The draft regulatory technical standards (RTS) set out detailed information relating to the content, methodology and presentation of certain environmental, social, and governance (ESG) disclosures required under the EU Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector (the Sustainable Finance Disclosure Regulation or SFDR1). These disclosure requirements will have significant implications for asset managers and funds.
On April 23, 2020, the three European Supervisory Authorities (European Banking Authority, European Insurance and Occupational Pensions Authority and European Securities and Markets Authority – the ESA's) issued a joint consultation paper seeking input on proposed ESG disclosure standards for financial market participants2, financial advisers3 and financial products4 (the CP). The standards have been developed under the SFDR, aiming to:
· Strengthen protection for end-investors;
· Improve the disclosures to investors from a broad range of financial market participants and financial advisers; and
· Improve the disclosures to investors regarding financial products.
In addition, the CP contains proposals under the recently agreed regulation on the establishment of a framework to facilitate sustainable investment (the Taxonomy Regulation5). The Taxonomy Regulation at Article 25 amends the SFDR by including a new Article 2(a) which sets out in more detail how to achieve greater clarity as to the content and presentation of the information in relation to the "do not significantly harm" (DNSH) principle6. The DNSH principal can be paraphrased as meaning that if an investment has a substantial positive environmental impact on an environmental objective (climate change mitigation for example), that investment objective cannot be achieved at the expense of other, different environmental objectives.
The CP contains 27 questions on which the ESA’s are seeking feedback from stakeholders on a number of measures to be included in the RTS. The CP responses are sought by 1 September 2020.
High Level summary of the RTS
The draft RTS relate to several disclosure obligations under the SFDR regarding the publication of:
· The details of the presentation and content of the information in relation to the principle of ‘do not significantly harm’ as set out in Article 2(17)7 and the new Article 2a of the SFDR8 consistent with the content, methodologies, and presentation of indicators in relation to adverse impacts9 referred to in Article 4(6) and (7) of the SFDR;
· A statement on an entity’s website of the due diligence policy in respect of the adverse impact of investment decisions on sustainability factors10 in relation to climate and other environment-related impacts (Article 4(6)) and adverse impacts in the field of social and employee matters, respect for human rights, anti-corruption and anti-bribery matters (Article 4(7));
· Pre-contractual information on how a product with environmental or social characteristics meet those characteristics or if an index has been designated as a reference benchmark, whether and how that index is consistent with those characteristics (Article 8 of the SFDR);
· Pre-contractual information to show, where a product has sustainable investment11 as its objective and (a) has a designated index as a reference benchmark, how that index is aligned with the sustainable investment objective and an explanation as to why and how that designated index aligned with the objective differs from a broad market index (Article 9(1)) or (b) if no index has been designated as a reference benchmark, an explanation on how that objective is to be attained (Article 9(2) and as referred to under Article 9(5) and (6) of the SFDR);
· Information on an entity’s website to describe the environmental or social characteristics of financial products or the sustainable investment; the methodologies used; the pre-contractual information referred to in Articles 8 and 9 and the periodic reports referred to in Article 11 (as referred to under Article 11(4) and (5) of the SFDR); and
· Information in periodic reports according to sectoral legislation specifying (a) the extent to which products with environmental and/or social characteristics meet those characteristics, and (b) for products with sustainable investment objectives and products the objective of which is a reduction in carbon emissions: (i) the overall sustainability-related impact of the product by means of relevant sustainability indicators and (ii) where an index has been designated as a reference benchmark, a comparison between the overall impact of the financial product with the designated index and a broad market index through sustainability indicators (Article 11 of the SFDR).
The SFDR does not provide for the development of RTS in relation to every article. The obligation on any financial market participant or financial adviser (as defined in the SFDR) to disclose its policies on how it integrates sustainability risks12 in its investment decision making process (per Article 3 of the SFDR) as well as in its remuneration policies (per Article 5 of the SFDR) and publish such information on its website and in pre-contractual disclosures (per Article 6 of the SFDR) remains unchanged by the CP. However, the draft RTS significantly increases those disclosure requirements imposed on financial market participants or financial advisers for whom sustainable investment is a key goal, as compared to those financial market participant or financial advisers who merely confine themselves to disclosing sustainability risk in their investment process.
