SFDR: Third Supervisory Report Published on Financial Institutions’ Adverse Impact Disclosures

In late October, the European Supervisory Authorities (the ESAs) announced the publication of their third joint annual report on both entity and product-level disclosures of Principal Adverse Impacts (PAIs) under Article 18 of the Sustainable Finance Disclosure Regulation (SFDR). The report is grounded in a survey of Member State National Competent Authorities (NCAs).

Overall, the report found that PAI-related disclosures are improving, but there is room to do more and the European Commission and NCAs have a role to play in this. For financial institutions, the main takeaway should be that expectations around the quality of SFDR reporting, as with all sustainability reporting, will continue to rise. 

With that in mind, the report sets out a helpful overview of good disclosure practices, such as making multiple translations of the PAI statement prominent on websites, using clear language and contextual information, and setting out the methodology used (including the relevance of specific metrics).

What is the Sustainable Finance Disclosure Regulation?

The SFDR is an EU regulation targeted at sustainable investments. Amongst other things, it requires financial market participants like banks, investment firms and pension funds (FMPs) to provide information about their PAIs. Reporting on these PAIs is considered by some FMPs to be among the more challenging aspects of SFDR compliance.

What is a Principal Adverse Impact?

A PAI is any impact stemming from investment decisions or advice that results in a negative effect on sustainability factors. FMPs are required to score the sustainability of their investments based on 14 mandatory and 31 voluntary PAI indicators, dealing with respect for human rights, environmental and employee matters, anti-corruption and anti-bribery matters. 

A PAI statement must include: (a) information on the policies in place to identify and prioritise the PAIs, (b) a description of the relevant PAIs, as well as actions planned or taken to manage them, (c) a statement on the due diligence policies in place to address PAIs, and (d) a demonstration of how the performance of the investments against the PAI indicators has evolved over time (using up to five prior reference periods). 

Disclosures are improving, but there is work still to do 

The report’s findings show that FMPs have improved the accessibility of their PAI disclosures to retail investors. There have also been positive developments on the quality of the information disclosed and the quality of the PAI statements overall. The ESAs also noted that, as more data becomes publicly available via the Corporate Sustainability Reporting Directive and associated European Sustainability Reporting Standards, accuracy should improve even further. 

There were particular improvements in product-related PAI disclosures, although the share of products disclosing SFDR PAI information remains quite low. The ESAs’ view is that further work is required to achieve full SFDR compliance. Parent companies have an important role to play here – one of the report’s observations is that parent companies can improve the quality and quantity of subsidiary disclosures by assisting with data collection and providing more general guidance on the PAI statement. 

Recommendations on good practice 

In order to drive further improvement in the quality of disclosures made under SFDR Articles 4(1)(a) and (b), the report sets out the following recommendations for good practice:

• Ensuring that PAI statements are easily accessible. The relevant webpage should be prominently found on a dedicated sustainability section of the website, with a clear reference to the SFDR. In the case of group companies, hyperlinks should be provided for each separate PAI statement belonging to the group.
   
• Ensuring that segment and label information within the PAI statement is clearly apparent and easily comprehensible. In some cases, the ESAs found that statements were written using small fonts and were surrounded by information that had no immediate connection with sustainability disclosures. An introductory paragraph before the PAI table is generally good practice, as is the avoidance of excessive abbreviations for the PAI indicators.
   
• Providing thorough explanations of each disclosure within the PAI statement.
   
• Providing translations of the PAI statement and having websites available in multiple languages. This removes one of the potential obstacles to full investor comprehension.
   
• Setting out the methods used for collecting and processing the available data, as opposed to generic references to the lack of availability of ESG data.
   
• Mentioning all mandatory indicators, even if they are not applicable to the entity.

Recommendations for the Commission, Member States and NCAs

The report makes several recommendations to the European Commission and NCAs, providing an early indication of the direction of travel in this area. 

Recommendations to the European Commission include to:

• Reduce the frequency of their assessment of the PAI disclosures to every two or three years (rather than annually), thus enabling ESAs and NCAs to focus more resources on meaningful analysis.
   
• Reconsider the “more than 500-employees” threshold as a method for achieving proportionality for FMPs, since it may not be the most appropriate way to measure the extent to which investments have PAIs. A more suitable threshold might instead be based on the size of the FMP’s investments.

Recommendations to the NCAs include to:

• Maintain and ensure regular external communication, for instance in the form of ‘Dear CEO letters’, guidance documents, surveys, and workshops.
   
• Keep assessment of PAI disclosures as part of the NCAs’ day-to-day supervisory approach.
   
• Consider checking the composition of investments. Where PAI disclosures show discrepancies with underlying investments, NCAs are encouraged to challenge FMPs and a financial product’s PAI disclosures based on actual investments and underlying companies’ adverse impact disclosures.