The European Supervisory Authorities’ Final Report and draft Regulatory Technical Standards (“RTS”) setting out the proposed “Level 2” requirements under the Sustainable Finance Disclosure Regulation (“SFDR”) were published on 4 February 2021 (here).
While the ESAs are proposing that the RTS should legally apply from 1 January 2022, they have also recommended that the draft RTS be used as a reference when applying the provisions of the SFDR in the interim period between the application of SFDR (as of 10 March 2021) and the application of the RTS. This recommendation was published by the ESAs on 25 February (the “Recommendation”) (here).
The SFDR is a Level 1 text which sets out relatively high-level sustainability disclosure requirements and which was enacted to address the twin objectives of increasing transparency of sustainability-related disclosures and to increase comparability of disclosures for end investors.
The relevant disclosure requirements apply both at entity level, to Financial Market Participants (“FMPs”) and Financial Advisors (“FAs”), and at product level to “financial products”. They encompass website disclosures, disclosures in pre-contractual documents, as well as periodic disclosures in annual reports. For further information, see our briefing here.
As is common with EU legislation, the SFDR confers a number of empowerments on the European Commission to adopt further Level 2 or delegated legislation setting out more detailed requirements in relation to the content, methodologies and presentation of SFDR disclosures, based on draft RTS adopted by the ESAs.
The Consultation on the Draft RTS
The ESAs launched a consultation on the draft RTS on 22 April 2020 with a closing date for comments on 1 September. In order to improve the transparency and comparability of product disclosures, the ESAs also devised harmonised templates for pre-contractual and periodic product disclosures, which were the subject of a separate consultation in September 2020, as well as consumer testing.
The draft RTS proved very controversial as they were significantly more onerous than the industry had expected and there was widespread concern that in-scope firms would be unable to comply with the finalised RTS by the 10 March 2021 deadline, which applies to most of the SFDR disclosures.
Ultimately, following representations from industry bodies, the European Commission agreed to postpone the application of the RTS, meaning that in-scope firms must only comply with the more general disclosure requirements set out in the SFDR by 10 March with the Level 2 requirements applying at a later date.
The Draft RTS
The draft RTS address the content, methodologies and presentation of sustainability-related disclosures required under the SFDR at both entity and product level. They comprise six chapters in all, including chapters on the principal adverse impacts sustainability statement (“PAISS”) as well as on the pre-contractual, website and periodic disclosure requirements. They also include five mandatory template disclosure statements in relation to the PAISS, pre-contractual disclosures and periodic disclosures. An FMP has a degree of flexibility regarding the presentation of the various disclosure templates in that the draft RTS allow an FMP to adapt the font type and size as well as the colours of the various templates.
Entity Level Principal Adverse Impact Reporting
The SFDR requires an FMP to publish on its website a statement on its due diligence policies with respect to the principal adverse impacts (“PAIs”) of its investment decisions on sustainability factors. Generally this requirement applies on a comply or explain basis, except for FMPs with over 500 employees.
In common with the SFDR, the reporting template includes reporting items for a description of principal adverse sustainability impacts; policies on the identification of PAIs; actions taken and planned to mitigate the PAIs; and adherence to international standards. It also includes a summary and a historical comparison of the disclosing FMP’s PAISS reports covering at least five previous reference periods.
The description of principal adverse sustainability impacts is intended to show how investments adversely impact indicators in relation to climate and environment; and social and employee matters, respect for human rights, anti-corruption and anti-bribery aspects. These indicators are divided into:
- a core set of universal mandatory indicators that will always lead to the PAI of investment decisions on sustainability factors, irrespective of the result of the FMP’s assessment; and
- additional opt-in indicators for environmental and social factors, to be used to identify, assess and prioritise additional PAIs.
The ESAs have revised the balance between the two lists of indicators following the consultation paper feedback. There are fewer universal mandatory indicators and more opt-in indicators. Additionally, the ESAs have provided separate indicators for impacts from investments in investee companies, sovereigns (and supranationals) and real estate assets.
Annex 1 of the draft RTS provides a mandatory reporting template that an FMP must use for the PAISS, which includes various reporting items and which must be published on the relevant FMP’s website by 30 June each year. FMPs must calculate their PAIs on at least four specific dates to obtain a representative level of PAIs over the course of the relevant reference period.
Pre-Contractual Product Disclosure
Article 6 of the SFDR requires FMPs to include descriptions of the following in pre‐contractual disclosures:
- the manner in which sustainability risks are integrated into their investment decisions; and
- the results of the assessment of the likely impacts of sustainability risks on the returns of the financial products they make available.
