More light in the dark? A first analysis of ESAs Q&A on the SFDR Delegated Regulation published on 17 November 2022 for the asset management industry

On 17 November 2022, the European Supervisory Authorities (ESAs) published a collection of questions and answers on Commission Delegated Regulation (EU) 2022/1288 (SFDR Delegated Regulation) (ESAs Q&A). The SFDR Delegated Regulation, often also called "SFDR RTS", applies from 1 January 2023. Over 34 pages, the ESAs Q&A compiles 70 questions asked by market participants and industry associations, partitioned in six chapters dealing with:

• general calculation principles for (i) principal adverse impacts on sustainability factors (PAI) and (ii) alignment with Regulation (EU) 2020/852 (EU Taxonomy) (chapter I);
• disclosures on PAI under Art. 4 and 7 Regulation (EU) 2019/2088 (SFDR) (chapter II);
• disclosures for financial products defined in Art. 12 (12) SFDR (chapter III);
• multi-option products (i.e. financial products offering investment options to the investor regulated in Art. 20 to 22 SFDR Delegated Regulation such as, for example, many insurance-based investment products in Germany, Austria and Sweden) (chapter IV);
• disclosures on EU Taxonomy alignment (chapter V); and
• disclosures for financial advisers according to Art. 2 (11) SFDR and financial market participants according to Art. 2 (1) SFDR (FMPs) providing execution-only services (chapter VI).

Available guidance on the SFDR framework

The ESAs Q&A is by far the most extensive and detailed guidance document which has been issued since the application date of SFDR on 10 March 2021. It builds on the ESAs clarifications published on 2 June 2022 which preceded the entry into force of the SFDR Delegated Regulation and therefore were based on ESAs' draft version issued in October 2021. The ESAs are not only the only EU institution which has provided guidance on the SFDR framework: the EU Commission has adopted two sets of Q&A (Q&A dated 14 July 2021, Q&A published on 25 May 2022) and the EU securities regulator ESMA has issued a supervisory briefing to national regulators on how to supervise sustainability risk management and disclosures in investment management (supervisory briefing dated 31 May 2022). In addition to the interpretation of the SFDR Delegated Regulation, the ESAs have also conducted a market review on voluntary PAI disclosures under SFDR which contains recommendations on good and bad practices (report dated 28 July 2022). Further questions on the interpretation of SFDR were submitted to the EU Commission by the ESAs on 9 September 2022 but have not been answered yet.

Relevance of the ESAs Q&A for ongoing implementation projects

While each of the 70 Q&A may be relevant under specific circumstances, we have identified a number of Q&A containing general principles which, based on our experience with SFDR implementation for FMPs from the European asset management industry, are likely to be most important for their ongoing SFDR implementation projects. These Q&A relate to:

• PAI disclosures (quarterly data collection, scope of relevant investment decisions, data sources, general calculation principles and use of the PAI statement template) (see section A below);
• disclosure of EU Taxonomy alignment (pre-contractual and periodic duties, calculation for real estate and infrastructure assets, permitted data sources and general calculation principles) (see section B below); and
• financial product disclosures (sustainable investment framework, good governance, use of disclosure templates) (see section C below).

When going through the ESAs Q&A, it is important to keep in mind that the questions have been phrased by market participants and, therefore, may not always use the right terms and categories under the SFDR framework. More importantly, the ESAs' answers do not in all instances match the questions asked since the ESAs use certain questions to issue general clarifications on topics they deem important (which is a practice we are familiar with from the EU Commission Q&As).

A. PAI disclosures

Quarterly data collection

The most important clarification relates to the collection of data underlying the calculation of the PAI indicators set out in Annex I Tables 1 to 3 of SFDR Delegated Regulation (PAI Indicators) (see question no. II.6). Since Art. 6 (3) SFDR Delegated Regulation requires FMPs to calculate the disclosed annual impact as the weighted average of end-of-quarter data, FMPs have struggled to understand to which extent the relevant data needs to be updated quarterly.

