European watchdogs consult on ESG disclosure – Investor takeaways

The Disclosures Regulation establishes three broad categories of financial product:²

1. An Article 8 Product: A financial product which “promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices”

2. An Article 9 Product: A financial product which “has sustainable investment³ as its objective”

3. Other Products: Financial products that do not fall within either Article 8 or Article 9

While there is (relative) clarity on when a financial product may be classified as an Article 9 Product, it is currently most unclear which financial products would qualify as Article 8 Products. Is Article 8 meant to include any financial product that is marketed on the basis of some “ESG” credential or method? Or is it meant to include financial products that actually, in fact, make some substantive contribution to “ESG” progress? What about financial products which integrate sustainability risks⁴ into their investment decision making process, but go no further in promoting or actualising ESG criteria?

The Consultation Paper and Draft RTS provide some additional colour on these questions. The key takeaways on the scope of the Article 8 Products definition are as follow:

1. Marketing ESG-related capital allocation will bring a product within Article 8

The Draft RTS clarifies that “promotion” in the definition of an Article 8 Product is intended to refer to how the financial product is marketed to investors rather than its actual effect on environmental or social characteristics.

Recital 21 states that “Financial products with environmental or social characteristics should be considered to be promoting, among other characteristics, environmental or social characteristics, or a combination thereof, when information provided to clients, in marketing communications or in mandatory investor disclosures… references sustainability factors⁵ that are taken in [sic] consideration when allocating the capital invested of the product”.

Several provisions in the Draft RTS⁶ draw a distinction between the “promotion” and the “attainment” of environmental or social characteristics, thereby suggesting that “promotion” refers to how the financial product is being marketed to investors while “attainment” refers to the actual performance of the financial product.

This clarity on what is meant by “promotion” is welcome and should assist asset managers and distributors seeking to classify financial products. Any financial product making claims as to any ESG-driven capital allocation should be classified as an Article 8 Product and will be required to make the detailed disclosures set out in the Draft RTS that are intended to deter greenwashing.

2. ESG risk integration will not, by itself, bring a product within Article 8

The Consultation Paper states that since all financial products will be required to take into account sustainability risks,⁷ the broad concept of “ESG risk integration” will not be sufficient for a financial product to qualify as an Article 8 Product. This is significant, given that proposed changes to MiFID suitability rules would require that advisers, discretionary portfolio managers and other intermediaries that are required to perform suitability assessments will be required to ask each client if their investment strategy should include none, either or both of Article 8 Products and Article 9 Products. Therefore, an asset manager seeking to maximise the distribution potential of its financial products by classifying some or all of them as Article 8 Products of Article 9 Products would need to do more than merely “ESG risk integration”.

The principal mechanism through which the Disclosures Regulation and the Draft RTS seeks to limit greenwashing is by requiring detailed disclosure.⁸ The Consultation Paper rightly suggests that this greenwashing risk is particularly significant with Article 8 Products, given the breadth of the definition of Article 8 Products.

The key takeaways on the detailed disclosures required in relation to Article 8 and 9 Products and how they are to be used to combat greenwashing are as follow:

3. The Consultation Paper recognises the breadth of Article 8 and the resultant risk that such products might not always meet investor expectations

The Consultation Paper acknowledges that the definition of an Article 8 Product makes it possible for Article 8 Products using certain ESG strategies (e.g. “best-in-class” strategies) to invest in companies which might be regarded as unsustainable or “brown” by end-investors. We would observe that this may be problematic for asset managers, distributors and end-investors as these Article 8 Products (e.g. those that continue to include brown investments) will likely go through the same distribution channels as other Article 8 products, which are more consistent with what might reasonably be expected to be the expectations of the end-investors seeking funds “promoting environmental or social characteristics” (something we expect many investors will be seeking, having been asked if such products form part of their investment preferences, by their advisers as part of their suitability assessment). As a means of mitigating the potential for this mismatch, the Consultation Paper raises the question of whether the ESAs should define certain widely used ESG investment strategies such as “best-in-class”, “best-in-universe” or “exclusions”, so that financial market participants can expressly disclose the use of these strategies.

