SFDR RTS 2.0 – A brief analysis of the ESAs Final Report published on 4 December 2023

On 4 December 2023, the European Supervisory Authorities (ESAs) published their final report (JC 2023 55) (Report) containing proposed amendments to the regulatory technical standards (SFDR RTS) under the EU Sustainable Finance Disclosure Regulation (SFDR). The ESAs suggest additional disclosures for sustainable investments, the introduction of new indicators for principal adverse impacts of investment decisions on sustainability factors (PAI) and specifications to existing indicators, new disclosures on GHG emission reduction targets and revisions to the disclosure templates. The Report is addressed to the European Commission (Commission) who must now decide whether to implement the suggested amendments by adopting a delegated act amending the current SFDR RTS.

1. What is the background of the suggested amendments?

The Report is the result of a Commission mandate provided to the ESAs in April 2022 and follows a consultation which ran from 12 April 2023 to 4 July 2023, with extensive feedback from stakeholders included at the end of the Report. The Commission mandate originally only covered proposals to review the PAI indicator framework and to introduce new disclosures on GHG emissions reduction targets. The ESAs have enlarged the mandate and included proposals in two additional areas, being disclosures on sustainable investments and revisions to the disclosure templates which must be used by financial products referred to in Articles 8 and 9 of SFDR (Article 8 Products and Article 9 Products).

In parallel to the Report's proposed amendments to the SFDR implementing provisions, the Commission is currently consulting with the industry and other stakeholders on a general review of SFDR, with the consultation period ending on Friday this week (for more information see here).

The Report follows several pieces of guidance issued by the Commission and the ESAs on concepts under SFDR in 2023:

• Q&A on ustainable investment and PAI consideration published on 6 April 2023 (for more information see here);
• Commission notice on the interpretation of EU Taxonomy and links to SFDR published on 16 June 2023 (for more information see here);
• ESAs' annual report on voluntary PAI disclosures issued on 28 September 2023 (for more information see here); and
• Explanatory notes on SFDR concepts published by the European Securities and Markets Authority (ESMA) on 22 November 2023 (for more information see here).

2. Which additional disclosures have been proposed for sustainable investments?

Understanding what constitutes a "sustainable investment" as defined in Article 2 no. 17 of SFDR has been one of the most challenging tasks within the SFDR framework. Since the April 2023 Commission Q&A it is clear that financial market participants must develop their own concept and methodology to define sustainable investments based on the three key parameters outlined by the Commission, being (i) contribution to an environmental or social objective, (ii) do not significantly harm any such objective (DNSH), and (iii) good governance of investee companies (the latter being of less importance now that the Commission has clarified in its June 2023 notice that investee companies meeting the DNSH criteria are deemed to fulfil the good governance requirement).

To support users of SFDR disclosures in understanding how a financial market participant defines sustainable investments, the ESAs propose the following additional disclosures:

• Specification how the proportion of sustainable investments is calculated, based on the two methods outlined by the Commission in the April 2023 Q&A, being based either (i) proportionally on the qualification of the economic activities underlying the investment (look-through method) or (ii) on the qualification of the investment itself if the underlying economic activities pass a certain threshold (pass or fail method) (new Articles 17a, 18 (5), 44, 54a and 61 of SFDR RTS);
• Information on the thresholds or criteria used in the context of the DNSH principle in the website disclosure according to Article 10 of SFDR, i.e. providing details how the PAI indicators are taken into account to determine that the investment does not significantly harm environmental or social objectives (new Articles 26 (2) lit. (a) and 39 lit. (a) of SFDR RTS);
• More detailed information on sustainable investments held as part of the periodic reporting for Article 8 and 9 Products, including delivery on minimum commitments made by Article 8 Products (new Article 54a of SFDR RTS), proportion of sustainable investments in an Article 9 Product (new Article 61 of SFDR RTS) and actions taken to attain the sustainable investment objective of an Article 9 Product (new Article 62a of SFDR RTS); and
• Replacement of the (somewhat vague) concept of "equivalent information" (which can be used to determine alignment with EU Taxonomy in the absence of public disclosures) by the more commonly used term "estimates" covering both investee company and third party provider data (new Articles 15 (3) lit. (b) and Article 17 (2) lit. (b) of SFDR RTS).