Many of the PAI Indicators are determined by reference to three main KPIs being: (i) the value of the FMP's or the financial product's investment; (ii) the enterprise value of the investee company; and (iii) the specific indicator value (for example emissions to water, greenhouse gas emissions). The ESAs now very clearly state that only the value of the investment needs to be measured quarterly. On the contrary, there is no duty to update the enterprise value or the indicator value on a quarterly basis. For both these KPIs, the FMP may use the latest available year-end data, usually from the financial and non-financial reporting (if any) of the investee company.

Hence, the FMP must still calculate the PAI Indicator for each end of the quarter, but it does not have to reach out to investee companies or data providers to obtain information on the enterprise value and the indicator value on a quarterly basis. This is not new since the ESAs have already included wording indicating this approach in their Clarifications dated 2 June 2022 (no. 9 to 11) which, however, was not overly clear. Now the ESAs have reinforced their position with additional clarifications and a sample calculation.

Scope of relevant investment decisions

As we know, Art. 4 SFDR contains the concept of FMPs considering PAIs in relation to their investment decisions at entity-level. The ESAs Q&A clarify the investment decisions to which such PAI consideration should extend. Investment decisions of an FMP which are not made in the context of a financial product are excluded (for example, investment decisions for a credit institution's or investment firm's own account). However, PAI consideration does apply to all investment decisions taken in relation to an FMP's portfolio management activities, irrespective of whether the relevant investment decision are made through a financial product or some other way (see questions no. II.19 to 21).

Delegating investment decisions to a portfolio manager does not liberate the FMP from including these investment decisions into its PAI consideration process (see question no. II.5).

Finally, we take from the answer to question no. III.5 that for the purposes of SFDR in general and PAI consideration in particular, it should also not be relevant if investment decisions are fully discretionary or the FMP invests according to investment guidelines stipulated by the client.

Disclosure on data sources

Albeit not a formal clarification but only a good practice recommendation, the ESAs Q&A statement on how to differentiate between various data sources for the PAI disclosures could also have significant influence on market practice (see question no. II.1). Based on the obligations set out in Art. 7 SFDR Delegated Regulation, the ESAs recommend that for each PAI Indicator, the disclosure should indicate the percentage of investments for which "real data" from investee companies has been used and for which the FMP has relied on the other data sources set out in Art. 7 (2) SFDR (i.e. research, third party data providers, experts or reasonable assumptions). The ESAs recommend disclosing these percentages in relation to each PAI Indicator, presumably in the column headed "Explanation" in Table 1 of Annex I SFDR Delegated Regulation.

In doing so, the ESAs introduce a secondary concept of data hierarchy ("real data" from investee companies versus other data sources) for which the wording in Art. 7 (2) SFDR contains no basis. While Art. 7 (2) SFDR differentiates between "readily available" (i.e. publicly disclosed) data and data from other sources, there is no distinction between these other data sources (investee company, research, third party data providers, external experts or reasonable assumptions).

General calculation principles

The ESAs Q&A contain a number of clarifications relating to the calculation of various PAI Indicators, some with a more general application and some relating only to specific PAI Indicators. Looking at the questions with a more general scope, the clarifications relating to "current value", "all investments" and short and long positions are most noteworthy:

• For the "current value of all investments" in an investee company, FMPs should use the definition of "investee company's enterprise value" in point (4) of Annex I SFDR Delegated Regulation (see question no. I.1).
• For all PAI Indicators calculated by reference to "all investments" in the denominator (for example the PAI Indicators relating to carbon footprint and greenhouse gas emissions/intensity), the ESAs clarify that "all investments" include all types of asset positions managed by the FMP or held by the financial product. In case of a financial product, these positions should not be netted by liabilities, meaning that the net asset value of the financial product cannot be used as a calculation basis (see question no. II.2).
• Finally, short positions should be included in the overall calculation and long and short positions in the same counterparty should be netted, without, however, going below zero (see question no. II.3).