4. Investment strategies applicable to funds or segregated mandates may disclose ESG criteria/aspects only if they are “binding”

The Consultation Paper also acknowledges that “product categorisation plays an important role in the perception end-investors have of a given product’s characteristics or objective”. Therefore, when describing the investment strategy being used to attain the relevant environmental or social characteristics in the pre-contractual disclosures, the Consultation Paper indicates that financial market participants⁹ may only disclose the “binding elements” of the strategy in order to avoid over-disclosure of non-binding sustainability criteria which may be dis-applied or overridden at the discretion of the financial market participant. However, the Draft RTS isn’t framed in the same way and could be interpreted as simply requiring the identification of the binding elements. In our view, this shouldn’t prevent a financial product from publishing marketing materials which suggest that certain non-binding ESG criteria are also taken into account. Given that marketing communications should not contradict information disclosed pursuant to the Disclosures Regulation,¹⁰ careful thought would need to be given as to how this additional information is presented and whether or not such additional disclosures would bring the product within the scope of Article 8. It may be that asset managers, as way of mitigating mis-selling risks, may elect to disclose only the binding ESG criteria – but greater clarity on whether this is a requirement under the Draft RTS would be welcome.

5. Portfolio breakdowns will be required – but the classifications are attracting controversy

On a plain reading, the Disclosures Regulation requires financial market participants to only provide “product-level” disclosure. Additional “investment-level” disclosure is required for both Article 8 and Article 9 Products,¹¹ but under the proposed Regulation of the European Parliament and of the Council on the establishment of a framework to facilitate sustainable investment (Taxonomy Regulation).

With a view to reducing the risk of greenwashing, the Draft RTS goes further than the Disclosures Regulation by requiring quite detailed portfolio breakdowns and, in particular, requiring a graphical representation of what proportion of the portfolio is comprised of “sustainable investments”. The graphical representation also needs to be accompanied by a narrative explanation. We would note however that the Taxonomy Regulation also requires a disclosure of how and to what extent the investments underlying the financial product are invested in “environmentally sustainable economic activities”.¹²

These difinitions are not the same, and the Consultation Paper acknowledges that “sustainable investments” is defined in the Disclosures Regulation without reference to the Taxonomy Regulation. Notwithstanding this, the Consultation Paper expresses the hope that disclosures required by the Taxonomy Regulation should “strengthen the link between “sustainable investments” as defined under [the Disclosures Regulation] and investments financing taxonomy-compliant activities, with a view to reducing regulatory divergence”.

Further, in relation to Article 8 and Article 9 Products, pre-contractual disclosures¹³ and periodic disclosures¹⁴ will be required to indicate the planned proportion¹⁵ of the total investments in different sectors and sub-sectors, including the fossil-fuel sectors.

The definition of “fossil fuel sectors” as “production, processing, distribution, storage or combustion of solid fossil fuels, with the exception of investment related to clean vehicles”, and thereby excluding oil and gas has attracted criticism on the ground that it draws an artificial distinction between solid fossil fuels like coal and lignite and other fossil fuels. Questions have been asked whether disclosures on the planned proportion of total investments in fossil fuel sectors that exclude anything other than solid fossil fuels can truly be said to let people know what they are investing in.¹⁶

One of the questions posed by the Consultation Paper is whether exposure to other specific sectors such as nuclear energy should also be mandatorily disclosed. Consequently, and particularly in light of the criticism which the current drafting has attracted, it is possible that the final RTS will set out a longer list of sectors to which exposure needs to be mandatorily disclosed.

6. Pre-contractual disclosures to be concise, but link to websites

The Consultation Paper recognises that the definition of “financial product” in the Disclosures Regulation is very wide and, as such, the pre-contractual disclosures for each type of financial product could look very different from one another, have different levels of granularity and be intended for varied audiences. After considering which of the varied approaches should be adopted as the template, the Draft RTS has adopted the approach of keeping the pre-contractual disclosures concise, with references to a relevant website where further information on methodologies and data sources will be made available. However, the Consultation Paper accepts that there are certain benefits¹⁷ of more detailed pre-contractual disclosures and, as such, one of the questions posed by the Consultation Paper is whether the proposed approach is appropriate.

