ESG Hot Topics: Newly Proposed amendments to the RTS from the ESAs: key impacts and reflections on the Future of ESG Compliance

Greetings, fellow ESG enthusiasts! ??

Welcome to the 14th blog post of ESG Hot Topics. In the ever-evolving world of sustainable finance, it is crucial to stay informed about regulatory developments. Today, we will explore the relatively recent proposed changes and amendments to the regulatory technical standards ("SFDR RTS") under the EU Sustainable Finance Disclosure Regulation ("SFDR").

The amendments were published by the Joint Committee of the European Supervisory Authorities (the "ESAs") on December 4, 2023, i.e., report, 2023 (JC 2023 55), and this initiative began in April 2022 when the European Commission tasked the ESAs with developing draft RTS concerning the disclosure of the Principal Adverse Impacts ("PAI") of investment decisions on sustainability factors, as outlined in the Level 2 Delegated Regulation under SFDR. The aim was also to introduce disclosure requirements for financial products' decarbonization targets.

Following a consultation period in April 2023, the ESAs have now published their Final Report, detailing their draft RTS. These proposals include additional disclosures for sustainable investments, the introduction of new indicators for PAI, specifications for existing indicators, new disclosures on greenhouse gas ("GHG") emission reduction targets, and revisions to disclosure templates. The report is now with the European Commission, which will decide on the implementation of these suggested amendments.

First, we are very happy to see at A Triple C Consulting that the European Commission is so active and responsive in its work. The SFDR and the EU Taxonomy are very complex technical regulations where various regulations overlap and definitions are both divergent and coherent, which adds extra intellectual agility to comprehend the regulations. Not only for lawyers but also for portfolio managers and advisors that sell financial products.

The evolution of the SFDR RTS has been an interesting story to follow, and it’s kind of been the last safeguard of what the EU Sustainable Finance package aims to achieve, which is to promote transparency and allocate money towards more sustainable companies and projects.

In that light, it’s good to see that they have left out the below question/part of the existing RTS, which is:

"What is the minimum share of sustainable investments with an environmental objective that do not meet the criteria of the EU Taxonomy?"

This section is about minimum commitments. At the financial product level, FMPs must retain the liberty to commit either at the overall level of EU Taxonomy alignment or at the level of any of the sub-components. The RTS needs, therefore, to be made very clear about how FMPs are supposed to display their “break down” of overall Taxonomy commitment across the various sub-components if needed.

Indeed, as EU Taxonomy is measured at the activity level, the mix of the sub-components will be specific to each company; as a consequence, a requirement to break down the overall Taxonomy commitment will only reduce, or even nullify, FMPs ability to take meaningful Taxonomy commitments.

We therefore advise against introducing the notion of sustainable investments with an environmental objective that is not aligned with the EU Taxonomy, and especially against the notion of “minimum” commitment in relation to this indicator. Why?

1. First, the notion itself lacks definition and is confusing as it brings together two notions, “sustainable investments” and “EU Taxonomy alignment,” that are distinct.
2. Second, as usual in pre-contractual documentation, the term “minimum” means that the proportion must be respected at all times. This means that FMPs are able to breach this “minimum” proportion because they might not have enough sustainable investments mapped to an E objective or because they actually have too much of it.
3. Thirdly, as a consequence of the first two points above, committing to a minimum proportion here would entail that there will be cases, for instance, when companies will start reporting their Taxonomy alignment, where FMPs will have to sell companies because their Taxonomy alignment has increased and that this has led to a breach of this specific ratio. This is, of course, contrary to the purpose of the SFDR and its objective of fostering capital reallocation within the EU to finance a more sustainable economy.

At A Triple C, we are very happy that they have now changed the way they cover the essentials of Article 8 funds of the SFDR. Why? It is because the question of how it was structured before gave rise to a lot of confusion about the ‘promotion’ aspect of what Article 8 funds aim for and must achieve. This is sort of a topic in itself, and we have mentioned in previous posts that PAI serves as a great indicator or metric for the attainment of the E/S characteristics of Article 8 products. Words and semantics do matter, especially in legal interpretation, and here, in this proposed new template, they are emphasizing how they are achieved instead of attained; it is more intuitive and in direct relation to what an Article 8 fund has to achieve - which corresponds with the word 'promotion'; since it's a positive loaded word with a forward-leaning connotation. It simply means that something good or better will materialize in the future. How? Simple, we will provide an analogy: In finance, we all want to get promoted to climb the corporate ladder. The same is true with Article 8 funds, which need to make investments that achieve actual positive outcomes based on their holdings. We want to be promoted, with higher salaries, greater responsibilities, and a new title, same with Article 8 funds. They have to achieve something good in order to demonstrate that they actually promote any of the set E/S characteristics.

