Principal Adverse Sustainability Impacts (PAI)
- Category: Taxonomy
The legal construct of principal adverse impacts (PAI) is expressed in SFDR, and refers to the impact of investment decisions and advice that result in negative effects on sustainability factors.
26 October 2022
ESAs' Joint Committee Letter to European Commission on the delay in delivery of mandate to review the principal adverse impact indicators and financial product disclosures in the SFDR Delegated Regulation, JC 2022 64
Joint ESAs Report on the extent of voluntary disclosures of PAI under SFDR (JC 2022 35) provides an overview of good examples of best practices, and less good examples of voluntary disclosures.
2 June 2022
ESAs Clarifications on the ESAs’ draft RTS under SFDR, JC 2022 23
6 May 2022
Mandate to ESAs on PAI product - a guiding principle for amendments to the regulatory technical standards should be "to reduce the risk of ‘false certainty’ and potential ‘safeguards washing’ by requiring well- substantiated evidence that investments align with the safeguards, and that implementation and application efforts do take place".
ESA’s Final report of 22 October 2021 on taxonomy-related product disclosure RTS with regard to the content and presentation of disclosures pursuant to Article 8(4), 9(6) and 11(5) of Regulation (EU) 2019/2088 clarifies that "principal adverse impacts are the most significant negative impacts of investment decisions on sustainability factors relating to environmental, social and employee matters, respect for human rights, anti‐corruption and anti‐bribery matters" (JC 2021 50, p. 36). This concept can apply at both an entity (financial market participant) and financial product level but not at economic activity level.
From 10 March 2021, Article 4(1)(a) SFDR mandates disclosure, on a comply or explain basis, of the Principal Adverse Impacts (PAI) that investment decisions have on sustainability factors on the website of Financial Market Participants (FMPs).
The disclosure should take the form of a statement on due diligence policies with respect to the adverse impacts of investment decisions on environmental and social sustainability factors.
Article 4(1)(b) requires that, where an FMP does not consider adverse impacts of investment decisions on sustainability factors, it must publish and maintain on its website clear reasons for why it does not do so, and where relevant, information as to whether and when it intends to do so.
Under Article 4(3)-(4) SFDR, from 30 June 2021, FMPs exceeding on their balance sheet dates the criterion of the average number of 500 employees during the financial year must publish and maintain on their websites a statement on their due diligence policies with respect to the principal adverse impacts of investment decisions on sustainability factors.
Joint ESAs Report on the extent of voluntary disclosures of PAI under SFDR (28 July 2022, JC 2022 35, p. 4)
PAI are conceptually related to principle of do no significant harm (DNSH). Recital 22 of the Commission Delegated Regulation of 6 April 2022 explains:
“The principle of ‘do not significant harm’ is linked to the disclosures of principal adverse impacts of investment decisions on sustainability factors. For that reason, financial product disclosures about the ‘do not significant harm’ principle should explain how the indicators for adverse impacts have been taken into account”.
However, the “does not significantly harm” principle of the Taxonomy Regulation focuses on the six environmental objectives recognized by the Taxonomy Regulation. The “principal adverse impact indicators” of the SFDR have a broader scope, ranging from environmental indicators to social and employee, respect for human rights, anti-corruption, and anti-bribery matters.
The notion of “minimum safeguards” in the Taxonomy Regulation, is smaller than the notion of “principal adverse impact” of the SFDR. For example, board gender diversity, which is a principal adverse impact indicator, is not a minimum safeguard for taxonomy alignment. Also, its application is limited to environmentally sustainable activities as defined by the Taxonomy Regulation.
Investment firms select their own key performance indicators (KPIs) to describe the contribution made, although they may rely on pre-defined indicators when disclosing how significant harm has been avoided (the principal adverse impact indicators).
Recital 18 SFDR states that when considering PAI financial market participants should consider the due diligence guidance for responsible business conduct developed by the Organisation for Economic Cooperation and Development (OECD) and the United Nations‐supported Principles for Responsible Investment.
Where financial market participants, taking due account of their size, the nature and scale of their activities and the types of financial products they make available, consider principal adverse impacts, whether material or likely to be material, of investment decisions on sustainability factors, they should integrate in their processes, including in their due diligence processes, the procedures for considering the principal adverse impacts alongside the relevant financial risks and relevant sustainability risks.
The information on such procedures might describe how financial market participants discharge their sustainability‐related stewardship responsibilities or other shareholder engagements.
Financial market participants should include on their websites information on those procedures and descriptions of the principal adverse impacts.
