SFDR 1.5: A New Set of RTS?

The Sustainable Finance Disclosure Regulation (SFDR)¹ has, since becoming effective in March 2021, changed the approach to the establishment and marketing of sustainable investment products in the European Union (EU). Financial market participants (FMPs) have expended significant resources in designing investment products and preparing disclosure documents compliant with the SFDR and the Regulatory Technical Standards (RTS) that have supplemented the SFDR since 1 January 2023. However, shortly after the first round of disclosures were prepared under the RTS, the Joint Committee of the European Supervisory Authorities (the ESAs) consulted at the European Commission’s (EU Commission) request² on amendments to the RTS in April 2023 (the Consultation)ᶾ, subsequently issuing their Final Report⁴ with proposed amendments (the Draft RTS)⁵ on 4 December 2023. The expectation was that the EU Commission and subsequently the Council of the EU (Council) and the European Parliament would approve the Draft RTS sometime in the course of 2024, with the new requirements coming into effect in 2025. The timing, however, no longer remains clear given the EU Commission’s new initiatives to roll back or ‘simplify’ certain sustainability reporting requirements for competitiveness reasons, various proposals from the Platform on Sustainable Finance on the categorisation of sustainable products under the SFDR⁶ and the proposed publication of legislation to revise SFDR in Q4 2025⁷.

The Draft RTS provides for new requirements or changes relating to:

• a new financial product disclosure of greenhouse gas (GHG) emission reduction targets;
• some “improvements and simplifications” to the financial product templates, contained in Annexes II-V of the RTS, including a new “dashboard” providing a snapshot of key information relating to sustainable investments, Taxonomy-alignment, PAIs and GHG emission targets; and
• an extension of the social PAI indicators as well as other changes to the PAI disclosure framework.

The ESAs are also proposing additional technical amendments to the RTS relating to:

• enhanced disclosure of how sustainable investments comply with the “do not significantly harm” (DNSH) principle;
• revision of the provisions for products with investment options such as multi-option products (MOPs); and
• other technical changes, including harmonised calculation of sustainable investments and a requirement to produce the disclosures in machine-readable format.

Of these proposed changes, some will have a greater impact than others. In this OnPoint we focus on the developments that will be most significant – namely:

1. Increased disclosures with regards to GHG emission reduction targets;
2. Changes proposed with respect to the PAIs; and
3. Changes to the disclosure templates in Annex II-V of the RTS (the Templates).

It is worth briefly noting what proposals from the Consultation were not part of the Draft RTS:

• Disclosure of PAI-related DNSH thresholds – while noting the feedback received on this topic, the ESAs highlighted that the DNSH element of sustainable investments is also under review by the EU Commission in their consultation⁸ on the SFDR Level 1 framework and therefore, in light of potential changes as a result of that consultation, the ESAs decided not to make any revisions.
• Amendments related to a “safe harbour” for taxonomy-aligned investments – the ESAs noted that the question of whether there was a “safe harbour” for investments in certain categories of economic activities deemed environmentally sustainable under Article 3 of the Taxonomy Regulation had been clarified in the interim by the EU Commission’s Q&A⁹ confirming the existence of such safe harbour.

The current proposals as set out in the Draft RTS provide for the following changes.

(1)    Changes to Greenhouse Gas Emission Reduction Targets

The Draft RTS introduces several key changes regarding the disclosure of GHG emission reduction targets at the product level. The changes aim to balance the need for detailed, decision-useful disclosures for investors with the need for comprehensible, summarised information suitable to retail investors.

The Draft RTS make clear that they apply not only to products having GHG emissions reduction as their investment objective under Article 9(3) SFDR, but also to other products classified under Articles 8 and 9 of SFDR that have set GHG emissions reduction targets.

It is important to note that these additional GHG emission target rules do not apply to products that do not set GHG emissions reduction targets at the product level.

The core aspects of the proposed changes include:

• Enhanced Disclosure Requirements: FMPs will need to provide more detailed information on GHG emission reduction targets, including specific metrics and methodologies used in their pre-contractual documents and periodic reports. Both these documents should also cross refer to additional complementary website disclosures made in accordance with Article 10 of SFDR.
  • For products that passively track EU Climate Transition or Paris-Aligned Benchmarks (the EU Climate benchmarks), simplified disclosures apply, comprising: (1) a short summary of how ESG factors are reflected in the benchmark tracked by the product; and (2) a hyperlink to a description of the relevant benchmark methodology.
  • For products that do not passively track an EU Climate benchmark, detailed disclosures are required and the reference to the benchmark methodology should only be provided as a complement.