Purpose of Consultation Paper and the objectives of the draft RTS
The overall objective of the draft RTS is to ensure that the financial market participant and financial advisers disclose relevant information regarding the due diligence policies of financial market participants and financial advisers in order for end investors to make informed decisions. The ESAs’ working group believes that the level of disclosure should be more than just high-level statements about policies. Article 4(2)(b) of the SFDR would seem to necessitate a more comprehensive disclosure of the adverse impacts of investment decisions on sustainability factors.
The ESAs’ working group also believes that the measures adopted should ensure sufficient consistency across the EU to make meaningful comparison possible for end investors, as set out in Recital (9) of the SFDR. End investors should be able to rely on the adverse sustainability impact disclosures made by financial market participants and financial advisers to explain sufficiently clearly how they take into account adverse impacts and the actions financial market participants take or intend to take to address them.
Principal adverse impact disclosure - Article 4(6) and 4(7) of the SFDR
The ESAs have laid out a set of mandatory indicators in Annex I of the draft RTS that they propose financial market participants should always consider to be principal adverse impacts of their investment decisions. These are accompanied by a suggested set of additional, non-exhaustive, indicators that are intended to be helpful in identifying, assessing and prioritising additional principal adverse impacts.
The draft RTS includes:
· A mandatory reporting template (Annex 1, table 1 of the RTS) to use for the statement on considering principal adverse impacts of investment decisions on sustainability factors. The template mandatory reporting items include a summary, scope, the principal adverse impacts (with a list of 32 mandatory indicators such as carbon footprint, solid fossil fuel exposure, water emissions, gender pay gap and child labour), policies on the identification of and actions taken in relation to principal adverse impact, notably as regards due diligence processes and engagement policies, as well as historical comparisons. The items listed in the mandatory reporting template are a core set of indicators that the ESAs deem will always lead to principal adverse impacts of investment decisions on sustainability factors, irrespective of the result of the assessment by the financial market participant. In addition, the CP notably recommends a mandatory graphical representation illustrating the planned proportions of investments with sustainable characteristics or objectives. It is important to note that not only is there a requirement to update this information annually, the RTS also requires that this statement should be updated each year to show progress made towards reducing the principal adverse impacts of investment decisions on environmental and societal factors;
· A set of indicators (Annex 1, tables 2 and 3 of the RTS) for both climate and environment-related adverse impacts (which lists 11 indicators) and adverse impacts on of social and employee matters, respect for human rights, anti-corruption and anti-bribery matters (which lists seven (7) indicators);
· A statement to be published where adverse impacts of investment decisions are not considered by financial market participants under Article 4(1)(b) and financial advisers under Article 4(5)(b) of the SFDR. The RTS require this statement to be published on financial market participant’s or financial adviser’s websites in a separate section titled, ‘No consideration of sustainability adverse impacts’, which is to start with a prominent statement that the financial market participant does not consider the adverse impacts of its investment decisions on sustainability factors and why it does not. The RTS also imposes a requirement on financial market participant to include, where relevant, information on whether and, if so, when they intend to consider those adverse impacts by reference to at least those principal adverse impacts stipulated in Annex 1 of Table 1. It is important to note that the option not to consider adverse impacts of investment decisions is not available from 30 June 2021 to financial market participants (or a financial market participant that is a member of a group) with 500 or more employees13; and
· Requirements for financial advisers in line with their obligations under Article 4(5)(a) of the SFDR.
Product pre-contractual disclosure - Article 8 and 9 of the SFDR, including “Do not significantly harm” – Article 2a of the SFDR
The draft RTS for Articles 8 and 9 of the SFDR set out the details of the content and presentation of the information to be disclosed at the pre-contractual level for products in the sectoral documentation (such as a UCITS prospectus or the Article 23(1) disclosure by an AIFM) prescribed by Article 6(3) of the SFDR. The draft RTS include:
· A requirement to use a mandatory reporting template (yet to be developed) for the presentation of pre-contractual disclosure. The ESAs states that they have delayed the drafting of templates (such as that in Table 1 of Annex 1) for these disclosures until there is greater certainty regarding what should be disclosed;
· A list of items to be included in the reporting clearly indicating the type of product and how the environmental or social characteristic (or combination thereof) or the sustainable investment objective of the product are achieved – this also includes narrative and graphical representations as well as specific descriptions in relation to the use of derivatives;
· Additional items of disclosure where the product designates an index as a reference benchmark; and
· Requirements for products making sustainable investments regarding how the product complies with the “do not significantly harm” principle from Article 2(17) of the SFDR in relation to the principal adverse impact indicators in Annex I of the draft RTS.
