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PAIs, otherwise known as Principal Adverse Impacts, are the negative impacts caused by a financial market player or their financial product on the environment and society. Disclosure requirements on PAI indicators under the EU's Sustainable Finance Disclosure Regulation (SFDR) recently became more demanding, in an attempt to increase transparency in the financial sector and prevent greenwashing.
What exactly are Principal Adverse Impacts (PAIs)? What are the PAI reporting requirements under the EU's SFDR? And what does this mean for the UK?
In other words: PAIs are the harmful consequences of an investment in the environment or society.
PAIs were introduced by the European Union under the Sustainable Finance Disclosure Regulation (SFDR) to measure and avoid the negative impacts of financial investments. Therefore, if we want to understand PAIs better it's a good idea to start there.
The Sustainable Financial Disclosure Regulation (SFDR) is a European regulation that was introduced to progressively “integrate sustainability considerations into the financial system” and “steer the flow of capital towards sustainable investments”. It achieves this by improving transparency when it comes to sustainable investment products facilitating more responsible investment, preventing ‘greenwashing', and providing clarity with regard to sustainability claims made by financial market participants.
When it comes to financial products, the EU SFDR requires specific firm-level and product-level disclosures detailing their Sustainability Risks and Principal Adverse Impacts (PAIs). These SFDR disclosures fall into three categories:
Firms falling under the scope of the SFDR must disclose any potentially adverse consequences an investment may have on sustainability factors (including environmental considerations), and they must also detail how they are mitigating the impacts.
Investment firms must disclose where an ESG event could negatively impact a material investment and align remuneration policies with sustainability risk management.
Depending on the classification of a financial product (ie. products that fall under Article 8 or 9 - see below for more detail) additional disclosures will be required.
❓ The categorisation of financial products under the SFDR: Asset managers and investment advisors must categorise their financial products into one of three different categories: article 6, article 8, and Article 9. The categorisation is determined by the level of ESG (environmental, social, and governance) characteristics of the product. Article 9 covers products with a sustainable investment objective; Article 8 covers products that promote ESG values and may involve sustainable investment factors, however sustainable investment is not their core objective; Article 6 covers products that do not integrate ESG considerations and don't meet the criteria of either article 8 or 9.
👉 To find out more about the Sustainable Finance Disclosure Regulation check out our article on the topic.
To achieve the SFDR's aim of improving the transparency of sustainable finance investments and products, the regulations require asset managers and investment advisors to disclose policies relating to Sustainability Risk and Principal Adverse Impacts - this is required both at the firm level and the product level. But what do each of these terms mean?
Sustainability Risks = This is a risk arising from environmental, social, or governance events (eg. climate change, pollution, etc.) that could result in a material (ie. significant) negative impact on the value of an investment.
Principal Adverse Impacts = This includes any negative effect that an investment could have on sustainability factors (for example, investments in companies or projects that result in considerable levels of carbon emissions, or pollution of the environment).
Core disclosures have been required under the SFDR as of March 2021 and mandate entity-level disclosures regarding the organisation's Sustainability Risks and PAIs. Disclosures at a product level are required where the financial product falls under the scope of articles 6, 8, and 9.
Enhanced disclosures only recently came into effect, and as of January 2023, enhanced disclosures are required with regard to PAIs at an entity level. At a product level, enhanced disclosures are only required for articles 8 and 9 financial products (ie. ESG financial products).
As of 2021, a financial market participant is required to disclose how they plan to incorporate PAIs into their investment process. To further improve transparency and integrate sustainability risks into financial products, the SFDR introduced further ESG disclosure requirements in January 2023. This requires organisations to report on certain Principal Adverse Impact (PAI) Indicators.
The EU created a list of 64 PAI indicators, 14 of which are mandatory and must be disclosed, the remaining 46 are discretionary. The mandatory indicators focus on a wide variety of environmental and social considerations (ie. ESG factors), including scope 1, 2, and 3 greenhouse gas emissions, biodiversity impacts, and gender pay gap data. They aim to show financial market participants and investors what sustainability risks are attached to their investments. It will allow investors to make more informed decisions when it comes to selecting ESG investments.
Let's take a look at the mandatory PAI indicators in a bit more detail:
The mandatory PAI indicators are split into climate and environment and social and governance.
The climate and environment indicators are greenhouse gas emissions (scopes 1,2 and 3), carbon footprint, greenhouse gas intensity, fossil fuel sector, non-renewable energy consumption and production, energy consumption intensity per high impact climate sector, biodiversity sensitive areas, emissions to water, and hazardous waste ratio.
The social and governance indicators include violations of UN Global Compact principles and OECD Guidelines, lack of processes and compliance mechanisms to monitor compliance with UN Global Compact principles and OECD Guidelines, gender diversity and pay gap, board gender diversity, human rights due diligence, exposure to controversial weapons, etc.
In addition to reporting on the 14 PAI indicators outlined above, firms should also disclose any other relevant indicators. It is necessary to report on at least one additional environmental indicator and one additional social indicator (taken from the list of 46 discretionary PAI indicators).