Personal scope of application of the PAI regime
The PAI regime applies to:
– Financial market participants (FMPs) – defined in Article 2(1) SFDR as including: credit institutions (as defined in EU CRR) and investment firms (as defined in EU MiFID) providing MiFID portfolio management; manufacturers of certain types of pension products (based on definitions in EU PRIIPs); AIFMs; UCITS management companies; and insurance undertakings (as defined in EU Solvency II) that make available insurance-based investment products (IBIPs) – e.g. fund link insurance products.
– Financial advisers – defined in Article 2(11) of SFDR as including: credit institutions, investment firms, AIFMs and UCITS management companies that provide investment advice as defined in EU MiFID, and insurance undertakings and insurance intermediaries that provide advice (as defined by the EU IDD) with regards to IBIPs.
Financial market participants are subject to two types of disclosures under the new PAI regime:
– entity level disclosures (Article 4 SFDR); and
– product level disclosures (Article 7 SFDR).
Financial advisers’ new PAI regime contemplates only the former type of disclosure (Article 4 SFDR).
Moreover, considering requirements introduced by Commission Delegated Regulation (EU) 2021/1253 of 21 April 2021 to MiFID II, it can be expected that other firms voluntarily or contractually agree to comply with the PAI regime (or adopt the “commercially reasonable endeavours” type obligation).
SFDR requirements of the PAI regime at entity level
Transparency rules regarding adverse sustainability impacts at entity level are stipulated in Article 4 of the SFDR. The said provision imposes on financial market participants the obligation:
1. to publish and maintain on their websites:
(a) where they consider principal adverse impacts of investment decisions on sustainability factors, a statement on due diligence policies with respect to those impacts, taking due account of their size, the nature and scale of their activities and the types of financial products they make available; or
(b) where they do not consider adverse impacts of investment decisions on sustainability factors, clear reasons for why they do not do so, including, where relevant, information as to whether and when they intend to consider such adverse impacts.
2. to include in the above statement on due diligence policies at least the following:
(a) information about their policies on the identification and prioritisation of principal adverse sustainability impacts and indicators;
(b) a description of the principal adverse sustainability impacts and of any actions in relation thereto taken or, where relevant, planned;
(c) brief summaries of engagement policies in accordance with Article 3g of Directive 2007/36/EC, where applicable;
(d) a reference to their adherence to responsible business conduct codes and internationally recognised standards for due diligence and reporting and, where relevant, the degree of their alignment with the objectives of the Paris Agreement.
In turn, financial advisers are required to publish and maintain on their websites:
(a) information as to whether, taking due account of their size, the nature and scale of their activities and the types of financial products they advise on, they consider in their investment advice or insurance advice the principal adverse impacts on sustainability factors; or
(b) information as to why they do not to consider adverse impacts of investment decisions on sustainability factors in their investment advice or insurance advice, and, where relevant, including information as to whether and when they intend to consider such adverse impacts.
Reporting entity-level principal adverse impacts according to Commission Delegated Regulation 6 April 2022
Commission Delegated Regulation 6 April 2022 supplementing Regulation (EU) 2019/2088 of the European Parliament and of the Council with regard to regulatory technical standards specifying the details of the content and presentation of the information in relation to the principle of ‘do no significant harm’, specifying the content, methodologies and presentation of information in relation to sustainability indicators and adverse sustainability impacts, and the content and presentation of the information in relation to the promotion of environmental or social characteristics and sustainable investment objectives in pre-contractual documents, on websites and in periodic reports specifies in Chapter II the content, methodology and presentation of the information required by Article 4(1) to (5) of the SFDR for the sustainability indicators on:
– adverse impacts on the climate and other environment-related adverse impacts and
– adverse impacts in the field of social and employee matters, respect for human rights, anti-corruption and anti-bribery matters.
The regulatory technical standards require a mandatory reporting template, set out in Annex I, for the statement on the consideration of principal adverse impacts of investment decisions on sustainability factors.
The indicators are divided into a core set of universal mandatory indicators that will always lead to principal adverse impacts of investment decisions on sustainability factors, irrespective of the result of the assessment by the financial market participant.
There are additional opt-in indicators for environmental and social factors, to be used to identify, assess and prioritise additional principal adverse impacts.
The regulatory technical standards lay down indicators for adverse impacts on sustainability factors from investments in investee companies, sovereigns (and supranational organisations) and real estate assets.