FMPs will need to ensure that they are clear as to their GHG emissions reduction targets, including defining the associated metrics and methodologies, and that they have appropriate processes in place to monitor and document data required to meet the new reporting requirements (as further described below).

• Standardised Reporting: The Draft RTS introduce standardised disclosures in the Templates for reporting GHG emission reduction targets to ensure consistency and comparability across disclosures. The Draft RTS do not specify any specific approach to climate target-setting. However, the Draft RTS require that GHG emission reduction targets are set in terms of financed GHG emissions (meaning the gross value of the GHG emissions) to assist with the comparability between products.
• How the Target is Achieved: FMPs will be asked to disclose and describe how a product intends to achieve its GHG emission reduction targets in the pre-contractual documents through:
  • divestment from assets with particular GHG emissions levels or excluding relatively higher-emitting assets from the portfolio; and/or
  • investing in assets that are expected to deliver GHG emissions reductions over the duration of the investment; and/or
  • engaging with investee companies to contribute to their GHG emissions reduction.

By framing this disclosure primarily through a series of tick boxes in the Templates, the Draft RTS aim to ensure comparability and comprehensibility for retail investors.

The Templates also allow FMPs to include an alternative method of achieving the product’s GHG emission reduction targets, provided a narrative explanation is included.

• Scope of Emissions: The Draft RTS contain clear guidelines on the scope of emissions to be included, covering Scope 1, Scope 2 and, where relevant, Scope 3 emissions. It is expected that FMPs will continue using estimates by third-party providers while the availability and reliability of scope 3 emissions data improves. The Draft RTS require FMPs to be transparent in their Article 10 SFDR website disclosures about the share of the investments for which gross GHG emissions (i) was reported by underlying investee undertakings, (ii) was retrieved from investee companies or (iii) could be estimated.
• Target Length: The maximum length between targets is five years. Where the investment horizon of the product is longer than five years, interval targets are to be disclosed with a maximum interval of five years. As with the standardisation measures above, these changes aim to assist investors with the comparability of different products.
• Baseline and Progress Measurements: As mentioned above, the baseline and any progress measurements are to be disclosed in terms of financed GHG emissions. The following asset classes should be included when assessing financed GHG emissions (where a product invests in such asset classes): listed equity and corporate bonds, sovereign bonds, business loans and unlisted equity, project finance, commercial real estate, mortgages and motor vehicle loans.

However, the FMP may also integrate other asset classes where they consider the investments are relevant and provided that the standards or methodology used to assess such asset classes is disclosed. To avoid overburdening retail investors with technical information, data for all asset classes apart from sovereign bonds will be aggregated in in the pre-contractual disclosures and periodic reports (although may also be disaggregated in website disclosures).

• Sovereign Bonds: Unlike other asset classes, where the attribution factor (e.g., ratio used to determine the share of total annual GHG emissions of the borrower/investee allocate to a specific loan/investment) is based on a measure of the value of the underlying assets, the attribution factor for sovereign bonds is generally based on macro indicators, such as output or population.
• Progress Reporting: In a product’s Template periodic report, FMPs will also need to include mandatory annual reporting on progress towards achieving GHG emission reduction targets, including any deviations and corrective actions taken. FMPs should be mindful of documenting such progress during the course of their products’ financial year in order to meet the new reporting requirements in their products’ annual reports.
• Carbon Credits/GHG Removal: The Draft RTS provide that product-level financed GHG emission should only reflect gross GHG emissions of the investments and financial products’ GHG emission reduction targets must be set on that basis as well. GHG removal and storage, carbon credits or avoided emissions implemented by investees companies/financed projects (including carbon credits purchased by FMPs) cannot be relied upon as a means of achieving the GHG emission reduction targets at product level.