7. Confidentiality may be a concern

Under the Disclosures Regulation, financial market participants are required to make website disclosures relating to various sustainability-related matters – these include disclosures relating to: (i) policies on the integration of sustainability risks in their decision-making process; (ii) the principal adverse impacts of their investment decision on sustainability factors; (iii) information on how their remuneration policies are consistent with the integration of sustainability risks; (iv) pre-contractual disclosures relating to Article 8 and Article 9 Products; and (v) periodic disclosures relating to Article 8 and Article 9 Products.

The Draft RTS requires that website disclosures should be “easily accessible, non-discriminatory, free of charge, simple, concise, comprehensible, fair, clear and not misleading”.¹⁸ There is no further explanation as to what these terms mean. It is possible that the expectation is that these website disclosures be publicly available.

This reading would seem to square with the Consultation Paper’s observation that some of the proposed website disclosures could pose confidentiality concerns to investment firms providing portfolio management services (i.e. because segregated accounts are also in scope of the disclosure requirements as a result of “portfolio management” being included in the definition of a financial product). These confidentiality concerns would also apply to tailor-made financial products designed for specific clients.

The Draft RTS does not provide a solution. Rather, Recital 17 simply states “Financial market participants should include on their website a clear, succinct and understandable summary of the information provided as part of the periodic reporting. When doing so, financial market participants should comply at all time [sic] with national and Union law governing the protection of confidentiality of information, including the protection of undisclosed know-how and business information and the processing of personal data”.

Although Recital 17 refers only to a summary of the periodic disclosures, the Disclosures Regulation requires that “the information” included in the periodic reports should be published and maintained on the website, without suggesting that a summary is sufficient.¹⁹ Therefore, the Disclosures Regulation could be interpreted as requiring all of the periodic disclosure (including the graphical and narrative explanations mentioned above and the list of major investments in the portfolio discussed below) to be made available on the financial market participant’s website.

In our view, this has the potential to put asset managers in a potentially difficult position and leaves some questions unanswered:

1. Does Recital 17 suggest that financial market participants must comply with their confidentiality obligations under other European and domestic laws even if they conflict with their obligations under the Disclosures Regulation?

2. Does Recital 17 have in mind confidentiality obligations applicable to the financial market participant (to which the disclosure obligations under the Disclosures Regulation and the Draft RTS apply) or also to the relevant financial product? What about confidentiality obligations applicable to portfolio companies?

3. Does the confidentiality obligation need to arise from a piece of domestic or EU legislation, or can contractual obligations also be taken into account? What about non-EU legislation?

While we would hope that some of these issues are addressed in the final RTS, it is likely that some questions will remain unaddressed. Asset managers will therefore need to give thought as to how to comply with the disclosure obligations under the Disclosures Regulation and the final RTS without breaching their confidentiality obligations (whether legal or contractual in nature).

8. Highly granular portfolio disclosure is required

One of the specific disclosures required to be made in the periodic reporting for Article 8 Products and Article 9 Products is “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,²⁰ including the sector and location of those investments”.²¹

We would note that the Disclosures Regulation did not indicate that such granular investment-level disclosure would be required in periodic reporting. Moreover, the drafting raises several questions:

1. How is the “average” to be calculated?

2. How should the reporting deal with investments that qualify to be included on the list but have been divested prior to the end of the investment period?

3. How is the location of an investment to be determined? Is it the location of the issuer, its underlying operations, or the listing venue in the case of listed investments?

4. In the case of fund of fund investments or derivative exposures, how is the sector of the investment to be determined?