Consequently, we are pleased to see the introduction of GHG reduction targets in the proposed RTS, which is the 2.0 aspect of promotion. What do we mean by 2.0? It means that reductions will be specified, which is, per definition, good for the environment. There are so many E/S metrics related to Article 8 that can be set based on the Fund Manager's appetite. Some use traffic lights as a monitoring system for this, which adds some ambiguity to it and can be rather arbitrary, but it's still a promoting aspect since the metrics are being monitored.

The new questions in the RTS of Article 8 funds:

• What are the environmental and/or social characteristics of this product, and how are they achieved?
• How does this product measure how each of the environmental or social characteristics will be met?
• How are good governance practices, such as tax compliance or employee matters, assessed for companies the product invests in?

Existing questions in the RTS of Article 8 funds:

• What environmental and/or social characteristics are promoted by this financial product?
• What sustainability indicators are used to measure the attainment of each of the environmental or social characteristics promoted by this financial product?

What prompted the proposed changes?

This report stems from a directive issued by the Commission to the ESAs in April 2022, following a comprehensive consultation process from 12 April 2023 to 4 July 2023, which garnered substantial input from various stakeholders, detailed in the report's conclusion. Initially, the mandate focused on revisiting the PAI indicators and introducing new metrics for GHG emissions reduction goals. However, the ESAs expanded their scope to include additional proposals concerning disclosures on sustainable investments and amendments to the mandatory disclosure templates for financial products outlined in Articles 8 and 9 of the SFDR.

The report builds on multiple guidance documents released by the Commission and ESAs on the SFDR framework in 2023, including:

• A Q&A on sustainable investment and PAI considerations published on 6 April 2023;
• A Commission notice clarifying the EU Taxonomy's interpretation and its connection to SFDR, issued on 16 June 2023;
• The ESAs' annual report on voluntary PAI disclosures, released on 28 September 2023; and
• Explanatory notes on SFDR principles published by the European Securities and Markets Authority (ESMA) on 22 November 2023.

What new disclosures are suggested for sustainable investments? Clarifying the definition of "sustainable investment" as per Article 2 no. 17 of SFDR has presented a significant challenge within the framework. The Commission's Q&A from April 2023 clarified that financial market participants are expected to craft their own definitions and methodologies for identifying sustainable investments based on three primary criteria set by the Commission:

(i) contributing to an environmental or social objective;

(ii) not causing significant harm to any such objective (DNSH);

and (iii) ensuring good governance practices among investee companies (with the latter criterion now deemed less critical following the Commission's June 2023 clarification that companies meeting the DNSH criteria automatically satisfy the good governance requirements).

To enhance clarity for SFDR disclosure users on how financial market participants delineate sustainable investments, the ESAs recommend incorporating additional disclosures as follows:

• Clarification on Calculating Sustainable Investment Proportions: This involves specifying the method used to determine the proportion of sustainable investments. According to the Commission's guidance in the April 2023 Q&A, this can be achieved through two approaches: (i) the look-through method, which calculates proportions based on the sustainability of the underlying economic activities of the investment, or (ii) the pass or fail method, which assesses the investment's qualification based on whether the underlying economic activities meet specified sustainability thresholds (as per new Articles 17a, 18(5), 44, 54a, and 61 of SFDR Regulatory Technical Standards (RTS)).
• Details on DNSH Criteria and Thresholds: This includes information on the thresholds or criteria applied under the Do Not Significantly Harm (DNSH) principle, specifically in website disclosures as per Article 10 of SFDR. It entails outlining how Principal Adverse Impact (PAI) indicators are considered to ensure investments do not significantly harm environmental or social objectives (introduced in new Articles 26(2) lit. (a) and 39 lit. (a) of SFDR RTS).
• Enhanced Reporting on Sustainable Investments: For Articles 8 and 9 Products, this involves providing more comprehensive details in periodic reports. This includes information on the minimum commitments for Article 8 Products, the proportion of sustainable investments within an Article 9 Product, and the measures taken to achieve the sustainable investment objectives of an Article 9 Product (introduced in new Article 54a, Article 61, and Article 62a of SFDR RTS, respectively).
• Refining the Term "Equivalent Information": The somewhat ambiguous term "equivalent information," previously used to determine alignment with the EU Taxonomy in the absence of public disclosures, is proposed to be replaced with the more precise term "estimates." This update would encompass data from both investee companies and third-party providers (new Articles 15(3) lit. (b) and Article 17(2) lit. (b) of SFDR RTS).