However, the Draft RTS recognise the potential contribution of carbon credits to climate change mitigation and provide for FMPs to report the volumes of carbon credits they have purchased and cancelled during the reporting period in the periodic reports. Such carbon credit report is optional and must be disclosed separately from reporting on the progress towards financed GHG emission reduction targets. Where FMPs elect to disclose on carbon credits, they should be attributable to one financial product only and accompanied by detailed website disclosures setting out the portion of carbon credits that have been certified by recognised quality standards for carbon credits.

• Alignment with Paris Agreement: FMPs must disclose in the Templates whether the GHG emission reduction targets are aligned with the goals of the Paris Agreement, specifically aiming to limit global warming to 1.5°C. For products that do not assess alignment with this goal, FMPs must include a mandatory disclosure that the product may not be compatible with the objective of limiting global warming to 1.5°C.

(2)    Changes to the PAI Disclosure Framework

The reporting of PAIs is notably provided for in Annex 1 of the RTS. The ESAs’ suggested updates to the PAI regime broadly include: (a) modifications to the lists of mandatory and optional PAI indicators; and (b) clarifications with respect to PAI indicator calculation and disclosure methodologies.

Modifications to the lists of mandatory and optional PAI indicators

As summarised below, there are several meaningful changes to the lists of mandatory and optional PAI indicators proposed by the ESAs. These proposals (a) expand the lists of both mandatory and optional indicators, particularly with respect to ‘social’ indicators, (b) seek to bring clarity to previously ambiguous indicators, and (c) aim to increase consistency around how certain reporting obligations and their corresponding data points are interpreted and calculated across disclosure regimes.

• New Mandatory ‘Social’ PAI Indicators
  • Amount of accumulated earnings in non-cooperative tax jurisdictions applying to investee companies where the total consolidated revenue on their balance sheet date for each of the last two consecutive financial years exceeds a total of EUR 750 million. This applies to investee companies in scope of the Accounting Directive¹⁰.
  • Share of employees of investee companies earning less than adequate wage. ‘Adequate wage' is as defined in the European Sustainability Reporting Standards (ESRS).
  • Exposure to companies active in the cultivation and production of tobacco.
• Modifications to Existing Mandatory PAI Indicators
  • Non-respect of OECD Guidelines for Multinational Enterprises or the UN Guiding Principles¹¹ including the principles and rights set out in the eight fundamental conventions identified in the International Labour Organization’s (ILO) Declaration and the International Bill of Human Rights. This replaces the previously used "violation" with "non-respect".
  • Unadjusted gender pay gap between female and male employees. This adds “unadjusted” to align with the ESRS.
• New Optional ‘Social’ PAI Indicators
  • Share of employees in investee companies not covered by collective bargaining agreements.
  • Share of non-guaranteed hour employees in investee companies as a share of total employees.
  • Share of temporary contract employees in investee companies as share of total employees.
  • Share of non-employee employees in investee companies as share of total employees. Given that SFDR does not contain a definition of ‘employee’ (nor a ‘non-employee’), these concepts must be interpreted in light of applicable national laws.
  • Share of persons with disabilities within the workforce of investee companies.
  • Share of investments in investee companies without remediation mechanism for stakeholders materially affected by the operations of the investee companies.
  • Share of investments in investee companies without remediation mechanism for consumers/end-users of the investee companies.

• PAI Indicators Changed from Mandatory to Optional
  • Lack of processes and compliance mechanisms to monitor compliance with OECD Guidelines for Multinational Enterprises or the UN Guiding Principles, including the principles and rights set out in the eight fundamental conventions identified in the ILO declaration and the International Bill of Human Rights.
  • Interference in the formation of trade unions or elections of workers representative.

Clarifications in respect of PAI indicator calculation and disclosure methodologies

The ESA’s key proposals include:

• Data sources: the proportion of a calculation in respect of a PAI indicator that is based on actual data from investee companies and the proportion that is based on estimates or assumptions should be disclosed under the ‘Explanation’ column of Table 1 of Annex I. This proposal would codify the voluntary best practice suggested under the ESAs’ consolidated Q&A on SFDR¹². Complying with this proposal would require in scope entities to maintain robust data-source records, thereby putting emphasis on the volume and quality of data being collected and relied upon.
• Value chains: PAI reports should also include the adverse impacts of investee companies’ value chains as part of their consideration of adverse impacts. However, this would only be required where either the investee companies themselves report the information under the Accounting Directive or the information is otherwise readily available. It is not clear yet what ‘readily available’ is intended to mean, and by extension, what level of ‘effort’ in scope entities will be expected to exert to search for and obtain this information.
• Derivatives: derivatives should be converted into equivalent positions in the underlying assets referenced by those derivatives based on the conversion method used in the Delegated Regulation supplementing the Alternative Investment Fund Managers Directive (AIFMD)¹³. This should bring certainty regarding the treatment of derivatives, and therefore, should facilitate more accurate disclosure.