Further disclosures must be made in the case of a financial product that promotes environmental or social characteristics (an “Article 8 Product” or a “Light Green Product”) and a financial product that has sustainable investment as an objective (an “Article 9 Product” or a “Dark Green Product”).
The draft RTS include mandatory templates in the Annexes for pre-contractual disclosures in relation to both Light Green and Dark Green Products, however, there is no template for pre-contractual disclosures that do not fall into one or other of these categories.
In addition to the mandatory templates, the draft RTS set out a list of items to be included in the reporting indicating clearly the type of product and how the environmental or social characteristic (or combination thereof) or the sustainable investment objective of the product are achieved.
In the case of a Light Green Product, an FMP’s pre-contractual disclosures must include information as to:
- whether or not the Light Green Product invests in sustainable investments, within the meaning of Article 2(17) SFDR, and if so, how those investments contribute to a sustainable investment objective and comply with the “do not significantly harm” principle under SFDR (the “DNSHP”), including an explanation of how the principal adverse impact indicators in Annex I of the draft RTS are taken into account and whether the sustainable investment is aligned with certain minimum safeguards (including the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights), in line with the minimum safeguards set out in Article 18 of the Taxonomy Regulation;
- information on the FMP’s policy to assess good governance practices of investee companies;
- the binding elements of the investment strategy used to select the investments to attain each of the environmental and/or social characteristics promoted by the financial product;
- the asset allocation planned for the specific product, including information regarding the investments of the financial product which are neither aligned with the environmental or social characteristics, nor are qualified as sustainable investments; and
- whether the financial product takes into account principal adverse impacts on sustainability factors.
Much of this information must also be disclosed in the case of a Dark Green Product, along with certain additional information.
The draft RTS also set out requirements for pre-contractual disclosures in the case of financial products with investment options and where a product designates an index as a reference benchmark.
Product Level Website Disclosures
Article 10 SFDR requires FMPs to make supplemental website disclosures regarding Light and Dark Green funds, which includes the information provided for the purpose of the pre-contractual disclosures as well as specified additional information.
The draft RTS set out the details of the content and presentation of this information, including a list of items to be covered in the disclosure, focusing on the methodology employed, the data sources used, and any screening criteria employed.
The RTS also includes requirements for products making sustainable investments regarding how the product complies with the DNSHP, including an explanation of how the principal adverse impact indicators in Annex I of the draft RTS are taken into account and whether the sustainable investment is aligned with certain minimum safeguards consistent with those set out in Article 18 of the Taxonomy Regulation.
Compared to the version included in the consultation paper, the RTS in the final report have the disclosure items re-ordered to reflect the order of disclosure in the pre-contractual section of the RTS. Also, the disclosure of direct versus indirect investments has been moved from pre-contractual and periodic disclosures to the website disclosures.
Periodic Level Product Disclosures
Article 11 SFDR requires FMPs to make certain periodic disclosures in respect of Light and Dark Green Products and the draft RTS set out a granular list of items to be included in the reporting, focusing on the success of the product in attaining its environmental or social characteristic or sustainable investment objective, including disclosure of the top 15 investments made during a particular reference period. Similar to the pre-contractual section, the draft RTS include a requirement to use a mandatory reporting template for the presentation of the periodic disclosure. Over time, FMPs will be required to disclose a year-by-year historical comparison of these periodic disclosures, and must continue to include further historical comparisons to cover at least five previous reference periods.
As mentioned, the ESAs have recommended that the RTS should apply from 1 January 2022. Nevertheless, the ESAs are also recommending that national competent authorities encourage FMPs and FAs to use the interim period from 10 March 2021 until 1 January 2022 to prepare for the application of the RTS.
The ESAs have also set out in the Annex to the Recommendation some more specific guidance as a reminder of the application timeline of some specific provisions of the SFDR, the Taxonomy Regulation and the RTS.
While industry attention has been very much focused on the SFDR deadline of 10 March 2021, in reality this is more the end of the beginning rather than an end in itself. Specifically, once that deadline has passed, FMPs and FAs will need to start preparing for the next SFDR deadlines, as well as reviewing and enhancing their 10 March disclosures. In doing so, they are likely to find the Annex to the Recommendation useful. Moreover, it will no doubt be both beneficial and good practice to refer to the ESAs’ draft RTS, as regards the approach to be adopted. Nevertheless, it is important to remember that the draft RTS are still subject to change, and being “encouraged” to apply the draft RTS is not the same as being legally obliged to do so.