Furthermore, the ESAs offer guidance on the specific formulae for calculating the proportion of sustainable investments (outlined in new Article 17a(1) of SFDR RTS), including references to methodologies employed for calculating net short positions in short selling and credit default swaps (new Article 17a(2) of SFDR RTS). Additionally, they introduce a "safe harbour" principle from the Commission's June 2023 notice, which stipulates that investments solely in Taxonomy-aligned economic activities are automatically recognized as sustainable investments (new Article 17(1) lit. (g) of SFDR RTS).

The European Supervisory Authorities (ESAs) have outlined several proposed modifications and enhancements to the Principal Adverse Impact (PAI) framework, aiming to improve clarity and comprehensiveness. These proposals include the introduction of new PAI indicators, revisions to existing ones, and general clarifications across the framework:

• Inclusion of Derivatives: It's proposed that derivatives be accounted for in PAI disclosures using the conversion method outlined in the Delegated Regulation of the Alternative Investment Fund Managers Directive (AIFMD), aiming to clarify a previously contentious issue regarding derivatives and PAI (introduced in new Article 6(4) of SFDR RTS).
• Value Chain Impacts: PAI disclosures should now consider impacts from an investee company's value chain, but only if such information is (i) reported by the investee company under the forthcoming European Sustainability Reporting Standards (ESRS) or (ii) otherwise readily available, though what constitutes "readily available" remains to be clarified (new Article 6(5) of SFDR RTS).
• Data Source Disclosures: Following the ESAs' best practice recommendations, the annual PAI statement must now include detailed information on data sources, distinguishing between data obtained directly, estimated data, or data considered as not contributing to adverse impacts (new Article 6(6) of SFDR RTS).
• Project Finance Specifics: For investments solely financing projects, the assessment of adverse impacts can be limited to those projects, as per previous ESA guidance on project finance (new Article 6(7) of SFDR RTS).
• ESRS Reporting Alignment: If an investee company, under ESRS reporting, omits data on a PAI indicator, deeming it non-material, it can now be assumed that the investment does not contribute to adverse impacts measured by that indicator, aligning ESRS and SFDR reporting standards (new Article 7(3) of SFDR RTS).

Despite discussions, the method for calculating PAI indicators expressed as a proportion of all investments to maintain year-on-year comparability remains unchanged:

New and Revised PAI Indicators:

• New Mandatory Social Indicators: Earnings in non-cooperative tax jurisdictions (new no. 13 in Table 1 Annex I of SFDR RTS).Exposure to tobacco cultivation and production companies (new no. 15 in Table 1 Annex I of SFDR RTS). The proportion of employees earning below an adequate wage (new no. 16 in Table 1 Annex I of SFDR RTS).
• Transformed Social Indicator: The debated indicator on interference in trade union formation has been adjusted to an opt-in indicator concerning the coverage of collective bargaining agreements (new no. 4 in Table 3 Annex I of SFDR RTS).
• Maintained Opt-in Social Indicators: All six proposed opt-in social PAI indicators from the consultation, including issues like grievance mechanisms and employment practices, have been retained and slightly adjusted for consistency with the ESRS.

Despite feedback from the consultation, no new mandatory or opt-in social PAI indicators have been introduced specifically for real estate investments, underscoring the dynamic and evolving nature of the PAI framework within SFDR regulations.

The ESAs have put forward a pivotal and comprehensive proposal regarding the reclassification of a previously mandatory PAI indicator, specifically indicator no. 11 from Table 1 Annex of the SFDR RTS, which assessed compliance mechanisms for adherence to the OECD Guidelines for Multinational Enterprises and the UN Global Compact. This indicator is now suggested to be optional and has been relocated to no. 14 of Table 3 Annex I of SFDR RTS. Originally designed to evaluate whether investee companies implemented appropriate due diligence, grievance, and reporting mechanisms akin to those required of larger firms under various national supply chain laws and the forthcoming Corporate Sustainability Due Diligence Directive (CSDDD) at the EU level, this change marks a significant shift. The necessity for extensive external analysis, given the absence of direct obligations on the part of investee companies, had led many to report minimal coverage or resort to proxy data, such as UN Global Compact signatory status, which often resulted in nondescript disclosures. Should the Commission adopt the ESAs' recommendation, only one mandatory PAI indicator related to international standards would remain, focusing on policies and procedures in alignment with the OECD Guidelines and the UN Guiding Principles for sustainable and Taxonomy-aligned investments, addressing non-respect of these standards.