In addition, the ESAs provide clarifications how the proportion of sustainable investments should be calculated (formula in new Article 17a (1) of SFDR RTS, reference to the net short position calculation methodology used for short selling and credit default swaps in new Article 17a (2) of SFDR RTS). The ESAs also take up the "safe harbour" concept from the June 2023 Commission notice under which investments made (only) in Taxonomy-aligned economic activities automatically qualify as sustainable investments (new Article 17 (1) lit. (g) of SFDR RTS).

3. Which amendments and additions have been proposed to the PAI framework?

The ESAs propose new PAI indicators and amendments to existing PAI indicators as well as some overarching clarifications to the PAI framework. The overarching clarifications cover the following topics:

• Derivatives should be included in the PAI disclosures based on the conversion method used in the Delegated Regulation supplementing the Alternative Investment Fund Managers Directive (AIFMD) (providing more clarity to a much-debated issue around derivatives and PAI) (new Article 6 (4) of SFDR RTS);
• PAI disclosures must include impacts from the value chain of the investee company but only to the extent that either (i) the investee company reports such information as part of its sustainability reporting under the draft European Sustainability Reporting Standards (ESRS) (for more information on the ESRS see here and here) or (ii) the information is readily available (it being unclear what "readily available" means and if this leads to an obligation to purchase third party data) (new Article 6 (5) of SFDR RTS);
• In line with the ESAs' previous best practice recommendations, the "explanations" column of the annual PAI statement according to Table 1 Annex I of SFDR RTS must contain information on the data sources used (i.e. whether information is (i) obtained from the investee company, sovereign/supranational or real estate asset, (ii) estimated or subject to reasonable assumptions (noting that the categories "additional research", "third-party data providers" and "external experts" in current Article 7 (2) of SFDR RTS have been amalgamated into "estimated"), or (iii) considered as not contributing to adverse impacts according to the new Article 7 (3) of SFDR RTS (see below) (new Article 6 (6) of SFDR RTS);
• For investments exclusively financing projects, the assessment of adverse impacts can be limited to these projects and this must be indicated in the annual PAI statement (following previous guidance from the ESAs on how to deal with PAI in the context of project finance) (new Article 6 (7) of SFDR RTS); and
• If the investee company is reporting under ESRS and has chosen not to report on a data point corresponding to a PAI indicator because it considers this data point as non-material, it can be assumed that the investment in the investee company does not contribute to adverse impacts measured by the respective PAI indicator (this is the much-needed clarification on how to align ESRS reporting under which PAI indicators are subject to materiality with the mandatory PAI indicator regime under SFDR) (new Article 7 (3) of SFDR RTS).

Interestingly, one of the most-debated provisions in the PAI framework, on the calculation basis for the PAI indicators which are expressed as a proportion, remains unaltered. The ESAs have decided to keep the reference to "all investments" instead of limiting the calculation basis to all relevant investments, mainly to maintain comparability with previous years.

Amendments to PAI indicators include 3 new mandatory social indicators for investee company investments, being:

• Amount of accumulated earnings in non-cooperative tax jurisdictions (new no. 13 Table 1 Annex I of SFDR RTS);
• Exposure to companies active in the cultivation and production of tobacco (new no. 15 Table 1 Annex I of SFDR RTS); and
• Share of employees earning less than the adequate wage (new no. 16 Table 1 Annex I of SFDR RTS).

The 4^th, much debated new mandatory social indicator suggested during the consultation, being "interference in the formation of trade unions or elections workers' representatives" has now been transformed into an opt-in PAI indicator and changed into "low coverage of collective bargaining agreements" (new no. 4 Table 3 Annex I of SFDR RTS).

All 6 new opt-in social PAI indicators in Table 3 Annex I of SFDR RTS from the consultation have been maintained (lack of grievance/complaints mechanisms (no. 6 and 20), share of non-guaranteed hour/temporary/non-employee employees (no. 10 to 12), insufficient employment of persons with disabilities (no. 13)). The wording of most new indicators has been adapted slightly following the consultation, in particular to ensure consistency with the ESRS. Although this has been raised during the consultation, no mandatory or opt-in social PAI indicators have been introduced for investments in real estate investments.