Article 6(3) of the SFDR requires that the product disclosure requirements must be integrated into existing sectoral disclosure formats. At the same time ESAs are asked to consider that the product disclosures should be “accurate, fair, clear, not misleading, simple and concise” in Article 8(3) and 9(5) of the SFDR.
The ESAs are of the view that it is more advantageous to provide the sustainability-related information in a dedicated section and that templates should be provided to harmonise how the information requirements should be met to improve comparability.
Product website disclosure - Article 10 of the SFDR, including “Do not significantly harm” – Article 2a of the SFDR
The draft RTS for product website disclosure set out the details of the content and presentation of information to be publicly disclosed on the website by the financial market participant for Article 8 and Article 9 of the SFDR products. This information must be provided in a section titled ‘Sustainability-related disclosures’ on the same part of the website as the other information relating to the financial product, including marketing communications. The draft RTS:
· Set out where and how the financial market participant must publish the information on the website, including the need to publish a two-page summary;
· Includes a list of items to be included in the disclosure, focusing on the methodology employed, the data sources used, and any screening criteria employed. In addition to requiring details as to the methodologies and data, there is an obligation to describe any limitations to the methodologies and the data sources, as well as how such limitations do not affect the attainment of the environmental or social characteristics promoted; and
· Includes requirements for products making sustainable investments regarding how the product complies with the “do not significantly harm” principle from Article 2(17) of the SFDR in relation to the principal adverse impact indicators in Annex I of the draft RTS.
Product periodic disclosure - Article 11 of the SFDR, including “Do not significantly harm” – Article 2a of the SFDR
The draft RTS for periodic product disclosure set out the details of the content and presentation of information to be disclosed for Article 8 and 9 of the SFDR products in the sectoral documentation prescribed in Article 11(2) of the SFDR. The draft RTS include:
· A requirement to use a mandatory reporting template (yet to be developed) for the presentation of the periodic disclosure;
· A granular list of items to be included in the reporting, focusing on the success of the product in attaining its environmental or social characteristic (or combination thereof) or sustainable investment objective. This includes a requirement to list the “top investments of the financial product” which requires inclusion of a list, in descending order of size, of the 25 investments constituting on average the greatest proportion of investments of the financial product during the reference period, including the sector and location of those investments. Another obligation is to include details on the “proportion of sustainability-related investments” which requires a graphical representation that illustrates those proportions and a narrative to accompany such graphical illustration; and
· Requirements for products making sustainable investments regarding how the product has successfully complied with the “do not significantly harm” principle from Article 2(17) of the SFDR in relation to the principal adverse impact indicators in Annex I of the draft RTS.
The Impact Assessment shows that the ESA's have not drafted the RTS without considerable thought. There is no doubt that the detail that the CP proposes financial market participants include is very clear and prescribed – leaving little room for doubt as to what needs to be included.
The flip-side to this is the fact that the obligations are significant. The Impact assessment notes that “the impact of introducing systems and processes to report the principal adverse impacts and the actions taken and planned may be significant, depending on the size of the investments undertaken and the kinds of exposures of the investments (e.g. sectors, countries).”
As mentioned above, as a basic starting point, there are 32 mandatory reporting items in the template. When these are taken together with (a) the graphical representation which “illustrate the planned proportions of (i) the total investments that are sustainable investments and, where relevant, the subdivision of those sustainable investments between environmental or social objectives and (ii) the total investments other than those in point (i) that contribute to the attainment of the environmental or social characteristics promoted by the financial product and, where relevant, the subdivision of those investments between environmental or social characteristics” and (b) the narrative which must explain “the planned proportions in point (a); distinguishing between direct holdings in investee companies and all other types of exposures to those companies (ii) the purpose of the planned remainder of the investments, including a description of any potential minimum environmental or social safeguards and whether those investments are used for hedging, relate to money market instruments or are investments for which there is insufficient data; and (iii) the planned proportion of investments in different sectors and sub-sectors, including the fossil fuel sectors”, and then adding further detail on derivatives and benchmarks - one starts to get an understanding as to the extent and depth of the information that is expected.
