SFDR 2.0 Trialogue Negotiations: Key Areas Of Focus For Fund Managers

Exclusion criteria applicable to Transition funds

Likely the area of most concern for Fund Managers implementing transition strategies, both institutions have proposed greater flexibility as regards the ability of Transition products to invest in fossil fuel issuers in certain limited circumstances.

The Council has proposed that Transition products should be able to invest in fossil fuel issuers where they (i) allocate at least 20% of their CAPEX to EU-taxonomy aligned activities and (ii) have a time-bound and measurable strategy to reduce their Scope 1 and Scope 2 greenhouse gas emissions.

The Parliament aligns itself with the Council’s proposal but goes significantly further by requiring that (i) any such fossil fuel issuers also allocate a higher percentage of CAPEX to EU taxonomy-aligned activities than new fossil fuel projects over a three-year rolling period and (ii) the issuer has made a commitment to phase out the use of hard coal or lignite if used for power generation purposes.

The more flexible proposal put forward by Council is likely to be more palatable to Fund Managers. However, Fund Managers implementing global or emerging market transition strategies may have concerns over the EU-centric nature of the CAPEX contribution requirement given expected associated data challenges

UNGP/OECD Guidelines Violators

For all categorised products, the Parliament has also proposed a less onerous exclusion in respect of violators of the UNGP Guiding Principles or OECD Guidelines than that proposed by the Commission and the Council. Under its proposals, any categorised product cannot invest in an issuer which is found in violation of those UNGP principles or OECD Guidelines in respect of “severe human rights and humanitarian law abuses which have not been effectively addressed, and where appropriate, remediated”.

 This divergence from the exclusion criteria set down in the EU Benchmarks framework, if implemented as proposed by the Parliament, may create operational complexity for funds tracking an EU Paris-aligned/EU Climate Transition benchmark or for funds which are subject to the ESMA fund naming guidelines unless the EU Benchmarks framework is amended in the same way. In particular, such funds may need to apply and monitor two overlapping but non-identical exclusion tests in respect of UNGP/OECD violations.

PAI Reporting at Product Level

While the Commission proposed removing fund-level PAI reporting in its entirety, both the Parliament and the Council have reintroduced it.

ESG Basics: The Parliament has proposed an obligation to report against fossil fuel exposure with the ability to voluntarily report against other relevant indicators. The Council does not impose any PAI reporting obligations on this category of fund.

Transition: Under the Parliament’s proposal, Transition products will be required to report against (i) GHG emissions, (ii) fossil fuel exposure and (iii) one other relevant indicator selected from a list of indicators set down in delegated acts. The Council has proposed that Transition products be required to report against three relevant indicators from the delegated act, with the ability to use alternative indicators if able to demonstrate that none of the indicators set down in the delegated acts are relevant. If investing in fossil fuel companies, Transition products would also be required to report on the proportion of investments in such companies.

Sustainable: The Parliament has proposed that sustainable products be required to report against (i) fossil fuels, (ii) GHG emissions, (iii) biodiversity and (iv) UNGP/OECD compliance monitoring frameworks. On the other hand, the Council has proposed giving Fund Managers more discretion, requiring them to select at least three indicators from the list set down in delegated acts, with the ability to use alternative indicators if able to demonstrate that none of the indicators set down in the delegated acts are relevant.

The framework proposed by the Council provides more flexibility to Fund Managers, allowing them to report against PAI most relevant to the fund’s investment strategy and bringing the ESG Basics category outside of the scope of the PAI reporting obligations. 

Engagement Strategy Disclosure

The Parliament has proposed that all categorised funds be required to describe their sustainability-related engagement strategy. To the extent that a categorised fund does not pursue an engagement strategy, the Parliament has suggested that it should provide a “clear and reasoned explanation” of why it does not pursue such a strategy.

The Council has not proposed imposing such a mandatory disclosure obligation on all categorised funds.

We expect this to be a key area of negotiation during the trialogue negotiations with Fund Managers concerned that the proposal put forward by the Parliament could disadvantage those funds which do not implement an engagement strategy. This is likely to be of particular concern for certain investment strategies where issuer engagement is inherently more difficult, such as passive, quantitative fixed income or fund-of-fund strategies.

Criteria applicable to ESG Basics funds

The Parliament has proposed tightening the ESG Basics category by imposing two additional conditions over and above those suggested by either the Commission or the Council.

These include an obligation to report on (i) the extent to which the fund invests in EU Taxonomy-aligned investments and (ii) the fund’s exposure to companies active in the fossil fuel sector.

This is likely to be monitored closely by Fund Managers currently implementing Article 8 strategies under the existing framework, particularly where those products may be expecting to fall within the ESG Basics category under the revised regime. The Parliament’s proposed additional conditions may reduce the relative simplicity of that category.