New Q&As from the European Commission on the Sustainable Finance Disclosure Regulation

The European Commission (Commission) has issued further guidance on the interpretation of the Sustainable Finance Disclosure Regulation (SFDR). This is in the form of responses to questions put to it in September 2022 by the European Supervisory Authorities (ESAs). The responses include guidance on the definition of sustainable investment, disclosures around the reduction of carbon emissions and principal adverse impact disclosures.

Unfortunately, some of the responses are not particularly enlightening and will be of limited use. However, the Commission does stress that the SFDR is intended to be a disclosure regulation, and therefore leaves a number of decisions to firms rather than mandating a particular approach. For some firms that, in itself, may be a helpful confirmation and they may also find other helpful clarifications or endorsements of their current approach.

It is also likely that the Commission's responses will embolden some firms to launch Article 9 funds, although – importantly - there has been no change to the previous guidance that all investments in such funds should qualify as "sustainable investments" (subject only to limited exceptions for liquidity and hedging).

In addition, the Commission has also issued some updated responses to its published Questions and Answers from July 2021 and May 2022.

We discuss some of the key points from the Commission's responses below.

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Definition of sustainable investment

The ESAs asked for guidance on the definition of "sustainable investment" in Article 2(17) of the SFDR. This is a fundamental concept, especially for an Article 9 or Article 8+ fund, and the lack of clarity in the definition has caused considerable confusion in the market.

As mentioned above, the Commission makes it clear that the definition of sustainable investment does not prescribe any specific approach for determining sustainability and, in particular, for determining whether a particular activity makes a "contribution" to an environmental or social objective. Instead, the obligation is for firms to disclose their methodology for classifying sustainable investments, provided that they adopt the SFDR-mandated framework for doing so (including application of the "do no significant harm" test).

The Commission also suggests that, where investment proceeds must be used for a specific project or activity, the sustainable investment test should be applied to that project or activity. Where the use of proceeds is not specified (such as when investing in general company debt or equity) the sustainable investment test can be applied at the level of the company, potentially suggesting that not all activities of the company need to be making a positive contribution in order for the company as a whole to qualify, provided the company as a whole passes the "do no significant harm" test.

The Commission also clarifies that a transition plan aiming to achieve "do no significant harm" in the future would not be sufficient to enable an investment to meet the threshold criteria for a sustainable investment. That is as expected and confirms that "significant harm" is measured at the date of investment: an investment only qualifies as sustainable if the tests are met at that time.

Carbon emissions reduction

The ESAs also asked several questions on the application of Article 9(3) of the SFDR, a category of Article 9 for products which have the objective of carbon emissions reduction.

The Commission clarifies that financial products which passively track Paris Aligned Benchmarks and Climate Transition Benchmarks are deemed to have sustainable investment as their objective and therefore firms are not required to provide an explanation of how the objective of reducing carbon emissions is attained for such products.

In addition, the Commission clarifies that a reduction of carbon emissions can be a promoted characteristic of an Article 8 product on the basis that Article 8 of the SFDR does not limit the types of characteristics that can be promoted by financial products. That is important and confirms the general market view that an Article 8 fund with a carbon reduction theme is not automatically within the scope of Article 9 and subject to the additional constraints that would imply. However, any information that is disclosed should not mislead investors into thinking that a reduction of carbon emissions is part of the product's objective (as that could suggest that it is an Article 9(3) product). Although this confirmation is welcome, some firms with promoted characteristics relating to carbon emission reduction may need to consider whether this will require additional and more explicit disclosures to be made.

Principal adverse impacts

One question asked the Commission for clarification on the meaning of "consider" in the context of whether a firm "considers" PAIs by a financial product under Article 7(1)(a) of the SFDR. In particular, the question asked whether this requires disclosure only of the relevant PAIs (or example, total greenhouse gas emissions) or also disclosure of the action taken by the firm to address the PAIs of the product’s investments (such as engagement with investee companies).

The response from the Commission, which does not answer the question fully, states that firms should disclose on their websites both a description of the PAIs and the procedures put in place to mitigate those PAIs. This is largely based on a reading of Recital 18 of the SFDR and leaves open the more fundamental question of whether "consider" requires a firm to take account of PAIs (and therefore collect them) prior to making an investment decision, or whether it is sufficient to collect them post-investment and take steps to mitigate them at that stage.

If you would like further information or assistance in understanding the Commission's Q&A responses, please speak to your usual Travers Smith contact or any of the individuals below.

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