Enhancements for GHG Emission Reduction Targets Disclosure:

The ESAs advocate for comprehensive disclosures regarding GHG emission reduction targets for all Article 8 and 9 Products, entailing:

• A strategy for reducing GHG emissions across underlying economic activities.
• Detailed GHG emission reduction goals, including percentage or absolute reductions from a baseline year, with interim and final targets differentiated between sovereign exposures and other investments.
• Confirmation of alignment with the Paris Climate Agreement's aim to cap global warming at 1.5 °C, along with the methodology employed.
• If applicable, an engagement strategy to encourage GHG emission reduction at the investee company level.
• Disclosure of the GHG accounting and reporting standard used, the proportion of investments it covers, and efforts to ascertain investee companies' GHG removals, storage, and carbon credit data.
• Details on carbon credits acquired and annulled within the reporting period.
• Achievements in GHG emission reduction during the reporting period, including explanations for unmet targets, their impacts, and corrective measures planned.

For calculating financed GHG emissions, financial market participants are encouraged to utilize the GHG Accounting and Reporting Standards issued by the Partnership for Carbon Accounting Financials (PCAF) in December 2022.

Proposed Amendments to Disclosure Templates:

Significant updates have been proposed for the disclosure templates applicable to Article 8 and 9 Products, informed by consultations and consumer testing across several EU countries. A notable addition is a new dashboard feature at the forefront of pre-contractual and periodic templates and on websites, showcasing:

• The environmental/social characteristics promoted and their investment percentage for Article 8 Products or the sustainable investment objective for Article 9 Products.
• Minimum commitments to sustainable and EU Taxonomy-aligned investments.
• The consideration of PAI at the product level.
• GHG emission reduction targets.

This dashboard aims to present each aspect with distinct icons, simplifying the presentation without resorting to color changes from grey to green to mitigate potential greenwashing concerns—a concept that faced substantial critique during the consultation phase. Additionally, the ESAs propose revising numerous headline questions in the disclosure templates to enhance comprehensibility for retail investors, a move that, while beneficial from an investor standpoint, could impose significant administrative burdens on financial market participants.

The ESAs suggest introducing a "health warning" at the start of pre-contractual, website, and periodic disclosures for Article 8 Products. This warning would indicate that the product possesses only limited sustainability characteristics and might pose risks to the environment or society. Such a measure raises concerns about its effectiveness in aiding retail investors in navigating the nuanced differences between Article 8 and 9 Products under the SFDR. There is a risk that this could contribute to the existing skepticism and critique surrounding Article 8 Products, which, in many instances, may be partially or wholly unfounded.

Further clarifications from the ESAs stipulate that adjustments to the disclosures may only pertain to the size and font type of the text, marking a departure from current practices that allow for color adaptations to align with corporate branding or icon replacements. This change comes alongside a mandate ensuring the maintenance of functional hyperlinks in disclosures, a direct response to the ongoing assessment of SFDR disclosures by national regulatory bodies. Additionally, all disclosures are required to be in a specific machine-readable format to facilitate their integration into centralized databases like the forthcoming European Single Access Point (ESAP).

Addressing the suitability of the current SFDR RTS for financial products with investment options, such as those found in unit-linked insurance plans (often referred to as "multiple option products" or MOPs), the ESAs propose new provisions and dedicated disclosure templates. This approach aligns with existing insurance market practices by mandating SFDR disclosures for each investment option, regardless of its SFDR product classification, with the exception of financial instruments under MiFID II. The ESAs also suggest that to avoid cluttered disclosures where numerous investment options are involved, a hyperlink to each underlying investment option’s SFDR disclosures may suffice—a solution aimed at addressing the insurance industry's chaThe European Commission is allocated a three-month period to review the report and decide on its endorsement, modifications, or the exclusion of certain recommendations.

What are the Next Steps in the Legislative Process:

The European Commission is allocated a three-month period to review the report and decide on its endorsement, modifications, or the exclusion of certain recommendations. Any changes proposed by the Commission will necessitate a subsequent consultation phase by the ESAs, potentially extending the timeline.

The application date remains undecided within the report, leaving it to the Commission to determine an appropriate commencement date. Market anticipations suggest that the amendments are unlikely to be applied before January 1, 2025, considering the substantial modifications required for compliance and the necessary preparation time for financial market participants.

Feel free to reach out to us if you need an ESG advisor or help with ESG data collection to support your existing ESG workflows and compliance efforts. At A Triple C Consulting, we have ESG legal expertise (Magic Circle Law firm based in Luxembourg), ESG data platform (Seneca ESG), and ESG climate and carbon accounting capabilities. A true end-to-end service offering at your disposal. ?? ?? ??

Best regards,

Albin Axelsson

Founder & CEO of A Triple C Consulting

[email protected]

www.atriplecconsulting.com

Note: The content provided in this newsletter is for informational purposes only and should not be construed as financial or legal advice.