The ESAs propose a significant and potentially far-reaching change in relation to former PAI indicator no. 11 from Table 1 Annex of SFDR RTS measuring the lack of processes and compliance mechanisms to monitor compliance with the OECD Guidelines for Multinational Enterprises and the UN Global Compact. This indicator has now been transformed into an opt-in indicator and moved to no. 14 of Table 3 Annex I of SFDR RTS. Applied properly, the indicator would have required assessing whether the investee company had adequate due diligence, grievance and reporting mechanisms in place, similar to obligations for larger companies under national supply chain legislation and the upcoming Corporate Sustainability Due Diligence Directive (CSDDD) at EU level. In the absence of own obligations of the investee company, this would have required an extensive external analysis. This is why many financial market participants and third party data providers either reported a very low coverage or used proxy information, e.g. being a UN Global Compact signatory, both of which did not lead to meaningful disclosures. If the Commission follows the ESAs' proposal, only one mandatory PAI indicator referring to international standards will remain, being no. 10 in Table 1 Annex I relating to "non-respect" (formerly "violations") of the OECD Guidelines and the UN Guiding Principles (formerly "UN Global Compact"). This means that financial market participants will only have to assess the existence of policies and procedures aligned with the OECD Guidelines and the UN Guiding Principles when making sustainable investments (as part of the DNSH assessment) and or Taxonomy-aligned investments (as part of the so-called "Minimum Safeguards").

4. Which additional disclosures have been proposed for GHG emission reduction targets?

The ESAs propose that all Article 8 and 9 Products having GHG emission reduction targets must include detailed information in a dedicated section of the pre-contractual, website and periodic disclosures (new Articles 14a, 18 (3), 29a, 42a, 51a and 59a and new sections in Annex II to V of SFDR RTS), consisting of:

• The strategy employed to decrease GHG emissions from underlying economic activities (pre-contractual, website, periodic);
• The GHG emission reduction targets calculated as percentage or absolute reduction from a baseline year, including intermediate targets and the final target split between sovereign exposures and all other investments (pre-contractual, periodic);
• Alignment with the Paris Climate Agreement objective to limit global warming to 1.5 °C and respective methodology (pre-contractual, website, periodic):
• Engagement plan to achieve GHG emission reduction at investee company level (if relevant) (website);
• GHG accounting and reporting standard methodology to measure financed GHG emissions and proportion of investments to which such methodology applies (website);
• Proportion of investments for which GHG emissions were estimated or obtained from third parties and best efforts applied to obtain information on investee companies' GHG removals, storage and carbon credits (website);
• Carbon credits purchased and cancelled during the reference period (periodic); and
• GHG emissions reduction achieved during the reference period and if the target has not been met, an explanation of obstacles encountered, their impact on progress and a description of planned corrective actions (periodic).

Financial market participants should apply the GHG Accounting and Reporting Standards for the Financial Industry issued by the Partnership for Carbon Accounting Financials (PCAF) issued in December 2022 to calculate financed GHG emissions for all investments covered in such standards (new Article 14a (2) of SFDR RTS referring to AR 46 in Appendix A of ESRS E1 on climate change).

GHG removals and storage as well as carbon credits may not be considered in the targets and their achievement (new Article 14a (2) of SFDR RTS). Financial market participants may choose to voluntarily disclose on carbon credits used by an Article 8 or 9 Product (including their certification by recognised quality standards) as part of the website disclosure (new Articles 29a (2) and 42a (4) of SFDR RTS). The periodic disclosure must in any case contain information on carbon credits purchased and cancelled during the reference period (new Articles 51a lit. (a) (iii) and 59a (1) lit. (a) (iii) of SFDR RTS). Excluding GHG emissions storage/removals and carbon credits entirely is in line with ESRS E1 (notably para. 34 lit. (b) of Disclosure Requirement E1-4) but much stricter than what current voluntary frameworks (e.g. Science-based Targets initiative (SBTi) or Net-Zero Asset Owner Alliance (NZAOA)) recommend. The ESAs' position may be understandable given the lack of standardized global frameworks and recent incidents of unreliable credits but neglects that significant progress toward the Paris Climate Agreement objectives will require many industries to partially rely on GHG removal/storage and carbon credits.

5. Which main amendments have been proposed to the disclosure templates?

The ESAs have proposed significant amendments to the disclosure templates for Article 8 and 9 Products. These amendments are based on the consultation and on consumer testing carried out in Italy, Poland, France and the Netherlands.