Template principal adverse sustainability impacts statement (Annex I to the Commission Delegated Regulation od 6 April 2022) requires specific parameters (in particular, GHG intensity, carbon footprint, GHG emissions, exposure to companies active in the fossil fuel sector, share of non-renewable energy consumption and production, energy consumption intensity) to be measured versus the following metrics:
- comparison of the impact (year n) versus impact (year - n) with explanation;
- actions taken and actions plant and targets set for the next reference period
GHG emissions must be accounted for separately for scope 1, 2 and 3 as well as the total.
Among indicators applicable to investments in investee companies are also:
1. emissions of inorganic pollutants (tonnes of inorganic pollutants equivalent per million EUR invested expressed as a weighted average);
2. emissions of air pollutants (tonnes of air pollutants equivalent per million EUR invested, expressed as a weighted average);
3. emissions of ozone-depleting substances (tonnes of ozone-depleting substances equivalent per million EUR invested, expressed as a weighted average);
4. investments in companies without carbon emission reduction initiatives (share of investments in investee companies without carbon emission reduction initiatives aimed at aligning with the Paris Agreement Energy performance);
5. breakdown of energy consumption by type of non-renewable sources of energy (share of energy from non-renewable sources used by investee companies broken down by each non-renewable energy source Water, waste and material emissions; water usage and recycling), etc.
The disclosure for these indicators is accompanied by more narrative elements. The disclosure for financial market participants also includes reporting items on a summary, policies on the identification of principal adverse impacts, actions taken and planned to mitigate the principal adverse impacts, adherence to international standards and a historical comparison covering at least five previous periods (reference periods). The ‘actions taken’ disclosure focuses on the engagement and other actions taken and planned by financial market participants and are included in the table with the principal adverse impact indicators. The reporting is carried out by 30 June each year with the previous calendar year as a reference period.
For financial market participants which do not consider principal adverse impacts of investment decisions on sustainability factors, the regulatory technical standards require a statement and explanation that must be published on their websites. Furthermore, financial advisers are required to disclose, in line with their obligations under Article 4(5) of the Sustainable Finance Disclosures Regulation, both when they consider principal adverse impacts in their advice and when they do not.
Commission Delegated Regulation 6 April 2022, Explanatory Memorandum
The “comply or explain mechanism” under Article 4(1) of the SFDR distinguishes between ‘principal adverse impacts’ and ‘adverse impacts’.
Point (b) of Article 4(1) of the SFDR sets out an “explain mechanism” under which financial market participants must, by way of example, provide clear reasons for why they do not consider degradation of the environment or social injustice caused by their investments.
Article 4 of that Regulation also encourages financial advisers to pay more attention to how the consideration of negative externalities is integrated in their investment or insurance advice.
To ensure comparability among different financial market participants, the regulatory technical standards set-out in the Delegated Regulation require a mandatory reporting template to describe how principal adverse impacts on sustainability factors are taken into consideration in investment decisions.
The regulatory technical standards divide indicators into a core set of universal mandatory indicators that will always lead to principal adverse impacts and additional opt-in indicators to identify, assess and prioritise the consideration of additional principal adverse impacts.
The regulatory technical standards also require a summary section, and information on policies on the identification of principal adverse impacts, actions taken and planned to mitigate the principal adverse impacts (for instance, reduction of carbon emissions by means of engagement or other policies), or adherence to international standards and historical comparisons.
The regulatory technical standards also include rules on the statement of no consideration of adverse impacts on sustainability factors by financial market participants and financial advisers.
PAI calculation methodology
PAI calculation methodology has been explained in the document of European Supervisory Authorities (ESAs) of 2 June 2022 ‘Clarifications on the ESAs’ draft RTS under SFDR” (JC 2022 23). In particular, the ESAs consider that the “sustainability indicators” and the indicators for principal adverse impact referred to in Article 4 SFDR, and Chapter II and Annex I of the draft RTS in the ESAs’ final reports refer to different disclosures under the SFDR.
However, it is possible to use the indicators for principal adverse impact to measure the environmental or social characteristics or the overall sustainable impact of the financial product, e.g. by showing improvements of the investments against those indicators over time. ESAs note that for the purposes of the disclosures of principal adverse impacts of investment decisions on sustainability factors, the assessment of the impact should be based on, at least, the average of four calculations made on 31 March, 30 June, 30 September, and 31 December of a calendar year reference period (year N). With regard to the calculations to be made as part of the reporting on principal adverse impacts of investment decisions required by Article 4(1)-(5) SFDR, the ESAs consider that all investments, both direct and indirect (which includes investments in e.g. funds and funds of funds), should be included in these calculations. This covers investments in assets such as equity and corporate bonds, sovereign debts, private equity, supranational entities, infrastructure, and real estate.
