SFDR Blog Series: Introducing the Principal Adverse Impacts (PAIs)

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SFDR Blog Series: Introducing the Principal Adverse Impacts (PAIs)

*On the 4th of December, the European Supervisor Authorities published a report containing proposed amendments to SFDR’s regulatory technical standards.

The proposals are:

Additional disclosures for sustainable investments
Introducing new, and specifying existing, PAIs
New disclosures on decarbonisation targets
Revisions to disclosure templates

The European Commission will now take until March 2024 to decide on the proposals. To find out more, read the report or contact a member of our team. The information in this article is up to date as of December 2023.

In our first blog of the series, we introduced the Sustainable Finance Disclosure Regulation (SFDR), outlining current requirements for investment firms, different fund classifications, as well as introducing the Principal Adverse Impacts (PAIs). In this second blog, we go into more detail regarding the PAI indicators, the resulting challenges faced by fund managers, and how we can help at KEY ESG.

From SFDR Level 1 to Level 2:The impact of PAI indicators

Existing Level 1 requirements regarding the PAIs are relatively simple compared to upcoming Level 2 requirements. If a firm chooses to consider the principle adverse impacts of investment decisions on sustainability factors, a website statement must be published. This statement must include the relevant due diligence, policies that identify and prioritise impacts, their associated indicators, and any actions planned to be taken as a result of these impacts. Since June 2021, this statement has been mandatory for firms with more than 500 employees, but it has become standard practice for smaller firms to comply. Firms that choose not to comply must publish a statement explaining this decision and whether there are plans to comply in the future.

Level 2 requirements, which come into effect January 2023, are much more prescriptive. As a result, firms that have only considered Level 1 requirements will need to restructure their existing PAI statement. Though Level 2 requirements include additional qualitative disclosures, the key difference lies in the introduction of quantitative data requirements: the PAI indicators. These are an extensive set of metrics that cover a range of ESG criteria, from greenhouse gas emissions to gender pay equality. Crucially, to complete these indicators, detailed information is required from individual assets that comprise fund portfolios. This presents a huge challenge for fund managers and is why recent SFDR discussions have been focused on these indicators.

Core PAI and Additional PAI Indicators: What do you need to disclose?

Given that this regulation is yet to be formally enforced, there is a degree of uncertainty amongst investment firms regarding the exact requirements of PAI indicators. To simplify this, we have summarised the requirements, as shown in Table 1. There are different disclosure requirements for investee companies compared to real estate assets, given their structural differences.

Investee companies: A total of 14 core indicators are split between environmental and social & governance issues, all of which are required. Fund managers must then select one additional indicator from each of the environmental and social & governance groups respectively.
Real Estate Assets: There are only two mandatory core indicators, both of which are environmental. Fund managers must then select one additional indicator from the five additional environmental indicators.

Table 1: Summary of the PAIs for Investee Companies and Real Estate Assets

Streamlining data submissions across an entire portfolio of assets is not a task that should be underestimated. Within each fund, assets will likely vary by sector, size, and ESG maturity. This will cause huge variation in scope regarding the data collection process. For example, collecting data for indicators linked to human rights violations will be a more involved process for a multinational company with extensive supply chains, compared to a small organisation operating domestically.

This annex contains the full list of PAIs along with their associated definitions (last update 09/06/2022).

So what is next for SFDR Level 2 and what should you prepare for?

The first submission of the new PAI statement that includes these indicators is expected by June 2023, based on 2022 data. As such, it is recommended that firms use the 2022 financial year to ensure that all assets start collecting the appropriate data to comply with new regulation. In the case where information regarding a particular indicator is unavailable, details must be disclosed regarding the efforts to acquire this information, including communication with the relevant asset, working with third parties and experts, or making reasonable assumptions.

Given that investment firms must report on the same set of core PAI indicators, a key aspect the PAI indicators introduce is comparability and benchmarking of ESG performance, either across different funds or across assets within a fund. Whilst there are no official requirements to publicly share fund PAI performance, it is expected that investors will request this information. SFDR legislation does not provide qualification on what may be a good or bad PAI score, but the investor landscape will naturally begin comparing funds against each other. As a result, we are beginning to already see firms starting to comply with PAI regulation, irrespective of current requirements. Some firms have published a subset of the mandatory indicators, or carried out an initial qualitative assessment, to demonstrate SFDR engagement to stakeholders. Other firms have already published PAI performance across all portfolios, as well as the associated methodology. Pressure from investors reinforces regulatory developments; it is quickly becoming an expectation that investment firms consider the PAI indicators ahead of Level 2 SFDR implementation.

Staying up-to-date with SFDR: KEY ESG can help

Finally, it is worth noting that precise details surrounding the PAI indicators are still regularly being modified, most recently in April 2022. Changes to definitions, such as the inclusion of radioactive waste in the hazardous waste core indicator, affect the data requests from fund managers to their portfolio holdings. It is likely that similar changes will occur this year before the official implementation at the start of 2023, so it is important that fund managers stay up to date with regulatory developments.

If you are not sure how to continuously monitor and implement these changes in your organisation, KEY ESG stays up to date with the latest SFDR developments for you, so you don’t have to. Our Fund Manager Platform cloud-based software is continuously updated to reflect any framework and methodology changes and automatically applies them to your data. The KEY ESG Fund Manager Platform allows you to invite portfolio companies to enter their SFDR data through our easy-to-use data entry portal, simplifying the compliance process. Progress of submissions are then automatically tracked across the portfolio and can be viewed at any time to analyse and improve portfolio performance, or to report back to stakeholders. You can confidently assess your fund progress towards being SFDR Level 2 compliant and easily keep track of any improvement.

For further information or to book a free demo, please get in touch with a member of our team.