Though uncertainties remain, the document has been welcomed by the market and provides clarity on a number of salient questions
On 5 April 2023, the European Commission published a Commission Decision answering questions raised by the European Supervisory Authorities (ESAs) on the interpretation of the Sustainable Finance Disclosure Regulation (SFDR), together with amendments to certain answers the Commission had previously given on the same topic.
Although some interpretative difficulties remain, the market generally welcomes the answers as pragmatic and contributing to a clearer and more workable SFDR regime.
Below, we provide a summary of the key takeaways from the Commission Decision.
Published in the Official Journal of the European Union on 9 December 2019, the SFDR sets out a mandatory disclosure regime on a wide range of environmental, social and governance (ESG) metrics and criteria, applicable to asset managers and other financial market participants (FMPs). The SFDR divides funds, segregated mandates and other financial products into three different categories, referred to by the market as "Article 6", "Article 8" and "Article 9" products, with Article 9 products being those with the highest sustainability ambitions and disclosure obligations.
Although the SFDR has only been applied since 10 March 2021, and its implementing provisions - the Regulatory Technical Standards (RTS) - since 1 January 2023, they have already significantly impacted products, disclosures and investor demand in the financial industry. Being a novel regulation with many uncertainties and gaps, the European Commission, the ESAs and many national EU regulators have published guidance and interpretations over the past two years. In doing so, they have also sought to keep up with fast evolving market practices, new products and standards.
The recent Commission Decision contains the third set of Q&A by the Commission, following two previous Q&As in decisions published in July 2021 and May 2022. Unsurprisingly, all three decisions include guidance on the:
- Boundaries of Article 9 products and, in particular, what it means to have sustainable investment as their objective.
- Interpretation of sustainable investments, as defined in Article 2(17) of the SFDR.
Following the first two Commission decisions, there had been considerable uncertainty as to the meaning of sustainable investments. According to a report, this led to several funds previously listed as Article 9 funds voluntarily reclassifying to Article 8 funds to avoid falling foul of the regulation.
The present Commission Decision aims to address this issue, as well as providing further guidance on a number of open points submitted for clarification by the ESAs in September 2022.
Key points to note on the Commission Decision are as follows:
1. Freedom of choice in relation to the concept of "sustainable investment"
The Commission confirms that the sustainable investment concept under Article 2(17) of the SFDR is open to all types of policies and methodologies. Accordingly, FMPs can make their own policy choices as long as they are consistent, reasonable and justifiable in light of the high sustainability ambition the market expects from sustainable investments. In particular:
- Sustainable investments are not limited to investments in specific economic activities. Sustainable investments may be made in a specific economic activity (e.g., by applying use of proceeds restrictions or investing in special purpose vehicles or other companies with a limited business purpose) as well as for a general purpose (e.g., in a company carrying out several economic activities). It is up to the FMP to determine the circumstances under which such a general-purpose investment may be considered to be contributing to an environmental or social objective (e.g., revenue thresholds, proportional calculation, pivotal role of a specific activity for a sustainable investment objective). The Commission expressly recognises that FMPs may use a variety of methods to make this determination.
- There are no pre-defined minimum requirements or prescribed methodologies for classifying a sustainable investment. While a sustainable investment must meet the key parameters in Article 2(17) of the SFDR (namely, being invested in an economic activity that contributes to an environmental or social objective; not significantly harming any of those objectives (DNSH); and ensuring that investee companies follow good governance practices), the SFDR does not set any minimum requirements or prescribe specific methodologies. The Commission reaffirms that the concept of sustainable investment is independent from the EU Taxonomy Regulation and its implementing provisions (EU Taxonomy). FMPs must - and indeed are given freedom to - design their own policy and make an assessment for each investment. However, such policy and assessment must be disclosed and are subject to public and regulatory scrutiny.
- Transition plans may not be sufficient to meet the DNSH test. The Commission confirms that a sustainable investment must meet the DNSH test at the point of investment and that intended future mitigations of existing significant harm (e.g., via a transition plan) should not be sufficient. Accordingly, the existence of a transition plan does not, by itself, meet the DNSH requirement; the FMP is required to make its own assessment as to whether the investment causes significant harm to a sustainable investment objective at the point of investment. The Commission statement also means that impact strategies (as per the globally accepted GIIN impact investing definition will continue to sit both in Article 8 and 9 products since companies in transition may not always meet the DNSH test at the time of the investment.
2. Financial products with the objective of carbon emissions reduction
In the context of Article 9(3) of the SFDR, the Commission issued several pieces of guidance on carbon emissions reduction strategies for Article 9 and Article 8 financial products:
- Firstly, the Commission confirms that Article 9(3) covers all products having carbon emissions reduction as their sustainable investment objective, regardless of whether they are actively managed or passively tracking an EU Climate Benchmark [insert link: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex:32019R2089.
