Technical standards with which sustainability information must comply are becoming clearer as far as the European supervisory authorities are concerned. They published a comprehensive consultation paper with a high level of detail and many calculation formulae on the level 2 implementation of the EU’s Sustainable Finance Disclosure Directive, or SFDR. The industry can propose amendments up to 4 July.
Approximately 100 pages of proposed changes would again require a significant time and cost investment from market participants. The paper was published in April by the European Supervisory Authorities, also known as the ESAs, on SFDR level 2 at the request of the European Commission. It includes the introduction of new, social PAI indicators, as well as clarification of the definition of the other indicators and the formulae of their calculation, and adjustments to the prescribed prospectus and periodic templates.
The SFDR requires all parties active in European financial markets to be transparent about how they integrate sustainability risks into their investment decisions and about the effects that sustainability risks and their integration have on the financial products they offer.For two years, financial market participants have been required to report on this, and since this year, very detailed pre-contractual disclosure requirements have applied here according to mandatorily prescribed templates.
This coming June, for the first time, financial market participants will also have to compulsorily report on the impact of their investments according to a prescribed template, within various so-called Principal Adverse Impact (PAI) categories. Until now, most of the 14 mandatory PAIs were environmental, e.g. the carbon impact of an investment portfolio on climate change. Five indicators were social in nature.
Upgrade existing indicators
In the review, the ESAs propose an expansion of the list to include four more social, mandatory indicators. For example, investors would also have to report the average percentage of employees in invested companies receiving lower than appropriate wages, and the percentage of investments in companies that have no commitments on non-interference in the formation of trade unions or election of employee representatives.
In addition to these mandatory, social PAIs, the authorities also suggest a hefty handful of optional social indicators, for example an indicator to report on the average percentage of disabled people among the staff of investee companies.
With both the mandatory new PAIs and the optional ones, the question will be whether market parties will actually be able to report on them, as companies do not always have or make these types of indicators available. Incorporating these indicators into an investment process is cost- and time-intensive, as experience in recent years has shown.
Existing indicators are also getting an upgrade as far as the ESAs are concerned, as they believe they “deserve clarification or a clearer definition”, they write in the document. These include, for example, an indicator where the metric will henceforth be ‘expressed as a weighted average’ instead of ‘expressed per million euros’, as well as distinguishing between hazardous waste and radioactive waste by treating them henceforth as two separate indicators, with two different calculation formulae.
As for those formulas, that is something that stands out in the voluminous document anyway. Whereas previously several PAIs were not clear on how to calculate them, the ESAs have now drawn up new formulae for those PAI indicators that did not already have that. Also because financial market participants asked for this clarification, the ESAs said in the document. In previous documentation, these kinds of formulas and calculation examples were missing, or provided scattered in multiple documents. Instead, in the new consultation document, the calculation examples have been expanded, to answer the questions from the market - which the authorities address in the document at length.
New templates
Common criticism from the industry is that the templates containing sustainability information that market participants have had to add to their prospectus since January 2023 are long and unnecessarily complex. In the consultation document, the ESAs therefore suggest adjusting the language, layout and structure, also to increase understanding for retail investors.
According to policy advisor sustainability Ivan aan den Toorn of Dufas, the ESAs aim to simplify and clarify the templates with some proposed changes, although he notes that it remains to be seen whether this makes the templates understandable enough for investors. Some questions have been swapped and reformulated, while others have been taken out. That could mean a lot of work for parties that have just implemented all the current templates in their organisations.
While in many areas the consultation paper seems to provide the clarification requested, in other areas it actually raises questions. For instance, the ESAs - still - do not explain to what extent market participants now have to quantify all mandatory PAIs as part of determining whether an investment is sustainable. Aan den Toorn: ‘Earlier, the belief in the market was that indicators should be included with threshold values, but that financial market participants should determine the specific values themselves. The consultation paper seems to suggest that the ESAs see more freedom in how you may include PAIs, as there is no definition on how to interpret them further.
The European Commission recently replied in a Q&A on the subject that financial market participants should conduct their own assessment for each investment, recalls Head of Government Affairs & Public Policy David Henry Doyle of S&P Global in a LinkedIN post on the subject. ‘This policy choice gives financial market participants greater responsibility to the investor community and means that they should be careful when measuring the key parameters of a sustainable investment,’ it is reported to have said.
Another concern is that some of the proposed adjustments could be very work-intensive, for example the idea of showing the threshold value of each PAI when determining SRI. Providers would then have to go through interminable lists if threshold values take into account differences between sectors and countries, of which, moreover, it is questionable whether clients are going to go all the way through them.
A related question is how quickly the proposed changes should be implemented as a whole. For many market participants, that time aspect plays a major role in their response to the consultation. Although the templates have only been mandatory since last January, they have to be changed by legislative amendments as early as September. Annexes frequent changes cost a lot of time and money. The industry can respond to the proposed amendments until 4 July.