5. Do the names of the investments need to be disclosed? If so, how should financial market participants address concerns relating to confidentiality or competitive advantage? As indicated above, while the Draft RTS acknowledges that the disclosures may be subject to conflicting confidentiality obligations, how this conflict will be addressed is far from clear. We would note that under the Prospectus Regulation and even under the Market Abuse Regulation, naming specific investments is not always required (although substantial holdings in public companies do need to be disclosed under the Transparency Directive). Further clarity on how asset managers are expected to navigate this sensitive area would be welcome.

One of the potentially most significant obligations imposed on asset managers (and indeed other financial market participants) by the Disclosures Regulation is the requirement to disclose, both at an entity level²² and at a financial product level,²³ the principal adverse impacts of investment decisions on sustainability factors. This obligation applies mandatorily to financial market participants with more than 500 employees, or on a “comply or explain” basis to smaller financial market participants, irrespective of whether the relevant product is classified as an Article 8 Product, an Article 9 Product or neither.

In order to assist with making these disclosures, the ESAs had been mandated to develop draft regulatory technical standards in respect of the sustainability indicators in relation to: (i) adverse impacts on the climate and other environment-related adverse impacts (by 30 December 2020); and (ii) adverse impacts in the field of social and employee matters, respect for human rights, anti-corruption and anti-bribery matters (by 30 December 2021).²⁴ Pursuant to this mandate, the Draft RTS provides: (i) a mandatory reporting template to use for the statement on considering principal adverse impacts of investment decisions on sustainability factors; and (ii) a set of sustainability indicators for both climate and environment-related adverse impacts and adverse impacts in the field of social and employee matters, respect for human rights, anticorruption and anti-bribery matters.

This initiative is clearly welcome in principle. However the approach in the Draft RTS is problematic.

The key takeaways on the approach to adverse sustainability disclosures are as follow:

9. The RTS appears, through rigid prescription, to have modified the basis on which the ‘adverse impacts’ disclosure is required to be made under the Disclosure Regulation, and in cases, could now require detailed disclosures on adverse impacts which the financial market participant may not consider “principal”

Under the Disclosures Regulation, financial market participants are required to determine whether their investment decisions had “principal adverse impacts on sustainability factors”. If so, they are required to disclose these principal adverse impacts.²⁵ The natural interpretation of this obligation is that the assessment of whether a particular impact is “principal” would be made by the relevant financial market participant and Recital 18 to the Disclosure Regulation appears to confirm that “materiality” is a relevant factor in determining whether an adverse impact is “principal”. If it concludes that its investment decisions could have some impact on sustainability factors, if this wasn’t a “principal” impact, the impact did not need to be disclosed (or even calculated in any significant detail).

This approach appears to have been, in effect, modified by the Draft RTS. The Draft RTS provides a non-exhaustive list of sustainability indicators against which adverse impacts are to be measured. The list of sustainability indicators has been split into: (i) a core set of mandatory indicators (set out in Table 1 of Annex I) that are deemed to always lead to principal adverse impacts, irrespective of the result of the assessment by the financial market participant; and (ii) additional indicators for environmental and social factors (set out in Tables 2 and 3 of Annex II), to be used to identify, assess and prioritise additional principal adverse impacts.

Since the mandatory indicators are deemed to always lead to principal adverse impacts, any impact on these sustainability indicators needs to be disclosed by the financial market participant.²⁶ To take an example, “deforestation” is a mandatory sustainability indicator. Therefore, irrespective of whether this is sustainability factor is relevant to the operations of a financial market participant, each financial market participant will be required to disclose “the share of investments in entities without a deforestation policy”. This consequence is recognised in the impact assessment accompanying the Consultation Paper, which acknowledges that a disadvantage of the proposed approach is “mandatory indicators may not be relevant for all financial market participants”.

In relation to the additional indicators, the Draft RTS requires the financial market participant to disclose principal adverse impacts on at least one of the sustainability indicators in each of Tables 2 and 3.²⁷ The rationale for this is not clear. The sustainability indicators in Tables 2 and 3 are those on which an adverse impact is not per se “principal”. It is for the financial market participant to determine if the adverse impact is “principal” and requires disclosure. Therefore, it seems odd that the financial market participant is nevertheless required to disclose an adverse impact on at least one of these additional indicators, potentially even in a situation where it doesn’t consider the adverse impact on any of those indicators to be material.

