SFDR: The journey continues for asset managers - ESAs propose significant changes to Level 2 SFDR for Article 8/9 products

The European Supervisory Authorities (ESAs) have published a joint consultation on changes to Level 2 SFDR (or the SFDR RTS). If adopted, the proposals could result in a significant reworking of disclosures for managers of Article 8/9 funds and may require managers:

• That are subject to, or opt-in to, the PAI regime to uplift existing PAI disclosures due to the inclusion of additional mandatory social indicators and technical revision of the PAI indicators;
• To revisit the ‘do no significant harm’ (DNSH) disclosures of Article 8+ or 9 funds (i.e. funds that make a sustainable investment) due to changes in the DNSH test (see below) and the above changes to the PAI indicators;
• To disclose whether the fund has a greenhouse gas (GhG) emissions reduction target; and
• To update their pre-contractual and periodic disclosures to follow the updated templates which include an additional ‘dashboard summary’ (highlighting the fund’s key features) and new GhG emissions reduction target disclosures. Proposed updates are also made to the website disclosure to reflect the DNSH test and introduction of GhG emissions reduction target disclosures.

The ESAs’ consultation follows the Commission’s request for it to review and revise the RTS in respect of a broader review of the PAI regime and disclosure of decarbonisation targets in April 2022. The deadline for feedback on the consultation is 4 July 2023 and the ESAs have not provided a timeframe for the expected publication of the final rules.

DNSH test – introducing thresholds or alignment with the Taxonomy?

Arguably the most significant proposals relate to the revision of the DNSH test. The current DNSH disclosure requires manages of Article 8+/9 funds to describe how investments do no significant harm to any environmental or social sustainable investment objectives, with reference to how the PAI indicators are ‘taken into account’. As ‘taking into account’ is undefined, managers are currently provided with a wide discretion to design the DNSH methodology which (in the ESAs’ view) undermines comparability between products and increases the likelihood of greenwashing under ‘sustainable investments’.

The ESAs raise further concern on the inherent inconsistencies between the parallel concepts of the SFDR DNSH test (which based on investments made generally by a fund) and the DNSH test in the Taxonomy technical screening criteria (TSCs) (which is tailored to specific economic activities). The ESAs’ view is that only a fundamental reform of the SFDR Level 1 legislation and shifting to a single Taxonomy-based system for the DNSH test would resolve this.

Before any reform of the Level 1 legislative framework however, the ESAs proposals would require managers to disclose the quantitative thresholds they use in relation to each of the PAI indicators to determine that investments DNSH. Managers would be required to provide a concise explanation of how such thresholds were determined and provide a hyperlink to the section on the website where further explanations and the thresholds are disclosed. In addition the ESAs propose using an optional ‘safe harbour’ whereby investments that meet the criteria to be considered ‘environmentally sustainable’ under the Taxonomy (i.e. Taxonomy aligned) do not require further DNSH disclosures.

Additional mandatory social PAI indicators

The proposals extend the list of mandatory Table 1 PAI indicators to include an additional four social indicators relating to:

1. Amount of accumulated earnings in non-cooperative tax jurisdictions;
2. Exposure to companies involved in the cultivation and production of tobacco;
3. Interference in the formation of trade unions or election or work representatives; and
4. Share of employees earning less than adequate wage.

An additional six Table 3 indicators (which are opt-in) are also suggested: 

1. Excessive use of non-guaranteed-hour employees in investee companies;
2. Excessive use of temporary contract employees in investee companies;
3. Excessive use of non-employee workers in investee companies;
4. Insufficient employment of persons with disabilities in the workforce;
5. Lack of grievance/complaints handling mechanism for stakeholders materially affected by the operations of investee companies; and
6. Lack of grievance/complaints handling mechanism for consumers/ end users of the investee companies.

Further technical revisions are also proposed to the formulation of certain PAI indicators which include greater clarification about the specific numerators and denominators used, including the definition of ‘current value of all investments’, as well as treatment of derivatives.

The proposals will likely have a significant impact on managers that are subject to, or opt-in to, the manager-level PAI regime and will require a broader re-assessment of investments against the new framework. It will also widen the DNSH harm test (as this is based on the PAI indicators) and may also require managers to revisit the classification of Article 8+/9 funds (as such funds would have to DNSH to the additional mandatory indicators).   

GhG emissions reduction targets

For funds that have a specific GhG emissions reductions target, additional detailed disclosures are proposed relating to how such targets will be achieved (whether through divestment or investing in companies with lower GHG emissions), whether there is engagement with investee companies as well as an indication of the share of the fund’s investments covered by the GHG emissions reduction target. Managers will also be required to complete a template table setting out the dates the intermediate and final targets are expected to be achieved.

Simplification of product templates

The ESAs have also taken the opportunity to propose simplifying the pre-contractual and periodic report templates with the view to making the information clearer for retail investors. Key to this is the proposed replacement of the current tick-box on the first page of the product templates with a ‘dashboard’ setting out the fund’s environmental/social characteristics (and percentage figure of investments committed to promoting such characteristics) or sustainable investment objective, in addition to four core elements of:

1. The percentage figure of minimum sustainable investments committed to;
2. Percentage figure of minimum Taxonomy alignment;
3. PAI consideration; and
4. The GhG emissions reduction target.

The ESAs have suggested that the inclusion of a dashboard would potentially allow for the removal of the ‘investment tree’ in the asset allocation section of the disclosures.

The proposals set out in the consultation paper come in light of continued speculation of the overhaul of the Level 1 SFDR framework.  Whilst the proposals are still at the consultation stage, they highlight the evolving and uncertain SFDR landscape that asset managers continue to navigate. All eyes will be on the European authorities for the direction they decide to take on the SFDR.