ESG regulations: a summary of EU regulations impacting asset managers

The Sustainable Finance Disclosure Regulation (SFDR) imposes sustainability-related disclosure obligations on financial services firms and financial products that have an EU-nexus.

The Taxonomy Regulation supplements and amends SFDR and: (i) establishes a taxonomy, or glossary, for assessing whether certain economic activities are considered “environmentally sustainable” in accordance with one or more of six prescribed environmental objectives; and (ii) introduces additional disclosure obligations for products in scope of SFDR. In time, the intention is to extend the taxonomy beyond purely environmentally sustainable objectives to include social objectives.

See our blog post for our thoughts on the applicability of SFDR to UK firms. See also a simple guide to the EC’s clarifications of the SFDR and a Q&A on the implementation of SFDR.

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A series of amendments to the existing AIFMD, UCITS and MiFID frameworks, which aim to integrate sustainability considerations into firms’ day-to-day operations. The measures form part of the EU’s sustainable finance action plan.

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The November 2021 letter delayed the adoption of the RTS until 1 January 2023, with the EU Commission citing the short three-month period for adoption and the length and required technical detail as the reason for the delay.

The purpose of the March 2022 Joint European Supervisory Authorities Supervisory Statement was to clarify the obligations of firms under SFDR in light of the delay to the adoption of the RTS. promote: In particular, the statement provided that firms must apply most of the provisions on sustainability-related disclosures laid down in the SFDR from 10 March 2021 notwithstanding that the RTS is delayed to a later date.

The statement included:

• a timeline of dates when provisions of SFDR, Taxonomy Regulation and the related Regulatory Technical Standards (RTS) come into force; and
• clarification that the first Principal Adverse Impact disclosures in accordance with RTS should be made in a statement published by 30 June 2023 in respect of a reference period corresponding to the calendar year 2022.

Following the December 2021 European Supervisory Authorities questions to the European Commission requesting clarifications on the SFDR and Taxonomy Regulation the Commission responded with a Q&A document.

The Q&A document from the European Commission responded to these questions.

The responses represented fundamental changes to the interpretation and application of SFDR and the Taxonomy Regulation and, in particular, included guidance clarifying that:

• Article 8 and 9 funds must ensure that portfolio companies within those portfolios follow good governance practices;
• disclosures for taxonomy alignment are required for all Article 8 products that promote environmental characteristics;
• disclosure requirements under SFDR apply to legacy funds that closed prior to implementation of SFDR; and
• PAI reporting can be reported at product level regardless of the existence of entity level reporting.

Whilst the contents of this supervisory briefing are non-binding and aimed at National Competent Authorities (NCAs) the briefing provides helpful guidance for investment managers on compliance with SFDR and the Taxonomy Regulation.

The briefing provides guidance on:

• the presentation of sustainability disclosures;
• fund names when utilising common ESG-themed nomenclature e.g. sustainable, impact, ESG, social;
• the importance of clearly identifying applicable sustainable investments or objectives in fund materials where a fund has those characteristics and consistency of related sustainability disclosures across fund documentation and marketing materials; and
• how firms will be supervised in practice by relevant NCAs adopting a risk-based approach to supervision for example, in performing periodic thematic reviews and spot checks of fund managers with regards to their compliance with sustainability regulations.

Prompted by “numerous requests for clarifications received from stakeholders” in their June Supervisory Statement the ESAs issued certain clarifications.

The clarifications covered:

• the methodology for Principal Adverse Impacts (PAI) disclosures including the provision of a worked example;
• the requirement that Article 9 products must only hold sustainable investments;
• the requirement for firms to disclose their “minimum proportion” of taxonomy aligned investments in pre contractual product disclosures;
• the distinction between the Do No Significant Harm (DNSH) disclosures and Article 4 and 7 SFDR disclosures; and
• investments must pass both the DNSH test under the SFDR and under the Taxonomy.

The report was the first report in the annual reporting cycle of the joint European Supervisory Authorities (ESAs) on the extent of non mandatory disclosures of the Principal Adverse Impact (PAI) indicators under the SFDR.

The report followed a survey of National Competent Authorities (NCAs), aimed to provide guidance on best practice and provide a picture of the then existing state of voluntary disclosures.

The report concluded that the level of compliance is subject to significant variation across the market and across jurisdictions. In particular, the ESAs identified that:

• the disclosures for financial market participants (FMPs) that do not take into account adverse impact of investment decisions on sustainability factors under Article 4 (1) (b) were lacking in detail;
• such FMPs largely failed to provide clear reasons for why they do not do so, with insufficient information as to whether and when they intend to consider such adverse impacts; and
• there was overall low level of disclosure of the degree of alignment with the objective of the Paris agreement, with disclosures on the alignment being vague and high level.

Best practice for managers was described in the report as including:

• full PAI statements, prominently displayed on the website of the manager (in the sustainability section) and including detail such as the methodology and data used for the assessment of the PAIs;
• clear details covering the process concerning consideration of PAIs; and
• clear decarbonisation objectives, with emissions calculations, setting out their climate strategy consistent with the Paris Agreement.

