European asset managers can choose to be exempted from reporting against some sections of the Do No Significant Harm (DNSH) framework when making fund-level ESG disclosures, under regulatory proposals published on Wednesday.
The use of DNSH is to ensure that that sustainability-themed investments do not come at the expense of harms to other environmental and social objectives – or are fully disclosed when they do – and is also present as a hurdle requirement for the EU taxonomy.
But DNSH rules under the Sustainable Finance Disclosure Regulation (SFDR) are notably different from those under the taxonomy.
Unlike the taxonomy’s DNSH test, which is defined at activity-level according to its six environmental objectives, the SFDR criteria are broader and there are no objective standards for what constitutes “significant harm”, putting the onus on fund managers to decide how social and environmental goals could be impacted.
On Wednesday, the European Supervisory Authorities (ESAs) published draft proposals for a “safe harbour” for some sections of the DNSH disclosures made under the SFDR for investments that are taxonomy-aligned.
The proposed optional safe harbour will only apply to environmental, but not social, DNSH disclosures and is seen as a short-term workaround until the diverging concepts of DNSH within the taxonomy and SFDR can be aligned.
The ESAs have previously consulted on a similar proposal to exempt taxonomy-aligned investments entirely from reporting against DNSH criteria under the SFDR regulation, but last year said they changed their plans “as a result of legal analysis”.
Reconciling the two regulations would require changes to the SFDR’s overarching legislation. That is beyond the powers of the EU’s three financial regulators, the European Securities and Markets Authority (ESMA), European Insurance and Occupational Pensions Authority (EIOPA) and European Banking Authority (EBA).
The latest safe harbour proposal for environmental DNSH disclosures for environmental taxonomy-aligned activities “might boost use of proceeds instruments focused exclusively on such environmental economic activities”, the ESAs said.
The regulators said the issue could be considered as part of an ongoing “comprehensive assessment” of SFDR announced by the European Commission (EC) earlier this year.
Legal observers suggested that flexibility around the application of DNSH would likely be welcomed by the industry, given the complexity of applying a DNSH test.
The proposed relief from green DNSH disclosures is accompanied by quantitative thresholds for DNSH tests, which could be made mandatory in an effort to further standardise the assessment process.
Additions to DNSH disclosures
Under the proposals, fund managers will have to report against four additional mandatory social DNSH indicators, two of which are entirely new.
These relate to portfolio company earnings booked in countries identified as non-cooperative tax jurisdictions by the EU, and the share of investments in companies which have not committed to respect the activities of trade unions.
The remaining two metrics will be mandatory for companies reporting under the EU’s future bloc-wide sustainability company-level reporting regime, the Corporate Sustainability Reporting Directive (CSRD). These are the proportion of employees in portfolio companies earning less than the “adequate” wage as defined by EU laws, and fund exposure to tobacco production.
Where relevant, fund managers can also choose to report against a set of opt-in social indicators which assess inclusive hiring practices and use of contract workers, among others.
The reframing of DNSH disclosures is part of a broader amendment to the SFDR reporting rules which is currently being considered by the regulators, with the remaining changes largely bringing fund-level disclosures in line with the CSRD’s company-level reporting rules.
Decarbonisation and disclosure templates
Fund managers with decarbonisation-themed investment products will be required to disclose whether they aim to reduce the financed emissions of holdings – which can be done through divestment and capital reallocation – or by delivering real-world emissions reduction through the improving climate performance of existing holdings.
Reporting financial institutions can use greenhouse gas accounting and reporting standards for company-level emissions, and the PCAF standard for emissions associated with financial products (which fall under scope 3).
In line with the CSRD drafts, disclosures regarding the use of carbon offsets and greenhouse gas removals should be disclosed separately to company emissions and “should not be considered a means” to achieve emissions reduction targets.
Finally, regulators have proposed significant rewrites to simplify fund disclosure templates for funds registered as ESG-themed under SFDR’s Article 8 and 9 categories, after acknowledging criticism of the “excessive length and the complexity of the information presented”.
However, one financial regulation lawyer told Responsible Investor that firms may be “loathe to go through another exercise of producing updated disclosure templates across all products”, after a similar exercise to meet the current SFDR requirements which came into effect earlier this year.
Stakeholders will be able to submit feedback to the regulators until early July. The finalised draft will need to be adopted by the European Commission before it is signed into law, subject to the approval of member states and the European Parliament.
No timeline has been given for the proposals eventual entry into force but Q4 2023 or Q1 2024 has been described as a “realistic” timeframe by analysts.