We understand that this departure is because the ESAs wish to provide comparable disclosure across financial market participants in terms of their impact on the mandatory indicators. However, the end result of these new proposals is that financial market participants are in effect being required to disclose “adverse impacts on principal sustainability indicators” rather than “principal adverse impacts on sustainability indicators”.

Asset managers would be well advised to review the Tables in Annexes 1 and 2 closely and consider whether the data requested therein will be (easily) available to them and what sort of reporting and systems build might now be required to satisfy these requirements.

10. Comparative data needs to be included

The “sustainable performance” of Article 8 and Article 9 Products is required to be measured by reference to sustainability indicators identified by the relevant financial market participant. In relation to each such sustainability indicator, the periodic disclosure is required to set out the performance of these indicators in the current reference period,²⁸ along with comparative disclosure with each of the previous reference periods that cover at least the shortest of the following: (a) the previous ten years; (b) the period from the date on which the financial market participant first considered the sustainability indicator reported on; or (c) from 1 January 2022.²⁹ This sort of comparative disclosure is a new concept introduced by the Draft RTS and was not referred to in the Disclosures Regulation – as such, one of the questions posed by the Consultation Paper is whether this historical comparison over a timespan of ten years is appropriate or if some other timespan would be more appropriate.

11. A detailed policy will need to be produced and described in disclosures

A financial market participant’s policy on identifying and prioritising principal adverse impacts will need to be approved by its governing body, and the date of such approval needs to be disclosed.³⁰ A description of the policy needs to be disclosed on the financial market participant’s website and should include: (i) the allocation of responsibility for the implementation of the policies within organisational strategies and procedures; (ii) a description of the methodologies to assess each principal adverse impact and, in particular, how those methodologies take into account the probability of occurrence and severity of adverse impacts, including their potentially irremediable character; (iii) an explanation of any associated margin of error within those methodologies; and (iv) a description of the data sources used.

12. Disclosures are required in relation to reductions in adverse impacts achieved by engagement and similar actions

The reduction in principal adverse impacts achieved by engagement or other actions taken during the relevant reference period³¹ also need to be disclosed.³² We would note that this disclosure obligation, as drafted, appears to assume that the reduction in impacts in a given period will be a function of engagement or other actions taken during that same period. In reality such engagement or actions may have been taken by financial market participants during previous reference periods. This disclosure may therefore end up saying that a reduction in impact was not caused by any actions during the current period, but previous periods.³³

13. The Draft RTS is silent on adverse impact disclosures at the level of the financial product itself

Under the Disclosures Regulation, by 30 December 2022, a financial market participant that discloses principal adverse sustainability impacts (either voluntarily or mandatorily) also needs to make these disclosures at the level of individual financial products. These periodic disclosures need to include: (a) a clear and reasoned explanation of whether, and, if so, how a financial product considers principal adverse impacts on sustainability factors; and (b) a statement that information on principal adverse impacts on sustainability factors is available in the periodic disclosures.³⁴ The Draft RTS doesn’t expressly provide any further detail on this financial-product specific disclosure obligation, including on what would qualify as a “clear and reasoned explanation” and what the format should be followed for disclosing the principal adverse impacts in the periodic disclosures.

The disclosure obligations set out in the Disclosures Regulation appear to have been drafted primarily with regard to an actively managed financial product investing into operating companies. This means that there are certain operational questions and difficulties of interpretation when applying these disclosure obligations to passive financial products which seek to track a benchmark or index, financial products investing in fund of funds or financial products with exposure to derivatives. While the Draft RTS discusses how the Disclosures Regulation would apply to these types of financial products, it still leaves several questions unanswered.