Centre piece of the amendments is a new dashboard at the beginning of the pre-contractual and periodic templates which must also be included in the website disclosure (new Articles 25 (1) and 38 (1) of SFDR RTS). This dashboard contains information on the following items:

• Environmental and/or social characteristics and percentage of investments promoting them for an Article 8 Product or the sustainable investment objective for an Article 9 Product;
• Minimum commitment relating to sustainable investments;
• Minimum commitment relating to EU Taxonomy-aligned investments;
• Consideration of PAI at product level; and
• GHG emissions reduction targets.

Each item is represented by its own icon, with two new icons introduced for sustainable investments and for GHG emission reduction targets. Luckily, the ESAs have dropped the idea of having the icons change colour from grey to green in case of positive answers. Due to the technical challenges and the significant greenwashing potential associated with such a solution this idea had been heavily criticized during the consultation. The ESAs also propose to change many of the headline questions in the disclosure templates to make them better understandable for retail investors (which is laudable from a retail investor perspective but leads to significant administrative burden for financial market participants).

In addition, the ESAs propose that the pre-contractual, website and periodic disclosures of Article 8 Products must contain a "health warning" at the beginning of each disclosure noting that the product only has limited sustainability characteristics and may be harmful for the environment or people. It is rather doubtful that such wording will help retail investors to distinguish between the not very intuitive disclosure categories of Article 8 and 9 of SFDR. It is more likely that this will add to the general distrust and public criticism of Article 8 Products which is in many cases partially or totally undeserved.

The ESAs also clarify that only size and font type of the characters used in the disclosure templates may be adapted (new Article 2 (1) of SFDR RTS). Contrary to the current market practice, adaptation of the colours used to corporate branding or replacement of the icons will no longer be permitted. As an outcome of the current SFDR disclosure assessment by national regulators, the ESAs have also thought it necessary to include a provision obliging financial market participants to keep hyperlinks in working order (new Article 2 (3) of SFDR RTS). All disclosures must be in a specific machine-readable format to permit storage on central databases like the planned European Single Access Point (ESAP) (new Article 2 (2) of SFDR RTS).

Finally, the ESAs have recognized that the current SFDR RTS are not suitable for financial products offering investment options. Typical financial product offering investment options are so-called "multiple option products" (MOPs) in unit-linked insurance. The ESAs propose to introduce additional provisions (new Articles 20 (2) to (6), 21 (2) to (6), 49a to 49g, 65 and 66) and dedicated pre-contractual and website disclosure templates (new Annexes VI and VII of SFDR RTS) for such financial products. In line with current market practice in the insurance industry, the ESAs propose that SFDR disclosures should be made for each investment option regardless of its status as financial product under SFDR (excluding only financial instruments under the recast Markets in Financial Instruments Directive (MiFID II)) (new Articles 20 (3) and (4) and 21 (3) and (4), 65 (2) and (3), 66 (2) of SFDR RTS). Moreover, as suggested during the consultation, the ESAs propose to permit replacing the disclosure on each underlying investment option by a hyperlink to the underlying investment option's SFDR disclosures. This is however limited to cases in which the number of underlying investment options hinders a clear and concise disclosure (new Articles 20 (5), 21 (5), 49d (3), 49g (3) and 65 (4) of SFDR RTS). It remains to be seen if this solves the insurance industry's issues with the individualization of SFDR disclosures for MOPs.

6. What are the next steps in the legislative process?

The Commission now has 3 months to review the Report and decide whether to endorse it in whole, make amendments or delete certain of the proposed amendments. Any amendments proposed by the Commission will require another consultation from the ESAs and thus prolong the process.

Once adopted by the Commission, the draft delegated regulation amending the SFDR RTS will be forwarded to the European Parliament and the Council for their scrutiny, typically within 2 to 4 months. After the end of the scrutiny period, the delegated regulation will be officially published and enter into force on the 20^th day following the publication. Entry into force does not mean application and the ESAs have deliberately left the application date open in the Report, asking the Commission to choose a suitable application date. According to current market expectation, the amendments will very likely not apply before 1 January 2025 since they require significant changes to current disclosures and financial market participants will need sufficient time to prepare for such changes.