carbon emissions is ensured in view of achieving the long-term global warming objectives of the Paris Agreement.

EC's response is clear that in Article 9(3) may have either a passive or an active investment strategy.

4. Can financial products promote carbon emissions reduction as an "environmental characteristic", as opposed to having it as an "objective"? In other words, can a financial product disclose carbon emissions reduction as an environmental characteristic under Article 8 of SFDR or should any product which targets carbon emission reduction always be considered having carbon emissions reduction as an "objective" and therefore will be required to disclose under Article 9(3)?

The EC responded that Article 8 of SFDR does not limit the type of characteristics that can be promoted by a financial product so does not prevent a product from having carbon emissions reduction as part of its investment strategy, provided the product does not have sustainable investment as its objective.

It is notable that the EC points out that marketing communications should not contradict the content of disclosures made pursuant SFDR to lead investors to believe that a product pursues sustainable investment, where the promotion of carbon emissions reductions is only a mere characteristic of the product investment strategy.

5. Can financial products with a passive investment strategy which designates a PAB or CTB index as a reference benchmark automatically be deemed to fulfil the requirements of Article 9(3) of SFDR in conjunction with Article 2(17) of SFDR? Likewise, can financial products with an active investment strategy focused on carbon emissions reduction be deemed to satisfy the conditions of Article 9(3) of SFDR in conjunction with Article 2(17) of SFDR where they apply the same requirements as those applied by PAB and CTB pursuant to the BMR framework?

The EC confirmed that where financial products are passively tracking PAB or CTB indices, they can be considered that they do not fall under Article 9(3) second paragraph and consequently FMPs do not have to provide a detailed explanation for how the continued effort of attaining the objective of reducing carbon emissions is ensured as these products are deemed to have sustainable investments as defined in Article 2(17) of SFDR as their objective.

EC went on to clarify that where products which are focused on carbon emissions reduction that are actively managed, FMPs must explain why they consider those products have sustainable investment as their objectives.

Again, this should be welcome news to asset managers who have had to reclassify Article 9(3) products as Article 8.

6. The meaning of "consider" in Article 7(1)(a) of SFDR? Could "consideration" of PAIs by a financial product mean the financial product only discloses the relevant PAIs of the investments or does "consideration" require disclosure of the action taken by the FMP to address the PAIs of the product's investments?

The EC clarified, referencing recital 18 of SFDR, that the description related to the adverse impacts shall include both the description of the adverse impacts and the procedures put in place to mitigate those impacts.

We expect there may have been different views taken of the requirement to "consider" PAIs but this level of clarification should be welcomed by asset managers. It is notable, that the action to be taken in order to mitigate any identified impact, is not prescribed and so could include a broad range of steps which could be taken in respect of relevant investee companies.

7. Does the reference to the "average number of 500 employees" under Article 4 include workers who are assigned to the FMP, even if employed by a third party that invoices their services back to the FMP?

The EC responded that the definition of who constitutes an employee should be governed by the national law of the relevant Member State.

8. In the context of periodic disclosure frequency for portfolio management services, should an in scope FMP provide quarterly reports based on the SFDR templates or can they use one of the quarterly reports to present a yearly report based on the SFDR templates for portfolio management?

The EC responded that portfolio management services should only require one SFDR annual report to be attached to one of the quarterly reports.

Conclusion

The EC's clarifications should be welcomed by asset managers and the generally flexible approach, particularly in relation to determining what can be considered sustainable investments under Article 2(17) of SFDR, should mean that asset managers will not have to significantly alter their methodologies and processes. This may provide some temporary relief in advance of the review of the SFDR RTS being carried out by the ESAs under the joint consultation paper issued earlier in April 2023 and the EC's comprehensive assessment of the implementation of SFDR.

Please speak with your usual contact on the ALG Asset Management & Investment Funds team if you would like to discuss the EC's responses in more detail.

Date published: 18 April 2023