Published 6 December 2021 by Audra Walton
On November 25th the European Commission announced in a letter to the Council of the European Union, that due to the “length and technical detail” of the second phase of the Sustainable Finance Disclosure Regulation (SFDR), it would be delayed until January 1, 2023 – six months later than previously planned, and the second delay this year.
What does the SFDR Level 2 require from investors?
As part of the SFDR Level 1 regulation, which has been in effect since March 10th, financial market participants are required to make a statement of how they incorporate Principal Adverse Impact in their investment decision process.
But the second phase of the SFDR goes a step further, requiring that financial market participants must report on a set of Principal Adverse Impact indicators, aggregated at entity level across its investments in a given period. With the deadline now moved, this period will be from January 1, 2022 to December 31, 2022. These PAI indicators are a set of environmental, social and governance indicators and metrics, ranging from carbon emissions, water emissions, biodiversity impacts, social violations, and gender parity on the board. The regulatory technical standards (RTS) for Level 2 provide a table with mandatory indicators, and two tables with voluntary indicators of which a financial undertaking needs to pick one of each. There is no requirement to report on PAI indicators on fund/portfolio/financial product level in the regulation (but as mentioned above, a narrative disclosure is required for products).
Note PAI indicators apply to corporate, sovereign, and real estate holdings.
How do these PAI disclosures affect companies?
PAIs provide a clear set of indicators and metrics on which to base stock selection and fund comparison. In looking to improve their PAI scores, fund managers may rank investee companies based on PAIs, engage those that don’t rank well, and even divest.
Besides an impact on stock selection, we would expect financial advisors / institutions to begin ranking funds based on PAIs or require funds’ PAIs to meet certain thresholds. While the regulation doesn’t require funds to publish their PAIs, it is likely that financial advisors / institutions will require fund managers to provide them. Many fund managers we have spoken to are already preparing for this. And while the regulation doesn’t set standards or benchmarks for PAIs, the market will inevitably start comparing and benchmarking PAIs as soon as reporting commences.
What can companies do to reduce their risk?
Identifying the level potential divestment due to ESG/SFDR reporting is essential, particularly for companies that have a moderate to high level of ESG risk or are not in a ‘green’ sector. CMi2i’s unique methodology looks at a company’s ESG performance/commitments and evaluates these using a proprietary methodology that identifies the likelihood ESG issue-driven engagement from shareholders, and/or divestment. CMi2i is also able to add financial performance metrics for a more comprehensive analysis. The result for companies is a clear breakdown of their shareholder base into high risk, medium risk, and low risk shareholders.
Investors increasingly want to be assured their capital is not invested in companies that will impact our world and societies in a negative way. The SFDR’s Level 2 requirements will provide much needed clarity on the level of negative impact a financial market participant is supporting through investment, thereby putting investee companies under increased scrutiny. The delay is immaterial in so much as nothing substantive has changed, other than the date for implementation – giving financial market participants 6 more months to evaluate the negative ESG impact of their investments.
The takeaway for issuers is the same: companies should get on the front foot by identifying the investors that are at risk of divestment and engage with them now.
Written by Audra Walton