Direct investments in “investee companies” are those securities issued by the investee company, e.g. listed and non-listed equities, corporate bonds, mortgage debt, covered (mortgage) bonds, private debt, asset backed securities. In terms of indirect investments in investee companies this encompasses investment in funds such as UCITS or AIFs where applicable, funds of funds or derivatives. Where the investee company is a holding company, collective investment undertaking or special purpose vehicle, information about the adverse impacts of the investment decisions of those companies could look through to the individual underlying investments of those companies and consider the total adverse impacts arising from them. Where such information is not available, in order to be able to fulfil the disclosure requirement for those investments, the RTS provided that the section should also contain details of the best efforts used to obtain the information either directly from investee companies, or by carrying out additional research, cooperating with third party data providers or external experts or making reasonable assumptions.
In the case of investment decisions where an investment exclusively finances a project or type of project, such as an investment in a green bond, social bond or project bond, the assessment of the adverse impacts of the investment decisions could be limited to the adverse impacts of the project or type of project funded by the instrument.
Application timeline for entity-level principal adverse impact statement
Application timeline for entity-level principal adverse impact statement has been laid down in the Updated Joint ESA Supervisory Statement of 24 March 2022, on the application of the Sustainable Finance Disclosure Regulation (JC 2022 12) - see box.
Interactions with MiFID II
Commission Delegated Regulation (EU) 2021/1253 of 21 April 2021 amending Delegated Regulation (EU) 2017/565 as regards the integration of sustainability factors, risks and preferences into certain organisational requirements and operating conditions for investment firms include, among other things, a requirement that EU MiFID II portfolio managers and advisers ask their clients about their “sustainability preferences”, and then comply with such preferences when making decisions or providing advice.
After the amendment the term “sustainability preferences” is defined in Article 2(7) of Delegated Regulation (EU) 2017/565 as a client’s or potential client’s choice as to whether and, if so, to what extent, one or more of the following financial instruments shall be integrated into his or her investment:
(a) a financial instrument for which the client or potential client determines that a minimum proportion shall be invested in environmentally sustainable investments (as defined in Article 2(1) of the Taxonomy Regulation);
(b) a financial instrument for which the client or potential client determines that a minimum proportion shall be invested in sustainable investments (as defined in Article 2(17) of SFDR);
(c) a financial instrument that considers principal adverse impacts on sustainability factors where qualitative or quantitative elements demonstrating that consideration are determined by the client or potential client.
Regarding the PAI, in operational terms, to facilitate internal processes and in particular the development of recommendations to clients or potential clients, based on a preceding analysis of financial instruments, investment firms might rank in advance and group financial instruments in terms of types of commitments and qualitative or quantitative indicators.
Recital 6 of the Commission Delegated Regulation (EU) 2021/1253 of 21 April 2021 stipulates:
"Financial instruments with various degrees of sustainability-related ambition have been developed so far. To enable clients or potential clients to understand those different degrees of sustainability and take informed investment decisions in terms of sustainability, investment firms that provide investment advice and portfolio management services should explain the distinction between, on the one hand, financial instruments that pursue, fully or in part, sustainable investments in economic activities that qualify as environmentally sustainable under Regulation (EU) 2020/852 of the European Parliament and of the Council, sustainable investments as defined in Article 2, point (17), of Regulation (EU) 2019/2088, and financial instruments that consider principal adverse impacts on sustainability factors that might be eligible for recommendation as meeting individual sustainability preferences of clients, and, on the other hand, other financial instruments without those specific features that should not be eligible for recommendation to the clients or potential clients that have individual sustainability preferences".
Explanatory Memorandum to the Commission Delegated Regulation (EU) 2021/1253 of 21 April 2021 (C(2021) 2616 final) reads as follows in this regard:
"Since investments pursued by financial instruments might cause different principal adverse impacts on sustainability factors, investment firms should explain to the clients or potential clients that the elements demonstrating the consideration of principal adverse impacts on sustainability factors might be relevant for various environmental, social, employee or governance matters, should allow for demonstrating that consideration and for showing the respective commitment to address principal adverse impacts over time, and might be represented by qualitative or quantitative indicators, including but not limited to those in accordance with the SFDR".
It is also useful to mention that the list of adverse environmental impacts relevant for the Directive on corporate sustainability due diligence (as set out in the European Commission Proposal of 23 February 2022, COM(2022) 71 final) is specified in the Annex to that Directive.