The key takeaways in relation to how disclosure obligations will fall on passive financial products are as follows:

14. “Index-level information” to be based on benchmark methodological disclosures but clarity is still needed on how adverse sustainability impacts are to be assessed and disclosed

The Consultation Paper states that the intention of the ESAs in the Draft RTS is to ensure a level playing field as between products with active investment strategies and passive investment strategies. The ESAs have consequently decided that the same level of investor information should be provided to investors in relation to both types of strategies. The Consultation Paper, therefore, suggests that products with a sustainable investment objective (i.e. Article 9 Products) employing a passive investment strategy should disclose “index-level information for the relevant disclosure requirements”.

There is no clear explanation of what “index-level information” or “relevant disclosure requirements” means in this context. Recital 28 of the RTS suggests that this is referring only to “core methodological disclosures” to be made in relation to a financial product. In other words, when describing how an Article 8 ETF or Article 9 ETF seeks to disclose how it will, as applicable, promote environmental or social characteristics or pursue its sustainable investment objective, it should be sufficient for such disclosure to be based on the disclosures set out in the methodology statement relating to the relevant benchmark.

However, it is currently unclear how an ETF which is an Article 8 or Article 9 Product would discharge its obligation to compare its sustainability impact to the impact of its reference benchmark and a broader market index.³⁵ Practically speaking, this would seem to require benchmark producers to make disclosures on the sustainability impact of their benchmark. This does not however seem to be required by the Disclosure Regulations nor any of the recent Benchmark Regulation reforms (except in relation to EU Paris-aligned benchmarks³⁶ or EU Climate Transition benchmarks³⁷).

15. There are additional requirements and restrictions on financial products pursuing low-carbon investment objectives

The Draft RTS requires that financial products should not pursue low-carbon investment objectives without using new EU climate-related benchmarks (i.e., the EU Paris-aligned benchmarks or the EU Climate Transition benchmarks).³⁸ If such benchmarks are not available, financial market participants are required to demonstrate (i) how the portfolio of the financial product is either aligned with the objectives of Paris Agreement or is on a decarbonisation trajectory; and (ii) that the investee companies in the financial product’s portfolio have been selected in accordance with the requirements for selecting companies to be included on the EU climate-related benchmarks.

The requirement to use a benchmark marks a point of departure between financial products pursuing low-carbon investment objectives (i.e. a sub-set of Article 9 Products) and other Article 8 Products or Article 9 Products, which are not necessarily required to use a reference benchmark.

This takeaway is not applicable solely to passive financial products but to any financial product that pursues a low-carbon investment objective.

The key takeaways in relation to how disclosure obligations will fall on a fund of funds or derivatives giving indirect asset exposures are as follow:

16. It is unclear whether one needs to look through a fund of funds to make the required disclosures

The Draft RTS requires that pre-contractual disclosures and periodic disclosures should distinguish between “direct holdings in investee companies and all other types of exposures to those companies”.³⁹

It is not clear how this requirement would be applied to a fund of funds structure. However, Recital 30 to the Draft RTS suggests that an investment via a fund of funds would be considered an indirect exposure to the investee companies underlying the investee funds. If this is correct, it may give rise to difficulties with providing the required level of disclosure on the underlying investee companies, for example where any of the investee funds are not subject to the Disclosures Regulation or where, in the case of a master feeder structure, the master fund is structured such that different investors in the master fund are provided exposure to different pools of assets.

17. Derivatives disclosure is currently suggested to be standalone, and it is unclear how it is to be satisfied

For Article 8 Products and Article 9 Products, the Draft RTS requires financial market participants to disclose how the use of derivatives by these financial products “meets each of the environmental or social characteristics promoted by the financial product”⁴⁰ or “attains the sustainable investment objective”.⁴¹ This is all the direction given in the Draft RTS.

One of the questions posed by the Consultation Paper is whether this disclosure on the use of derivatives should be stand-alone (as currently provided) or should be integrated with the graphical and narrative explanation of the financial product’s portfolio. However, in our view, the more pertinent question is whether the current provision gives asset managers enough guidance on what this disclosure should look like or if it should be clarified further.