Bearing in mind that this level of detail is to be provided just in relation to sustainability, the overall information package provided to investors is extensive, and possibly excessive. As such, we would hope that following the consultation, the final detail of these disclosures may be different or even shortened. Nevertheless, the relatively short deadline between the closing of the CP (September 1, 2020) and the deadline by which the draft RTS must be finalized by the ESAs taking into account the results of the consultation (due 30 December 2020, with the exception of the RTS under 4(7) of the SFDR) is challenging, to say the least.
Should the RTS come into force in a form largely unchanged from the current draft CP, then financial market participants face large hurdles, not just in terms of devising and putting in place systems to provide the requisite information, but they also have an incredibly short period of time in which to prepare given that the SFDR and the RTS are scheduled to apply from March 10, 2021. The ESAs are aware of this timing concern, indeed they reference it in the introduction to the CP so it is possible that this deadline of March 10, 2021 may be delayed.
1) Click here to access Dechert’s OnPoint “Disclosure Regulation – What Is It and Who Is Impacted?”
2) Per article 2(1) of the SFDR “‘financial market participant’ means: (a) an insurance undertaking which makes available an insurance‐based investment product (IBIP); (b) an investment firm which provides portfolio management; (c) an institution for occupational retirement provision (IORP); (d) a manufacturer of a pension product; (e) an alternative investment fund manager (AIFM); (f) a pan‐European personal pension product (PEPP) provider; (g) a manager of a qualifying venture capital fund registered in accordance with Article 14 of Regulation (EU) No 345/2013; (h) a manager of a qualifying social entrepreneurship fund registered in accordance with Article 15 of Regulation (EU) No 346/2013; (i) a management company of an undertaking for collective investment in transferable securities (UCITS management company); or (j) a credit institution which provides portfolio management;”
3) Per article 2(11) of the SFDR “‘financial adviser’ means: (a) an insurance intermediary which provides insurance advice with regard to IBIPs; (b) an insurance undertaking which provides insurance advice with regard to IBIPs; (c) a credit institution which provides investment advice; (d) an investment firm which provides investment advice; (e) an AIFM which provides investment advice in accordance with point (b)(i) of Article 6(4) of Directive 2011/61/EU; or (f) a UCITS management company which provides investment advice in accordance with point (b)(i) of Article 6(3) of Directive 2009/65/EC”.
4) Per article 2(12) of the SFDR “‘financial product’ means: (a) a portfolio managed in accordance with point (6) of this Article; (b) an alternative investment fund (AIF); (c) an IBIP; (d) a pension product; (e) a pension scheme; (f) a UCITS; or (g) a PEPP.”
5) Regulation of the European Parliament and Council for the establishment of a framework to facilitate sustainable investment, and amending Regulation 2019/2088 on sustainability-related disclosures in the financial services sector (https://data.consilium.europa.eu/doc/document/ST-5639-2020-INIT/en/pdf). The Taxonomy Regulation is not yet in force. It needs to be adopted by the European Parliament at second reading before it can be published in the Official Journal of the EU (“OJ”). It will enter into force 20 days following publication in the OJ. For more details on the Taxonomy Regulation, please click here to access Dechert’s ESG Snapshot “Overview of the EU Taxonomy Regulation”
6) Cf. article 2a of the SFDR as amended by article 25 of the Taxonomy Regulation.
7) Per Article 2(17) of the SFDR, "'sustainable investment' means an investment in an economic activity that contributes to an environmental objective, as measured, for example, by key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land, on the production of waste, and greenhouse gas emissions, or on its impact on biodiversity and the circular economy, or an investment in an economic activity that contributes to a social objective, in particular an investment that contributes to tackling inequality or that fosters social cohesion, social integration and labour relations, or an investment in human capital or economically or socially disadvantaged communities, provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance"
8) A new Article 2a will be inserted into the SFRD by Article 25 of the Taxonomy Regulation
9) Neither the SFDR nor the Consultation Paper define 'adverse impacts' but Recital 20 to the SFDR stipulates that principal adverse impacts "should be understood as those impacts of investment decisions and advice that result in negatives effects on sustainability factors".
10) Per Article 2(24) of the SFDR "'sustainability factors' mean environmental, social and employee matters, respect for human rights, anti‐corruption and anti‐bribery matters."
11) Cf. above footnote 7.
12) Per Article 2(22) of the SFDR, "'sustainability risk' means an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment".
13) Article 4(3) of the SFDR.