SFDR Mandatory Indicators & Principal Adverse Impact (PAIs)

In this article, you will learn about the following:

• Principal Adverse Impact Statement 
• What are Principle Adverse Impact (PAI) Indicators?
• Why do we Care about Principle Adverse Impact (PAI)?
• PAI Require FMPs to Provide Two Types of Disclosure
• Mandatory Adverse Sustainability Indicators

Principal Adverse Impact Statement

As part of the European Action Plan on Sustainable Finance, financial market participant (FMPs) offering financial products in the EU are required to comply with the Sustainable Finance Disclosure Regulation (SFDR), which is being introduced in stages since March 10th 2021. The purpose is to increase market transparency and direct capital towards more sustainable businesses.

For further details on the main components of the SFDR, download our free comprehensive guide The Essentials of the SFDR.

A new final report on the draft regulatory technical standards (RTS) was published by the European Supervisory Authorities (ESAs) on December 4th, 2023. This report revises the framework for principal adverse impacts (PAIs) and financial product disclosures under the Sustainable Finance Disclosure Regulation (SFDR), addressing several aspects that were not covered in the previous reports from 2021 and earlier.

Key updates from the December 2023 report

The main updates include

• Extended Social Indicators: The revised RTS proposes new indicators for PAIs, particularly focusing on social impacts, which were less comprehensively addressed in earlier regulations.
• Decarbonisation Targets: There is now a requirement for product-level disclosures regarding greenhouse gas emission reduction targets.
• Simplified Disclosure Templates: The report suggests improvements to the disclosure templates to enhance clarity and usability for financial market participants (FMPs).
• Do No Significant Harm Principle: The ESAs have clarified that the existing rules regarding the Do No Significant Harm (DNSH) principle will apply to all sustainable investments, including those aligned with the EU Taxonomy.

These amendments reflect ongoing efforts to enhance the quality and transparency of sustainability-related disclosures in the financial sector. Therefore, the reference to the October 22nd, 2021 report is no longer current, as significant developments have occurred since then.

What are Principle Adverse Impact (PAI) Indicators?

Principle Adverse Impact indicators are essentially a set of mandatory indicators and metrics which aim to show financial market participants how certain investments pose sustainability risks.

• As of 2023, there are 14 mandatory PAI indicators and 31 voluntary indicators.
• FMPs with 500 or more employees are obligated to publish their PAI statement annually, while smaller entities can follow a "comply or explain" approach.
• The deadline for annual PAI reporting is June 30th each year.
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Why do we Care about Principle Adverse Impact (PAI)?

Under these rules, fund managers, financial advisors and other financial institutions will need to collect ESG data and disclose any sustainability risks associated with their investments and financial products.

The reporting requirements cover the entity and product level, while the entities consist of a firm's policies and decision-making on sustainability risks. The financial products themselves include (non-exhaustive): investment and mutual funds, UCITS, insurance-based investment products, private and occupational pensions and insurance and investment advice.

PAI Require FMPs to Provide Two Types of Disclosure

The principal adverse impact indicators require FMPs to provide extensive disclosures on various ESG-related matters including environmental and social indicators including human rights. They are subject to two types of disclosures.

Entity-level disclosures (Under Article 4 of the SFDR)

These disclosures are based on a “comply or explain” principle urging FMPs to indicate whether they consider the principal adverse impacts on sustainability factors of their investments, and include a statement on their due diligence policies with respect to such impacts. FMPs which do not consider PAIs must explain the reasons being their decision and, where relevant, whether they will consider them in the future.

After a first delay regarding the date of application of the RTS from January 1st to July 1st 2022, the European Commission announced on November 25th 2021 that it would once again push back the RTS’ date of application to January 1st 2023. This was due to the length and technical detail of the regulatory technical standards involved, and the timing of the submissions to the Commission.

However, the first entity level PAI reports were still due in June 2023, based on the reference period of January 1st 2022 to December 31st 2022. Hence, (and starting in June 2023) by 30 June each year financial market participants shall publish the information referred to in paragraphs 1(a), 2, 3 and 4 of Article 4 of the SFDR on their websites (Articles 2 and 4 of the RTS) in a separate section titled 'Principal adverse sustainability impacts statement'. Furthermore, this information should be presented in accordance with the template in Annex I of the RTS.

Product level disclosures (Article 7 SFDR)

From December 30th 2022, FMPs which consider PAIs on sustainability factors will be required to disclose how each of their financial products considers such impacts in their pre-contractual disclosure documents. FMPs which do not consider principal adverse impact will be required to explain the reasons for that decision in their pre-contractual disclosure documents, effective from 10 March 2021.

Product level disclosures must be included in a firm’s relevant pre-contractual disclosures and periodic reports. The reporting requirements aim to increase transparency on ESG data and therefore to protect the end investor. The presence of the SFDR means that funds cannot simply be described as sustainable investments; firms will have to demonstrate sustainability and firms will need to explain specifically how they are achieving their ESG goals.

Mandatory Adverse Sustainability Indicators

The RTS provides a prescribed format or template for the PAI in Annex I, published on February 4th, 2021. It will require FMPs that consider PAI on sustainability factors to provide extensive disclosures on various ESG related matters, including environmental and social indicators. In total, 14 key indicators (9 indicators related to the environment, and 5 covering social factors) are considered mandatory for the proper assessment of adverse sustainability impacts across a range of ESG factors.

Key Updates from 2023

Increase in Mandatory Indicators: In 2023, the total number of mandatory indicators was updated to 17, including 9 environmental indicators and 8 social indicators. This change reflects the introduction of three new mandatory social indicators to capture social impacts more comprehensively.

Additional Indicators: In addition to the 17 key indicators, FMPs must consider at least one additional environmental indicator and one additional social indicator from a list of 31 additional indicators. This allows for flexibility in reporting, acknowledging that different industries and company types may track different metrics.

The PAI statement is intended to show investors and prospective investors how investment decisions made by a financial market participant are (or are not) impacting a prescribed set of mandatory sustainability indicators, and several voluntary ones. The RTS also contains additional indicators deemed as mandatory for reporting on investments in sovereigns and supranationals, as well as  investments in real estate assets.

Requiring all relevant financial market participants to report against the same indicators and to use a standardised template form will encourage investors to compare asset managers’ approaches to sustainable investment and support them in making truly informed investment decisions.

These updates reflect the ongoing efforts to enhance the quality and transparency of sustainability-related disclosures in the financial sector, ensuring that FMPs provide comprehensive and accurate information on the adverse impacts of their investment decisions on sustainability factors, as outlined in the December 2023 report by the European Supervisory Authorities (ESAs).

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