PAI in SFDR regulation explained

Principal Adverse Impact (PAI) in SFDR regulation explained

What is SFDR?

SFDR stands for Sustainable Financial Disclosure Regulation. The SFDR was first introduced in 2019 by the High-Level Expert Group on Sustainable Finance (HLEG) and first effected in March 2021.
This regulation is one of the key initiatives that are designed to help achieve the climate neutrality goal of the European Green Deal by 2050. Hence, the SFDR’s primary goals are to “integrate sustainability considerations into the financial system” and “steer the flow of capital towards sustainable investments.”
The SFDR wants to achieve this goal by improving understanding of the impact of investments by stakeholders in the financial sector. It aims at fostering sustainable investments while also mitigating greenwashing. See our Regulations Knowledge Base to learn more about other sustainability regulations such as the CSRD.

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What are PAIs?

Since Q2 2021, in an effort towards increasing transparency and integrating sustainability risks, the  Sustainable Finance Disclosure Regulation (SFDR) imposes mandatory ESG disclosure: investors must report on Principal Adverse Impacts (PAIs) of their portfolios.
PAI consist of a list of sustainability factors that firms need to take into account for their investment policies and decisions. Those indicators relate to environmental and social topics. According to the regulation, asset managers, EU banks, venture capital funds, and all the other financial market participants (FMPs) must disclose on a set of mandatory indicators.

The challenge of disclosing PAIs

Principal Adverse Impacts (PAI) is widely considered as the most challenging aspect of SFDR. While financial market participants do their best to collect and compile market data to inform decision making and fulfill regulatory compliance, FMPs lack access to investee-reported data. PAI data is often not readily available and is difficult to collect. It is challenging to find data sources that cover a broad and extensive universe of companies worldwide and to streamline the process of aggregating and reporting PAI indicators. The lack of directly reported quantitative data represents one of the main issues, this is often the case for private companies, SMEs and emerging markets. This can make it difficult to comply with regulatory requirements and attracting funding from ESG-conscious investors.

Who is affected by the regulation?

The SFRD is an initiative aimed at helping financial market participants within EU boundaries achieve sustainability goals. However, entities which are not part of the EU are bound to be affected if they provide their services in EU territory either directly or through subsidiaries. The factor of market pressure can also lead to indirect SFDR impact on non-EU entities.

SFDR applies to firms in the financial industry within the EU. These firms include:

  1. Financial advisors
  2. Commercial banks
  3. Asset managers
  4. Insurance providers
  5. Venture capital funds
  6. Pension fund providers

SFDR requires disclosure at entity and product level

Entity level disclosures (Article 4 SFDR)

According to Article 4, FMPs are required to make entity-level disclosures on how the firm assesses PAI and establishes fund-level disclosures on a comply or explain basis. This means that FMPs which do not consider the PAIs must provide a statement that specifies clear reasons behind the decisions and whether they will consider them in the future. However, this ‘’opt-out’’ option is not available for larger firms: FMPs with more than 500 employees during the financial year (or FMPs that are the parent undertaking of a large group with more than 500 employees) cannot opt-out and need to collect the PAI indicators for all their investment decisions regarding all financial products managed and offered by the company, and then aggregate on the company level and disclose on their website.

Product level disclosures (Article 8/9 SFDR)

Under SFDR, FMPs are required to disclose product level information for ESG-related and non-ESG related products. This means that FMPs will have to follow product-specific disclosures, that require mandatory reporting of PAI for the 14 mandatory metrics and a choice of 2 from a list of 46 voluntary indicators.
The products and services organisations offer must be classified into three categories, as laid out by article 6) mainstream products which do not integrate of sustainability into the investment process, article 8) products promoting environmental or social characteristics, and article 9) products targeting sustainable investments.

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