Use of the PAI statement template

When disclosing on their consideration of PAI according to Art. 4 SFDR, FMPs should use the PAI statement template set out in Table 1 Annex I SFDR Delegated Regulation. The ESAs Q&A clarify that FMPs may not delete rows of the template relating to PAI Indicators which are not relevant for their investments. Specifically, where an FMP does not make investment decisions relating to a category of investments (here sovereigns and supranationals as well as real estate assets), it must nevertheless keep the respective rows in its PAI statement. The ESAs suggest either leaving them empty or including zero values (see question no. II.11). From our perspective, it would be preferable to leave them empty as including zero values could be misunderstood as making investments which do not have any relevant impact.

While this approach may be cumbersome but acceptable for FMPs investing only in investee companies (as in the case which has led to the question), it is highly unattractive for FMPs investing only in one of the other investment categories. For example, an FMP investing only in real estate assets would have to include 16 empty rows in its PAI statement (relating to investee companies and sovereigns and supranationals) before coming to the relevant PAI Indicators for real estate assets.

Remaining complexity of the PAI concept

While the above clarifications are helpful to better understand the concept of PAI consideration, this concept is still by far the most complex and challenging within the entire SFDR framework. Market participants continue to struggle with the role of the PAI Indicators which can be used for a multitude of mostly unrelated functions:

• PAI consideration by FMPs under Art. 4 SFDR;
• PAI consideration by financial products under Art. 7 SFDR;
• Do no significant harm (DNSH) analysis for sustainable investments according to Art. 2 (17) SFDR; and
• Voluntary use of PAI Indicators to measure the attainment of: (i) environmental or social characteristics for an Art. 8 SFDR financial product; or (ii) the sustainable investment objective for an Art. 9 SFDR financial product (see ESAs clarifications dated 2 June 2022, no. 7 c) and question no. II.18).

In addition, the most pressing questions relating to PAI consideration are still unanswered: What does it mean to "consider" PAI? Is this limited to disclosures or is there any duty to take action? The ESAs have included them into their submission to the EU Commission on 9 September 2022 and the EU Commission's answers to these questions are awaited with suspense by the entire financial services industry.

B. Disclosure of EU Taxonomy alignment

Pre-contractual and periodic EU Taxonomy alignment

Following the guidance contained in the EU Commission Q&A published on 25 May 2022 (p. 9 to 11) and in the ESAs clarifications dated 2 June 2022 (no. 37 to 42), the ESAs reconfirm their position on the binding nature of the disclosure on the minimum proportion of EU Taxonomy alignment and set out an intricate system of disclosure duties differing between pre-contractual and periodic disclosures (see question no. V.8):

Calculation of EU Taxonomy alignment for infrastructure and real estate assets

Art. 17 SFDR Delegated Regulation is the main provision on the calculation of EU Taxonomy alignment for Art. 8 SFDR and Art. 9 SFDR financial products. For investments in investee companies, Art. 17 (2) SFDR Delegated Regulation makes reference to the rules on EU Taxonomy alignment in the context of non-financial disclosures under Art. 8 EU Taxonomy, including the EU Taxonomy KPIs of turnover, capital expenditure (CapEx) and operating expenditure (OpEx) introduced in EU Taxonomy and detailed in Commission Delegated Regulation (EU) 2021/2178 (Art. 8 Taxonomy Delegated Regulation).

Since there is no similar system of KPIs for investments in infrastructure or real estate assets under EU Taxonomy or Art. 8 Taxonomy Delegated Regulation, it was unclear how to perform this calculation. On the one hand, Art. 17 (1) letters (d) and (e) SFDR Delegated Regulation refer to "market value", on the other hand the EU Taxonomy alignment disclosures in the periodic disclosure templates in Annex IV and V SFDR Delegated Regulation specifically relate to the three EU Taxonomy KPIs turnover, CapEx and OpEx. Hence, many FMPs have applied the EU Taxonomy KPIs also to investments in infrastructure or real estate assets.