👉 Note that there are additional PAI indicators that are mandatory for disclosures on investments in sovereigns, supernationals, and real estate assets.
Those who fall under the remit of the SFDR disclosure requirements are subject to two types of disclosures when it comes to PAI indicators - entity and product level disclosures:
Under Article 4 of the SFDR asset and investment managers must disclose whether or not they take PAIs into consideration when it comes to their investments. They must also include a statement on the due diligence that they carry out with regard to this. Where no PAIs are considered, this must be explained and an indication must be given as to whether or not they will be considered in the future.
❗️Following a series of delays, the first entity-level PAI disclosures are due in June 2023.
Under Article 7 of the SFDR, asset and investment managers who consider PAIs will be required to disclose how their financial products consider such impacts. This essentially means that funds can no longer be labelled as being an ESG investment without demonstrating that this is actually the case. This is where the PAI indicators come into play. As outlined above there are 14 mandatory indicators that must be reported on, alongside the requirement that two further PAI indicators are selected from the additional list of 46 discretionary indicators.
The most challenging aspect when it comes to PAI is the lack of data available. PAI data can be difficult to collect and is not always readily available which presents a challenge for financial market organisations that need to comply with regulatory requirements and attract ESG investors.
When trying to collect relevant data an asset manager might find that some of the companies (companies who form part of the financial product offering) don't yet consistently report on the relevant metrics that need to be collected when it comes to PAI indicators, which means that the data might not even exist. Thankfully though, company reporting requirements are also becoming increasingly regulated. For example, the Corporate Sustainability Reporting Directive (CSRD) expands on the scope of the Non-Financial Reporting Directive so that more companies are subject to its reporting requirements. It's expected that reporting requirements will continue to increase in scope and scale in the coming years.
ESG investment is particularly vulnerable to a lack of transparency and non-standardised definitions. PAI takes steps to remedy this by standardising the reporting metrics and the data required, allowing for a fair comparison across different financial products. Without PAI indicators to guide asset managers investors can't be sure that they're making the best decision when it comes to their ESG investment. PAI indicators allow investors to accurately and honestly answer the question: what are the adverse impacts on the environment and society of the financial products I'm investing in?
💡 In 2023 the European Supervisory Authorities proposed amendments to the SFDR, including adding product disclosures regarding decarbonisation targets, including intermediate targets, the level of ambition, and how the target will be achieved.
The push for more ESG reporting by PAI indicators is also likely to propel innovation and change in the financial sector. Financial market players will have no choice but to step up to the mark. It may be a painful transition to begin with as they struggle to find all the granular data required for their disclosures, however, this will have the benefit of forcing change in the financial market as a whole.
The SFDR is an EU regulation and so it applies to member states only. However, non-EU investment managers might also find themselves subject to the regulation where they market hedge funds or private equity funds into the EU under AIFMD private placement rules, or where they provide portfolio management or investment advice to EU firms that are themselves subject to the SFDR requirements.
The UK left the European Union, and as of 31 December 2020 is no longer subject to EU regulation. Therefore, the UK isn't subject to the requirements of the EU SFDR.
However, the UK is in the process of developing the Sustainable Disclosure Requirements which is the UK's answer to the SFDR. It is in the final stages of consultation, with the final results expected at some point in 2023. Once the final rules are published they will come into effect in the UK one year later.
Like the SFDR, the UK's SDR will mean that any investment funds or assets that want to market themselves as an ESG investment will first need to meet certain criteria. These criteria aim to prevent greenwashing, improve transparency, and make it easier for potential investors to understand how their investment will help create a positive environmental or social change.
Despite similar goals, the UK's SDR and the EU's SFDR don't converge as much as some have hoped. For a start, the proposed UK SDR uses different categories when it comes to investment classification and labels. The SFDR splits investments into articles 6,8 and 9 categories which are not intended to be considered labels but rather determine the level of disclosure required by a financial product depending on its level of sustainability. Whereas the proposed UK SDR will use ‘focus, impact and improve' as labels that allow investors to understand the sustainable outcome of a particular fund or asset.
Another key difference between the two is that the EU SFDR contains disclosure requirements on Sustainability Risks and Principal Adverse Impacts (PAIs), whereas the UK's SDR will look to adopt quantitative KPI disclosures based on the Task Force on Climate-Related Financial Disclosures and International Sustainability Standards Board standards.
Regulations like the SFDR and the UK's upcoming SDR are making strong inroads when it comes to creating transparency in the financial markets and preventing greenwashing. The EU's SFDR is particularly strong with regards to its disclosure requirements and these have only increased with the introduction of additional reporting requirements on PAI indicators in 2023.
As governments across the world continue to work towards net zero emissions by 2050, we're likely to see increasingly demanding disclosure requirements for both financial market organisations and companies alike. This may create a pain point in the short term for financial market players and companies who have to provide data as part of their disclosure requirements, however, the long-term benefits far outweigh these annoyances. The increasingly demanding disclosure requirements on environmental and social considerations are preventing greenwashing and improving transparency across the financial sector - something that will encourage and support green investing in the long run.
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