As many so-called ‘Article 8’ and ‘Article 9’ funds are deep in the trenches of preparing their first periodic reports under the Sustainable Finance Disclosure Regulation (SFDR), the European Supervisory Authorities (ESAs) recently launched a new regulatory review for consultation. The review promises to ‘extend and simplify’ requirements to sustainable investments. But what does that mean, and how can fund managers with sustainable investment mandates prepare for what’s ahead?
Peder Michael Pruzan Jørgensen and Mette Dalgliesh Olsen, Raison Consulting, April 16, 2023.
New consultation promises to ‘extend and simplify’ SFDR
As most fund managers will know by now, preparing for the requirements under the Sustainable Finance Disclosure Regulation (SFDR) is no small feat. In our experience, this is especially the case in private markets, where companies often lack the knowledge, resources and data that is required by funds with sustainable investment objectives.
The latest consultation paper from the European Supervisory Authorities(ESAs) promises to “extend and simplify” the current complex in several areas. For fund managers who are hoping this will translate into fewer reporting obligations, we are sorry to disappoint. The review does however hint at several positive developments, including closer alignment with the EU’s Corporate Sustainability Reporting Directive (CSRD) on social indicators, more clarity on Principle Adverse Impact (PAI) accounting protocols, and a welcomed suggestion to simplify language and reporting templates in response to criticism from stakeholders.
Towards greater clarity on ‘sustainable investments’?
The most noteworthy part of the review is the call for greater clarity on what constitutes a ‘sustainable investment’, notably when it comes to applying the concept of ‘Do no significant harm’.
“Do No Significant Harm” (‘DNSH’) is a core pillar of both the EU Taxonomy for Sustainable Activities (‘EU Taxonomy’) and the Sustainable Finance Disclosure Regulation (‘SFDR’). The DNSH principle recognises that investing in activities with a substantial positive contribution to sustainable development objectives like wind farms or electric vehicles can also come with negative impacts on society e.g. by filling up landfills with old parts or using up natural resources for batteries. Across the two complexes, the DNSH principle therefore requires companies and investors who want to label themselves as “sustainable” to ensure that they do not cause significant harm to society in the process.
This is a topic which has boggled many fund managers preoccupied with sustainable investments since the launch of the SFDR. To give a concrete example: In the current regulation, funds with sustainable investment objectives can freely decide what constitutes ‘significant harm’, leaving high levels of discretion to individual fund managers and limited grounds for comparison across funds.
The rather vague approach to DNSH under SFDR is in sharp contrast to the application of the DNSH principle in the EU Taxonomy for Sustainable Investments, which includes more detailed environmental DNSH criteria at an economic activity level. As an example: if a company is involved in several activities covered by the EU Taxonomy, it would need to meet all the DNSH criteria that applies to these activities to be considered “sustainable”. In contrast, the DNSH requirements under SFDR are “sector-agnostic” and applies to the investment (company) level.
In practice, this means that investors could have some of their investments fail the DNSH requirements under the SFDR but not the EU Taxonomy – or vice versa. And herein lies the real problem as such conceptual discrepancies undermine the very purpose of both the SFDR and the EU Taxonomy, which is to create greater clarity on what constitutes as a “sustainable investment”.
What can fund managers with sustainable investment mandates do to prepare?
In the latest review, the ESAs appear concerned that the high levels of discretion related to DNSH could lead to greenwashing of “sustainable investments” under SFDR. While the review does not provide conclusive answers as to how the DNSH issue will be resolved, it hints towards much closer convergence between the SFDR and the EU Taxonomy going forward – potentially even a single “DNSH Taxonomy”. Still, patience is called for as the ESAs leave the issue to be addressed by the planned ‘comprehensive assessment’ announced by the European Commission in January 2023.
In the meantime, we advise fund managers with sustainable investment objectives to start preparing their investment frameworks and processes for what’s ahead through these three steps:
- Set clear DNSH thresholds and ensure they can be measured and monitored throughout the investment lifecycle. As a first step, we suggest taking a good look at your fund’s current DNSH framework to ensure that clear thresholds and criteria are in place, both at the point of investment and throughout the ownership period. In this process, the Principle Adverse Impact (‘PAI’) indicators should be taken into consideration, but as data can be difficult to come by at the point of investment, particularly in private markets, alternative assessment methods may be required.
- Ensure that your DNSH thresholds are aligned with the EU Taxonomy DNSH criteria, where possible.Based on the latest consultation from the ESAs, it is likely we will see higher degrees of convergence between the DNSH criteria for sustainable activities in the EU Taxonomy and the requirements to sustainable investments under SFDR. Therefore, if a fund is heavily invested in one or more economic activities considered eligible under the EU Taxonomy (say plastics, tourism, or real estate), we suggest to review and, where possible, incorporate the specific DNSH criteria developed for these economic activities in the fund’s DNSH framework and ‘test’.
- Opt-in to the Principle Adverse Impacts (PAI) regime for all sustainable investment products. Finally, for fund managers who have not done so already, we suggest opting into PAI for all sustainable investment products sooner rather than later as the wiggle room for opting out of PAI for these products is likely to get smaller in the coming years. As mentioned above, this creates new challenges related to data availability and quality, especially for private market funds who invest in unlisted small and medium-sized companies. That said, there are plenty of ways to support smaller portfolio companies in building up capacity and setting up their data collection processes in a manner that is proportionate to their size, nature and impact, and where data quality can be improved over time.
Raison Consulting is an advisory company specialised in sustainable investments in private markets. We help investors, fund managers and companies across asset classes unlock their full impact potential while meeting the growing requirements to sustainable investments. Raison is based in Copenhagen and co-founded by Mette Dalgliesh Olsen and Peder Michael Pruzan-Jørgensen with more than 35 years combined experience in driving sustainable transformations for both large, medium and small cap companies across sectors and geographies. Reach out on LinkedIn or via info@raison-consulting.com.
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