The ESAs now clarify that the EU Taxonomy KPIs should not be used when calculating the EU Taxonomy alignment of infrastructure and real estate assets for the purposes of SFDR. Instead, the calculation should be only based on market values and this should be explained in the respective disclosure templates. We understand this to mean that in the case of a financial product investing only in real estate or infrastructure assets, the bar charts in the periodic disclosure templates (Annex IV and V SFDR Delegated Regulation) should show 0% EU Taxonomy alignment and the actual alignment based on market value must be disclosed separately. Since the pre-contractual EU Taxonomy alignment does not make any split according to the EU Taxonomy KPIs, it should be possible to fill out the pie chart based on market value instead of turnover.

According to the ESAs, this should ensure comparability between various financial products. In our opinion, having to disclose 0% on the bar charts in the periodic disclosure and to mention the actual EU Taxonomy alignment elsewhere probably leads to investor confusion rather than to increased comparability. In addition, this would mean that for infrastructure and real estate assets, all EU Taxonomy alignment based on expenditures which is provided for in the EU Taxonomy and the Art. 8 Taxonomy Delegated Regulation would not count at all in the context of SFDR. To give a practical example in relation to real estate, this would mean that a real estate fund making significant investments to improve the quality of its assets in line with the requirements in No. 7.2 of Annex I to Commission Delegated Regulation (EU) 2021/2139 (Climate Delegated Act) (Renovation of existing buildings) would not be able to include these investments into its EU Taxonomy alignment calculation for SFDR purposes. This interpretation by the ESAs will surely not help to address the imminent need to improve existing assets and it remains to be seen if the deviation from the overall EU Taxonomy approach makes sense going forward.

Permitted data sources

Several of the questions in the ESAs Q&A deal with the data sources for EU Taxonomy alignment in the context of SFDR. According to Art. 17 (2) and Recital (35) SFDR Delegated Regulation, public disclosures of investee companies should be the primary source of information and, where they are available, also the only one. If no such public disclosure is available, FMPs may use equivalent information obtained directly from the investee companies or third party providers. Moreover, where no such information can be obtained, FMPs can make complementary assessments and estimates to compensate for limited and specific parts of the required data (see also the EU Commission Q&A published on 25 May 2022, p. 10 and 11). The ESAs reinforce this principle and state that they expect EU Taxonomy alignment disclosures for investee companies to become much more straightforward when the full EU Taxonomy disclosure obligations under the Art. 8 Taxonomy Delegated Act will apply (see question no. V.9).

Moreover, the ESAs clarify that "equivalent information" must have the same content and level of granularity as provided by the "official" non-financial reporting under the Art. 8 Taxonomy Delegated Act. In particular, equivalent information can only relate to activities which are classified under the EU Taxonomy framework (i.e. currently in the Annexes to the Climate Delegated Act). Moreover, it should only rely on actual information (unless specific circumstances permit assessments and estimates, see above) and the EU Taxonomy DNSH assessment should not be made on the basis of mere controversy-based approaches (see questions no. V.10 and V.11).

This clarification reinforces the rigorous process the EU Commission and the ESAs wish to establish for EU Taxonomy alignment. It remains to be seen how FMPs can cope with this approach going forward, in particular in relation to the many investments which will continue to be out of the scope of EU Taxonomy reporting duties. In question no. V.5, the ESAs acknowledge that until the further development of the ESG information chain, FMPs and regulators will need to rely on the available data. However, the ESAs expectation that there will be a major improvement in the availability of data with the entry into force of the EU Corporate Sustainability Reporting Directive (CSRD) seems to ignore that EU FMPs and financial products invest globally outside the scope of EU regulation and that the CSRD does not exhaustively cover all investments even within the EU.

