The finance industry is adjusting to a rapidly evolving regulatory environment which places complex non-financial reporting requirements on corporates and investors. Financial Market Participants (FMPs) are now faced with a dizzying array of disclosures and due diligence regimes that they must comply with, or face regulatory and stakeholder scrutiny. Among the most complex of the reporting regimes implemented to date is the Sustainable Finance Disclosure Regulation (SFDR), which establishes standardised policies, procedure and KPIs to define sustainable investments and counteract attempts to “greenwash”.
The SFDR leverages a number of tools to provide investors with transparency on non-financial KPIs, including the Principal Adverse Impact (PAI), which measure negative environmental and social impacts of financial investments.
The SFDR mandates FMPs, including investment firms, asset managers, insurance companies, and pension funds disclose their sustainability practices and policies, including their impact on the environment and society through PAI indicators. The regulation is designed to ensure that investments that classify themselves as “green” or otherwise sustainable are actually delivering on those promises in the construction of the portfolio. Before the SFDR, it was difficult to compare the sustainability profile of different financial products given a lack of standard lexicon or data points used to measure and assess.
In addition to providing regulation to standardise data collection and reporting processes, the SFDR also creates common systems of providing this information to key stakeholders. Since the SFDR Level 2 came into force at the beginning of 2023, FMPs must publish a statement on their website regarding the consideration of PAIs in their investment decisions. By June 30, FMPs will be required to disclose their first PAI reporting, including investment level metrics.
The technical rules around SFDR disclosures and PAIs are provided in the Regulatory Technical Standards (RTS). As such, the RTS provides a list of mandatory and additional opt-in PAI indicators that FMPs must report. Additionally, the RTS provides a number of different standardised templates that FMPs must use to disclose information: these include the PAIs, a summary section, and other additional information on policies and actions taken to mitigate the PAIs.
The objective? Ensuring comparability and standardisation among different investments and portfolios. It is important to note FMPs that choose not to consider PAIs are required to follow the rules set out in the RTS on the statement of no consideration of PAIs.
PAIs listed in the RTS include 18 mandatory and 46 additional indicators around environment and social issues. The RTS includes separate indicators relevant for investments in sovereigns and supranationals, as well as real estate assets. Accordingly, FMPs are expected to provide information on all mandatory indicators, as well as one or more additional environment-related indicators and one or more additional indicators on social issues. Furthermore, the FMPs should provide information on any other indicators used to identify and assess any additional PAIs on a sustainability factor.
As mentioned above, PAIs focus on identifying and measuring the material negative impacts of an investment on the environment and society. Unlike other frameworks and regulations, such as the EU Taxonomy, which aim to promote positive environmental contributions, PAIs specifically focus on identifying how certain investments generate a negative impact. They provide investors with a comprehensive understanding of the risks associated with their investment and allow for informed decision making. However, while PAIs are a great tool for funds to start measuring the adverse impact of their investments, LPs increasingly expect funds to integrate positive environmental or social measurements and considerations in their investment processes.
Given the complexity of PAI reporting, especially for private markets, and the more stringent requirements associated with SFDR Level II, FMPs are under intense pressure to adapt to the changing regulatory landscape.
As part of our SFDR advisory practice, we regularly speak with experienced investment managers about their PAI reporting challenges. Here are some of the things that come up most often:
Funds need granular data on their portfolio assets in order to report effectively on PAIs. However, very few companies collect metrics that can be used to calculate PAIs in a systematic and centralised way. This also implies that estimates provided by ESG data vendors are often not enough to comply with PAI reporting obligations.
As a result, most funds will need to collect the required information directly from their portfolio companies, many of whom are simply not familiar with ESG to effectively report back to investors on the requested KPIs. Given the hands-on process of gathering PAI data from portfolio companies, funds needs to find ways to implement effective, accurate an auditable data collection processes.
A sound PAI data collection strategy does not only mean pinpointing the type of information needed within a firm, but they also require clear communication and transparency to portfolio companies. Managing the data flow and inevitable questions along the way requires significant project management skills from fund managers, and adds a whole new set of responsibilities to the daily work load.
Many funds have found it is necessary to bring on new specialised investment professionals who can not only handle the financial management process, but also apply broad regulatory and sustainability analyses in-depth.
However, such figures might be difficult to find, and upskilling of existing employees might require the allocation of even more valuable time and resources from fund manager.
While PAIs are a central pillar of European financial reporting regulations, there are hundreds of other data points that are required to satisfy requests from other global frameworks and bespoke investor questionnaires. This is all the more true as regulatory pressure is not the only force driving change in the financial industry: a growing number of forward-thinking investors are now betting on impact as an integral, if not central, part of their overall investment strategy.
Sustainability data all flows from the operation of the businesses. Building a flexible data collection process enables reporters to quickly and accurately pull the necessary KPIs with limited resources. To this end, it is wise not to reduce PAI reporting to another box-ticking exercise, but to think of how it can fit into the fund’s broader sustainability vision and data management systems. Identifying the synergies - as well as the differences - between PAIs and other sustainable finance metrics and frameworks can make the difference in collaboration between investors, investees and other core stakeholders.
This is easier said than done. Taking a holistic approach and building an all encompassing data management system and process takes substantial resources, and in-house sustainable finance and impact reporting teams often struggle to get additional headcount.
Of course, in such resource constrained environments, seeking support from external experts can be in order. Given that these regulatory regimes require frequent updates, it's important to find a solution that not only gives you the tools to complete today’s task, but empowers your team to be self-sufficient in the outyears.
SFDR, and particularly PAI reporting, is difficult. From the very first step of collecting raw data from portfolio companies, investors are struggling to stay on top of these regulatory processes and ensure compliance. While we have highlighted three pain points we see most often, these are just the tip of the iceberg. There are broad usability issues across the regulation that impose substantial burdens on mandatory reporters, and many questions left unanswered.
We will cover all of these challenges (as well as solutions and/or suitable approaches to overcoming them) in our exclusive webinar for investment professionals, PAIs Deep Dive: Challenges and Best Practices for Private Market Investors.
The webinar will feature the contribution of sustainable investment specialists such as Benjamin Howard-Coopert, Head of Sustainable Finance at Briink, Danielle Cohen Henriquez, Sustainable Finance Managing Consultant at South Pole, and Blandine Machabert, Head of Impact at RAISE France, part of RAISE Group.
If you are already looking for a more scalable solution to PAI reporting, you should check out the Briink Digital Reporting Platform:
At Briink, we don’t believe in one-size-fits-all approaches when it comes to SFDR reporting. That is why we leverage our knowledge of the private equity and venture capital markets to help forward-looking investors achieve their impact goals through cutting-edge technology and AI.
Join leaders in the sustainable finance space like Apex Group Ltd, RAISE Capital and Continental. Get in touch to learn more, or explore our 60-days-plan to EU Taxonomy and PAIs compliance by downloading the program brochure.
Disclaimer: The information provided in this content is for educational and informational purposes only and should not be construed as legal or investment advice. The content is not intended to be a substitute for professional advice. Always seek the advice of a qualified professional before making any investment or legal decisions. The author and publisher of this content are not responsible for any actions taken based on the information provided. Any reliance on the information in this content is solely at the reader's own risk.
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