The report also covered some recommendations to NCAs covering topics such as the requirement to continuously observe the market for non compliance from managers and carry out market surveys, questionnaires and inspections.

The European Commission Notice, answered a number of frequently asked questions on Article 8 of the EU Taxonomy Regulation (the Disclosures Delegated Act) and provided further details following the December 2021 FAQs, which sought to provide guidance on the reporting of taxonomy eligible economic activities and assets.

The FAQs specifically clarified:

• the position where financial undertakings are not able to access required information on underlying investee entities;
• addressed how managers should weight their holdings in a portfolio to report taxonomy eligible assets;
• address the question of whether undertakings should report a breakdown of Taxonomy eligibility per environmental objective; and
• whether mortgages qualify as eligible for an asset manager (as an investment) or only for the bank that originated the loan/mortgage.

The European Supervisory Authorities (ESAs) published Q&As on the SFDR  Regulatory Technical Standards (RTS) in November 2022.

The purpose of the Q&As was to provide additional guidance and answer 70 questions from market participants on the RTS.

It clarified the following points:

• the data which is required to be collected quarterly for PAI Impact reporting, being the value of the investee company;
• that enterprise value and indicator value (e.g. GHG emissions) are not required to be measured quarterly, however Principal Adverse Impacts (PAI) Indicator calculations must still be performed with just the value being updated quarterly;
• managers which have delegated investment decisions to a portfolio manager must include such investment decisions in their own PAI analysis;
• market participants should distinguish between data that is calculated by the underlying investee company and data obtained from elsewhere;
• PAI reporting should follow the form set out in Table 1 of the Annex to the SFDR Delegated Regulation and market participants should not remove the irrelevant rows but indicate their irrelevance by leaving them blank or recording nil;
• market participants must have their own policy for assessing good governance, including assessments for sound management structures, remuneration of staff, employee relations and tax compliance; and
• guidance for the calculation of EU Taxonomy alignment for infrastructure and real estate assets given the lack of KPIs for these sectors in the EU Taxonomy, with a recommendation to use market values.

The Technical Screening Criteria (TSC) notice from the European Commission contained frequently asked questions on:

• how GHG emissions should be calculated (including methodologies) under the TSC;
• how to manage requirements for benchmarking when no benchmarks are available;
• application of the regulations with regards to the defence industry;
• certain specific sector based guidance on afforestation, manufacturing, energy, waste and water; and
• the interpretation of the do no significant harm test.

The notice sought to provide guidance on the disclosure obligations under Article 8 of the Taxonomy Regulation which was effective 1 January 2023.

The notice from the European Commission covers 34 FAQs including:

• the timeline for the Complementary Delegated Act;
• the timeline for the TSC in respect of the four environmental objectives of:

1. sustainable use and protection of water and marine resources;
2. transition to a circular economy;
3. pollution prevention and control;
4. protection and restoration of biodiversity and ecosystems; and

• the intersection, timeline and impact for the Corporate Sustainability Reporting Directive and the Taxonomy Regulation.

With much anticipation, on 14 April 2023, the European Commission published responses to the questions the joint European Supervisory Authorities (ESAs) had raised previously on the SFDR.

The most significant guidance was in relation to:

• the definition of “sustainable investments” in Article 2(17), with the guidance clarifying that, provided that the investment;
  • meets the test as per their disclosed methodology;
  • does not significantly harm the environmental and social objectives; and
  • follows good governance.

• market participants can classify investments as “sustainable investments” and can do so at the level of a company (rather than determined by a specific activity or by a use of proceeds funding instrument);
• clarification that Article 9(3) products, which have an objective of reduction of carbon emissions, can utilise both a passive or an active investment strategy;
• confirmation that the SFDR does not prescribe the use of Paris Aligned Benchmarks (PAB) or Climate Transition Benchmarks (CTB) nor any other type of index, the SFDR is a transparency regulation;
• clarification that market participants with products which do not passively track a PAB/CTB, are required to provide a detailed explanation of how the continued effort of attaining the objective of reducing carbon emissions is ensured in view of achieving the long-term global warming objectives of the Paris Agreement, whereas those that do track a PAB or CTB are not required to include this level of detail and are deemed to have sustainable investment as their objective and make sustainable investments;
• Article 8 funds which can promote carbon emissions reductions as a characteristic without becoming an Article 9(3) fund, however those with a carbon reduction objective must be Article 9 funds and therefore falling within the requirements thereof. Market participants should be clear to investors in marketing materials on the distinction between a carbon emissions reduction characteristic and an objective;
• clarification of the meaning of the word “consider” in the context of Article 7(1) of SFDR in the context of Principal Adverse Impacts (PAI) reporting. The disclosed description relating to the adverse impacts should include both a description of the adverse impacts and the procedures put in place to mitigate those impacts; and
• the question from the September 2022 letter on whether the 500 employee threshold in relation to PAIs should include secondees was responded to by the European Commission referencing the definition of employees as set out in the relevant national law.