General calculation principles

The ESAs Q&A also contains several clarifications on general calculation principles for EU Taxonomy alignment:

• Similar to the PAI disclosures (see above A.), EU Taxonomy alignment calculation based on " investments of a financial product" should be based on the market value of the relevant investments in the numerator and the denominator of the EU Taxonomy formula in Art. 17 (1) SFDR Delegated Regulation and not on the net asset value of the financial product (see question no. I.2).
• Moreover, the ESAs clarify that investments which are formally held by a financial product but economically allocated to someone else via a total return swap should not be included in the numerator for the EU Taxonomy alignment calculation (see question V.12).
• Finally, the ESAs state that investments in economic activities which are aligned with more than one of the EU Taxonomy objectives or that, in addition, also contribute to another environmental or social objective should not lead to double counting. This is particularly relevant for the periodic reporting for which the ESAs require a breakdown based on single EU Taxonomy objectives (ESAs clarifications dated 2 June 2022, no. 41) as well as for the minimum proportions of sustainable investments with an environmental objective outside of the EU Taxonomy and sustainable investments with a social objective which have to be disclosed in the pre-contractual and periodic disclosures for Art. 8 and 9 SFDR financial products. According to the ESAs, investments should be allocated only to one of the relevant categories based on contribution or alignment to avoid creating the impression that the financial product holds more EU Taxonomy aligned or other sustainable investments than it actually does (see question no. V.15).

C. Financial product disclosure

The focus of the ESAs Q&A clearly lies on PAI and EU Taxonomy alignment, but they also contain some noteworthy guidance on financial product disclosures.

Sustainable investments under Art. 2 (17) SFDR

The ESAs confirm that within the scope of Art. 2 (17) SFDR, FMPs are in general free to define the circumstances in which economic activities contribute to the pursued environmental or social investment objectives (see question no. III.6). There is no prescribed methodology for measuring if the underlying economic activity contributes to the sustainable investment objective (see question no. V.16). FMPs could use the EU Taxonomy KPIs (turnover, CapEx and OpEx) for measuring the proportion of sustainable investments if they wish so but the ESAs do not issue a respective recommendation or state that they consider this to be good practice. This freedom of methods differentiates "general" sustainable investments from sustainable investments which are EU Taxonomy aligned. For the latter, an assessment of the "significant contribution" needs to be performed on the basis of the detailed technical screening criteria set out in the Climate Delegated Act.

Nevertheless, the ESAs note that FMPs should set up a consistent framework for sustainable investments and should not interpret the requirements of Art. 2 (17) SFDR differently for different financial products they make available (question no. III.6). What this means exactly will need to be tested in practice. In our view, different asset classes, economic activities, data sources and sustainable investment objectives will continue to require different assessment processes in relation to contribution as well as DNSH. On the contrary, overarching principles such as the minimum share of revenues associated with the sustainable investment objectives could be applied similarly across various asset classes and strategies.

The ESAs also note that it should not be possible to escape the specific requirements of Art. 9 (3) SFDR by rephrasing the objective of a financial product from "reduction of carbon emissions" into "reduction of greenhouse gas emissions". In their opinion, the category of Art. 9 (3) SFDR is not limited to carbon emissions and should be extended to greenhouse gas emissions as the main category (see question no. II.7). The reference to "carbon emissions" in Art. 9 (3) SFDR may indeed have been caused by a terminology error made when introducing the two climate benchmarks to which Art. 9 (3) SFDR refers (EU Climate Transition Benchmark and EU Paris-aligned Benchmark). The respective Regulation (EU) 2016/1011 (Climate Benchmarks Regulation) speaks of "Scope 1, 2 and 3 carbon emissions" but the implementing provisions for the Climate Benchmarks Regulation correct this and refer to greenhouse gas emissions instead, in line with internationally accepted standards.

