SFDR: Commission provides helpful clarity on ESAs’ questions from September 2022

The European Commission has published its long-awaited response to the list of additional questions raised by the European Supervisory Authorities (ESAs) on the SFDR in September 2022. The clarifications will be welcomed by many asset managers, particularly those with Article 9 funds, and provide helpful guidance that will largely avoid the re-working of current disclosures for managers of Article 8/9 funds.

There are, however, potentially significant developments for managers subject to or opting-in to the fund-level PAI regime, with the Commission clarifying that in addition to describing the PAIs of their investment decisions, managers must also disclose the policies put in place to mitigate such impacts.

Managers to decide how to define “sustainable investment”

Under the first limb of the SFDR definition of “sustainable investment”, a fund must invest in an economic activity that contributes to an environmental or social objective (in addition, investments must also do no significant harm to any other environmental or social objective and investee companies must follow good governance practices).

The Commission has confirmed that the SFDR does not prescribe a set approach for determining the contribution of an investment to environmental or social objectives. Accordingly, managers are provided with the discretion to use their own methodology for determining whether investments are sustainable. Importantly however, the Commission expects managers to disclose the methodologies for how they have determined that investments meet the definition of “sustainable investment”. This emphasises the need for managers to ensure they clearly set out the basis upon which an investment will be considered sustainable.

The ESAs previously queried whether the first limb of the definition of “sustainable investments” (as above) required managers to breakdown their investments on a specific economic activity basis rather than consider this across the investment itself. By way of example, if a manager were to invest EUR 100,000 in a renewable energy company, and only 20% of the company’s activities contributed to environmental/social characteristics, the ESAs sought clarification on whether the entire EUR 100,000 holding, or only 20% of the holding, should be considered a “sustainable investment”.

The Commission has clarified that the notion of sustainable investments can apply in respect of both the fund’s investment itself (such as the general equity or debt of an investee company) as well as at the level of the investee company’s specific economic activity. This pragmatic approach will be welcomed by managers of Article 9 funds and largely avoids the introduction of minimum thresholds. The specific reference to debt from the Commission also provides scope for credit managers to fall within scope of Article 9.

As part of the policy choice of providing managers with the discretion to determine the basis on which their investments are “sustainable investments” however, the Commission highlight the increased responsibility managers owe to investors which “means they should exercise caution when measuring the parameters of ‘sustainable investment’”. It is likely that Article 9 funds will remain a key area of supervisory focus from regulators therefore and whilst the guidance provides flexibility the regulators see the bar as high for Article 9 funds.

Transition funds 

In respect of the ESAs’ query of whether an economic activity can contribute to the environmental objective of climate change mitigation if it is only covered by a transition plan, the Commission has commented that a transition plan aiming to achieve no significant harm in the future would not meet the definition for sustainable investment. Accordingly, this suggests that transitioning assets must meet the do no significant harm and good governance tests on day one (rather than in the future) to be considered “sustainable” under the SFDR. This is consistent with the approach adopted in the market.

Article 9(3) SFDR funds with the objective of carbon emissions reduction 

The Commission has clarified that funds with a reduction in carbon emissions as their objective can be both actively managed (i.e. not track the Paris-Aligned Benchmarks (PAB) or Climate Transition Benchmarks (CTB)) or passively managed (by tracking the PAB or CTB).

Where funds falling within scope of Article 9(3) (i.e. that have a reduction in carbon emissions as their objective) do not passively track the PAB or CTB (i.e. are actively managed) then managers must provide a detailed explanation 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.

Funds falling within scope of Article 9(3) that passively track the PAB or CTB do not need to provide the above explanation.

A fund may promote carbon emissions reduction under Article 8

The helpful clarification that funds with investment characteristics of carbon emissions reduction do not exclusively fall into the Article 9(3) category is caveated with guidance that the fund’s Article 8 disclosures should not mislead investors into thinking that the fund has a sustainable investment objective.

“Considering” PAIs at fund-level

The Commission has clarified that when “considering” PAIs at the fund-level, managers must not only describe the adverse impacts of their investment decisions, but also disclose the procedures put in place to mitigate such impacts. This is a relatively significant development for managers of funds that are subject to or opt-in to the fund-level PAI regime that goes beyond the Level 1 SFDR requirement (which requires managers to disclosure how PAIs are considered) and more closely aligns the fund-level PAI regime with the requirements of the manager-level PAI regime. The guidance is particularly noteworthy in light of the ESAs’ proposals to extend the list of mandatory PAI indicators (which we covered here).

500 employee threshold – who constitutes “employee”?

In respect of individuals employed by third parties that invoice their services back to the manager (such as interim workers or workers that provide services within a group as part of a shared services agreement), the Commission has confirmed that the definition of “employee” (for the purposes of the 500 employee threshold under the manager-level PAI regime) should follow that under national law.

This will be particularly helpful to asset managers that operate within a larger group that have more than 500 employees. 

SFDR periodic reports for MiFID firms providing portfolio management services

The Commission has clarified that MiFID firms providing portfolio management services subject to quarterly reporting are only required to provide the SFDR periodic reports for Article 8/9 funds on an annual basis and that the SFDR periodic reports would need to be included in every fourth report.

Up next - the ESAs’ final proposals

The Commission’s responses to the ESAs’ questions close the loop on long-awaited guidance that will come as a relief to many managers and, for the time being at least, means that it remains largely status quo for managers in their SFDR journeys. The publication of the ESAs’ final proposals (which we covered here) will be the next topic on the horizon with potentially significant changes lined up for the Article 9 category of fund.