Notably, the calculation basis for the PAI indicators which are expressed as a proportion remains unaltered. The ESAs have proposed to keep the ‘denominator’ in these calculation as "all investments" instead of changing this to “all relevant investments” (as contemplated during the consultation), mainly for ease of historical comparability.

(3)    Changes to Disclosure Templates in Annex II-V (the Templates)

While previous amendments to the RTS have been relatively contained, the current proposals as set out in the Draft RTS introduce changes throughout the Templates and will require all FMPs who promote environmental or social characteristics/invest a proportion of its assets into Sustainable Investments (as defined under SFDR) (Article 8 products) or that have a sustainable investment objective (Article 9 products) to prepare new Annex II and Annex III disclosures, not only in terms of organisation but also in terms of substantive content.

The amendments to the Templates are being described by the ESAs as updates “simplifying the language, restructuring the information provided in order to avoid repetitions and removing the green colour in all disclosures except for taxonomy graphs”.

One significant new development is the proposal to introduce a “dedicated dashboard” which will provide key information on the first page alongside more detailed disclosures in the following pages. The introduction of the dashboard follows consumer testing which reported the dashboard as particularly welcomed. The dashboards will also show whether the financial product has a GHG emissions reduction target. Furthermore, icons have been added for “visual clarity, indicating whether the product makes sustainable investments, EU Taxonomy-aligned investments, considers PAI or has a decarbonisation target”.

While the dashboard may appear to ease comprehension, there is a risk that attempting to simplify what, in many cases, is quite nuanced and complex information, could actually cause confusion and misunderstandings.

While the dashboard and the addition of new sections relating to GHG emissions (see above section on Changes to greenhouse gas emission reduction targets) are significant changes, there are many smaller changes which themselves will require FMPs to undertake a comprehensive review of all the information in the current form of the Templates. In many instances information can be carried across from the existing Templates, however, some of the questions have been reformulated or otherwise changed, the headings recorded and new sections introduced. FMPs will, therefore, need to carefully identify the changes to questions posed and also to the information that is required in the response. For example, in Article 51 of the Draft RTS, the wording of the question has changed from “To what extent were the environmental and/or social characteristics promoted by this financial product met?” to now asking “What are the environmental and/or social characteristics of this product and how were they achieved?”.

For financial products that include a commitment to make sustainable investments, a new Article 54a of the Draft RTS includes the question “How was significant harm to the environment and people avoided within the sustainable investments made?”. FMPs are now required to state which methodology for calculating sustainable investments has been used, how those sustainable investments have not harmed any sustainable objective provided for under Article 2(17) of SFDR, how the PAIs have been taken into account in the DNSH analysis and also provide a concise explanation of how the DNSH thresholds and criteria were determined along with a hyperlink to additional information in the Article 10 “website” disclosure regarding the DNSH thresholds/criteria.

While the changes to the Templates are clear on their face, it is important to note that these proposed Template changes also have a knock-on impact on the website. For example, the ESA’s current proposals require that the dashboard is included in the summary section of the website disclosures. Some of the articles in the Draft RTS relating to website disclosures have been amended and/or expanded, new provisions included and, in some instances, new phraseology introduced. All of which will require FMPs to also review all their current website disclosures and update as necessary to align with the new requirements.

Timing

The ESAs have submitted their proposals for the Draft RTS to the EU Commission. As noted above, the EU Commission intends to revise the primary legislation of SFDR and, at the time of writing, it is not clear if the Draft RTS will be approved by the relevant legislative bodies in their current form, nor when the new provisions may become effective.

Assuming the EU Commission does decide to proceed to amend the RTS, it will need to review the Draft RTS, and if happy with the proposals adopt them. Once adopted by the EU Commission, the Draft RTS will need to be reviewed and approved by the European Parliament and the Council of the EU.