Principal Adverse Impact (PAI) disclosures under the SFDR 

What is PAI?

A Principal Adverse Impact (PAI) is any impact of investment decisions or advice that results in a negative effect on sustainability factors, such as environmental, social and employee concerns, respect for human rights, anti-corruption, and anti-bribery matters. For financial market participants and financial advisers (“financial undertakings”), providing the required PAI information is one of the most challenging obligations under the Sustainable Finance Disclosure Regulation (“SFDR”). Until recently, little information was available on the application of PAI obligations and the related disclosure requirements. More clarity has been provided with the introduction of the SFDR Delegated Regulation, which enters into force on 1 January 2023. 

PAIs should be disclosed in the following, independently applicable, ways: 

1. Disclosure on an entity level (article 4 SFDR), by publishing an annual PAI statement on the website, this requirement applies to both financial market participants and financial advisers; and
2. Disclosure on a product level (article 7 SFDR), by publishing PAI information in pre-contractual financial product documentation, such as fund information memoranda or prospectuses, this requirement applies to financial market participants only. 

PAI disclosure on an entity level: the annual PAI statement

A PAI statement is an annual statement provided by a financial undertaking on how it considers relevant PAIs of its investment decisions on sustainability factors. 

Publication of the PAI statement is mandatory for financial market participants with 500 or more employees during the financial year to which the particular PAI statement relates.

For other undertakings, a “comply or explain” requirement applies instead. Financial undertakings which include any PAI in their investment decisions or advice should explain in their PAI statement how they do this (i.e., how they “comply”) while financial undertakings who do not consider any PAI should separately describe why not (i.e., they should “explain”).

The annex to the SFDR Delegated Regulation provides a PAI statement template and an overview of all identified PAI indicators. Financial undertakings should use this template in case they comply. The template is divided into various elements such as identified PAI descriptions, PAI indicators, shareholder engagement policies, descriptions, and historical comparisons (with reference to relevant provisions of the SFDR Delegated Regulation).

The PAI description should cover the applied metrics, impacts, explanations, and actions taken/planned for each adverse sustainability indicator identified. The PAI indicators cover a wide range of environmental, social and governance risks (also known as “ESG” risks). In devising the PAI indicators, particular emphasis has been put on climate and other environment-related concerns as well as employee, human rights, anti-corruption, and anti-bribery matters. 

Action required for the PAI statement

As explained in one of our previous blogs, financial undertakings should already be on their way in preparing the PAI statement related to the year 2022. Much more granular reporting requirements are coming their way for the PAI statement 2023, as the SFDR Delegated Regulation will apply.

The different PAI statement scopes and timelines are as follows: 

It is advisable for financial undertakings to already start gathering the necessary information in order to disclose the more detailed PAI statement relating to the year 2023, as the increased regulatory requirements under the SFDR Delegated Regulation on PAI screening will require additional time and attention. 

PAI disclosure on a product level: publishing PAI information

In addition to publishing the annual PAI statement, financial market participants must be transparent about PAI on financial product level. This obligation does not apply to financial advisers.

Again, for financial market participants with 500 or more employees it is mandatory to comply. For others the “comply or explain” principle may be applied.

If no PAI on sustainability factors are considered for a certain financial product, the pre-contractual information must include a statement to this effect, including the reasons for non-consideration. In case any PAI on sustainability factors are considered, the pre-contractual disclosure for each individual financial product must include a detailed description of how this is done. In short, the SFDR requires that the pre-contractual information includes:  

• A clear and reasoned explanation of whether, and, if applicable, how a financial product takes the PAI on sustainability factors into consideration; and  
• A statement that the information on the PAI on sustainability factors will be provided in a periodic or annual report. 

These requirements have to be met by 31 December 2022. 

Actions required for PAI disclosure on product level

Unfortunately, the SFDR and the SFDR Delegated Regulation do not stipulate detailed requirements on how to publish PAI information in pre-contractual information, other than: “a clear and reasoned explanation”. The European Supervisory Authorities (ESAs) have limited their guidance so far to the fields in the templates in the SFDR Delegated Regulation (in effect per 1 January 2023). ESMA did clarify that existing financial products’ pre-contractual information disclosures must also be amended to comply with the PAI disclosure requirements set out in article 7 SFDR.

The lack of delegated rules on product level disclosure affords financial market participants considerable discretion to tailor product level PAI disclosures to their products, compared to entity level disclosure. However, it is recommended to pay attention to the entity level disclosures when designing pre-contractual product disclosures to prevent misalignment between the two. 

Regulatory expectations and challenges

In conclusion, given the SFDR’s novelty it is not completely clear how to implement all its disclosure requirements, while the challenges posed by the SFDR have gained the supervisors’ attention. The Dutch Authority for the Financial Markets (AFM), for example, has acknowledged that compliance with sustainability regulations creates new hurdles for the market and they confirmed the challenge of the lack of necessary information to meet the transparency requirements. Additionally, the European Central Bank has set out its supervisory expectations for banks’ compliance with managing climate and environmental risks, which should be considered by financial market participants.

It is clear that the supervisory authorities are mindful of the integration of sustainability risks in investment decisions and advice. Therefore, it is important to either comply with the more granular requirements of the SFDR Delegated Regulation for PAI disclosures or to properly explain deviation!

You may read here more on SFDR compliance from a Risk & Compliance perspective.