- Secondly, products passively tracking an EU Climate Benchmark will be deemed to have a sustainable investment objective, while actively managed products would need to prove how they align with an EU Climate Benchmarks methodology. However, passively tracking an EU Climate Benchmark does not release managers from all SFDR assessment obligations. Managers of active and passive products must both prove how they meet the DNSH and good governance criteria under the SFDR.
- Thirdly, the Commission also provides the much-needed confirmation that Article 8 products can also pursue carbon emissions reduction strategies as long as their disclosures make it sufficiently clear that the product does not have a sustainable investment objective.
3. Considering principal adverse impacts (PAIs) of investment decisions on sustainability factors at product level
One of the greatest mysteries of the SFDR has been the distinction between "considering" PAIs (a concept used in Articles 4 and 7 of the SFDR) and "taking into account of" PAI (as required under the SFDR RTS for sustainable investments). In respect of how to deal with PAI at product level under Article 7, the Commission confirms that the information to be disclosed should include PAI as well as the procedures to mitigate those impacts. Accordingly, it's unlikely that only mechanically collecting and disclosing PAI information without giving thought to mitigation would amount to "considering" PAI. Additionally, the Commission clearly does not establish any duty to achieve real mitigation and it also does not prescribe how ambitious the "considered" mitigation measures must be.
4. Application of the 500-employee threshold in Article 4(3) of the SFDR
All FMPs exceeding on their balance sheet dates the criterion of the average number of 500 employees during the financial year are obliged to "comply" with Article 4, meaning they must collect information on PAI and publish an annual PAI statement. The Commission clarifies that the term "employee" must be interpreted in light of the applicable national law. Moreover, the Commission confirms there is no "consolidation exemption" for the PAI-related obligations. An FMP participant falling under Article 4(3) cannot be considered to be exempt simply because its parent company is also subject to the same obligations. This clarification makes sense since the SFDR PAI disclosures are limited to the respective FMP and do not extend to its subsidiaries.
5. Periodic disclosures for portfolio management services
Periodic disclosure under the SFDR is tied to the periodic financial reporting for the respective product. However, the ESAs identified a potential contradiction between the periodic financial reporting for portfolio management services under MiFID II (to be made quarterly) and recital 21 of the SFDR (according to which periodic disclosures under the SFDR should be made annually). In its response, the Commission clarifies that firms providing portfolio management services are only required to provide the SFDR periodic disclosure on an annual basis, to be included in each fourth quarterly financial report (as of yearend) issued pursuant to MiFID II. However, there is still an area of uncertainty: under the MiFID II "Quick Fix" enacted in 2022, mandatory financial reporting to professional investors has been abolished entirely and it is now unclear whether the SFDR periodic disclosure tied to this reporting is nevertheless required. In light of the Commission's confirmation of the intention to have an annual SFDR periodic disclosure for portfolio management, it may be safest to also disclose on an annual basis in relation to professional investors.
Importance for the market and next steps
The Commission Decision reinforces the open nature of the SFDR, leaving room for asset managers to adapt it to their needs rather than prescribing specific methodologies and requirements. This is a clear signal to the ESAs and the many national regulators who would prefer a more prescriptive "labelling" approach, which is easier to supervise and for investors to understand. The French AMF, for example, recently published a position paper, proposing pre-defined minimum requirements for Article 8 and 9 products and a link to the EU Taxonomy.
In the Commission Decision, the Commission reconfirms that the SFDR is not intended as a labelling regime. While labels for retail investors may emerge over time (e.g., based on the proposed EU Ecolabel for financial products), the main purpose of the SFDR remains disclosure and not standardisation. Accordingly, FMPs should remain free to develop their own sustainability strategies, thus enabling the transition to a sustainable economy. It remains to be seen if the ESAs will share this position, in particular in light of their recent consultation on funds' names guidelines in which they have suggested minimum requirements for retail and professional investor funds using terms related to ESG, sustainability or impact in their names.
However, with great freedom comes great responsibility, since FMPs will have to make their own policy choices and justify these against the applicable regulation. The Commission and the ESAs also remain committed to combat greenwashing and, therefore, intend to keep a close eye on whether FMPs are disclosing their policies and methodologies in a comprehensive, fair and non-misleading way.
Finally, it's important to note that the relief provided by the Commission Decision may only be temporary. Following a request by the Commission in the April 2022, the ESAs simultaneously published an extensive consultation paper to amend the SFDR RTS which, in many ways, swings the balance back towards standardisation and more prescriptive supervision. We will soon share a separate analysis of the consultation paper.