Although a few questions have been answered in the ESAs Q&A, the category of sustainable investments under Art. 2 (17) SFDR still remains very unclear, as demonstrated by the many questions asked by the ESAs in their questions on the interpretation of SFDR submitted to the EU Commission on 9 September 2022. These questions relate to main concepts of the sustainable investment category, such as:

• Does "contribution" relate to the products or services of a company or is it sufficient if the company runs its operations in a more sustainable manner than others?
• For companies with various products or services, what is the threshold that needs to be passed to consider the investment in such companies as sustainable investments?
• Is it sufficient to only avoid or reduce harm (for example by reducing greenhouse gas emissions)?

In the absence of clear answers by the EU Commission FMPs will continue to apply very differing levels of sophistication and ambition when determining what is a sustainable investment according to Art. 2 (17) SFDR.

Good governance for Art. 8 SFDR financial products

Question no. II.3 clarifies that to comply with the good governance criterion for an Art. 8 SFDR financial product, an FMP must have its own assessment policy covering at least sound management structures, employee relations, remuneration of staff and tax compliance. The FMP is however not obliged to use reference metrics such as UN Global Compact or the OECD Guidelines for Multinational Enterprises.

With this answer, the ESAs again make a clear distinction between the so-called "Minimum Safeguards" required for EU Taxonomy alignment and the qualification as sustainable investment under SFDR, and the more generic "good governance" concept in Art. 8 SFDR. This is reassuring for FMPs given the detailed framework the Platform on Sustainable Finance has recently recommended to use for the Minimum Safeguards.

Use of the disclosure templates

In line with the instructions contained in the pre-contractual and periodic disclosure templates to be used by Art. 8 and 9 SFDR financial products (Annexes II to V SFDR Delegated Regulation), the ESAs confirm that sections which are not relevant may be deleted. This is limited to sections which only need to be filled out under specific circumstances, as expressly indicated by the instructions included (in red text) in the disclosure templates (see question no. III.1). This is inconsistent with the guidance issued by certain national regulators, such as the Luxembourg CSSF, which have required that all sections should be maintained and shown as not being applicable.

D. What FMPs should do next

Virtually every conversation with FMPs on sustainability disclosures revolves around the two big challenges of unclear regulation and lack of data. The guidance provided in the ESAs Q&A at least provides some help with the first of these challenges.

However, it should be kept in mind that most FMPs are in the final stages of their SFDR implementation projects and are rushing to finetune their disclosures and to meet any regulatory deadlines by 1 January 2023. Having to analyse and integrate the ESAs Q&A will present yet another difficult challenge for FMPs struggling with the already complex regulation.

In addition, although there are only six weeks to go until SFDR Delegated Regulation applies, many questions on fundamental concepts of SFDR still remain unanswered, such as the questions on the interpretation of SFDR submitted to the EU Commission by the ESAs on 9 September 2022. From 1 January 2023, FMPs will need to disclose alignment with the remaining 4 EU Taxonomy objectives (water/marine resources, circular economy, pollution and biodiversity/ecosystems) while there is still no regulation (not even a draft) defining the technical screening criteria for these objectives. Finally, FMPs may also be forced to amend their almost final disclosures if the EU Commission's proposal to integrate the EU Taxonomy extension to nuclear energy and fossil gas into the SFDR Delegated Regulation before year end is successful.

In this situation, pragmatism and clear prioritisation is crucial to managing the ever growing and changing regulatory requirements. FMPs are well advised to review the ESAs Q&A and assess to which extent changes to reflect the ESAs Q&A are still possible without jeopardizing the completion of the work which needs to be done before year end. For example, pre-contractual and website financial product disclosures need to be ready on 1 January 2023, hence FMPs will have to check to which extent they can still integrate the clarifications on EU Taxonomy alignment and financial product disclosures. On the contrary, the first PAI statement will only need to be published by 30 June 2023 which leaves more time to consider the ESAs Q&A sections relating to PAI. Regardless of how quickly FMPs will manage to integrate the new guidance, it has now become clear that SFDR implementation will continue to keep FMPs busy well after 1 January 2023 – it is a marathon, not a sprint.