To achieve the EU SFDR’s goal of improving sustainable finance by increasing transparency and creating standards, asset managers and advisers must disclose the manner in which they consider two key factors: Sustainability Risks and Principal Adverse Impacts. Subject to specific thresholds, asset managers are required to disclose their policies at both the firm and product level, while advisers are required to explain how they consider these factors in their advice.
The EU SFDR outlines specific definitions for Sustainability Risks and Principal Adverse Impacts:
Sustainability Risks refer to environmental, social or governance events, or conditions, such as climate change, that could cause an actual or a potential material negative impact on the value of an investment.
Principal Adverse Impacts are any negative effects that investment decisions or advice could have on sustainability factors. Examples could include investing in a company with business operations that significantly contribute to carbon dioxide emissions, or that has poor water, waste or land management practices.
Asset managers and advisers need to provide specific information on Sustainability Risks and Principal Adverse Impacts
Larger firms (having more than 500 employees) are required to disclose how they consider Principal Adverse Impacts from 30 June 2021, with reporting of Principal Adverse Impacts estimated to commence mid-2023 (representing Principal Adverse Impacts data throughout 2022).
From 1 January 2023, asset managers will be required to break out how they consider Principal Adverse Impacts into more specific and quantifiable detail, with reference to indicators related to climate and the environment, and indicators related to social and employee issues, respect for human rights, and anti-corruption and anti-bribery matters. Out of the current 64 environmental and social indicators, which can be grouped into broader categories, such as greenhouse gas emissions, biodiversity or water, 18 are core, and for the other 46, investment managers have some flexibility with regards to providing detail on the impacts.
Interest in Principal Adverse Impacts has increased following the inclusion of client sustainability preferences within EU MiFID II, which came into effect on 2 August 202210. One of the ways that clients may now elect to express their sustainability preferences is through the consideration of Principal Averse Impacts on sustainability factors in investments. As a result, some investment managers and advisers disclose how Principal Adverse Impacts are considered in an investment.
Example of considering Principle Adverse Impacts in an investment
PAII=Principle Adverse Impact Indicator; PAI = Principle Adverse Impact
For asset managers, the incorporation of Sustainability Risks and Principal Adverse Impacts takes place at several points in the investment process.
Checklist for asset managers incorporating Sustainability Risks and Principal Adverse Impacts into the investment process
Along with the other considerations referenced above, it is worth recognising that regulators continue to review the Principal Adverse Impacts and financial product disclosure requirements in the EU SFDR Delegated Regulation. The European Commission has invited the European Supervisory Authorities to: (1) streamline and develop further the regulatory framework; (2) consider extending the lists of universal indicators for Principal Adverse Impacts, as well as other indicators; and (3) refine the content of all the indicators for adverse impacts and their respective definitions, applicable methodologies, metrics and presentation11.