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Principal Adverse Impact (PAI) is a key concept in the EU’s Sustainable Finance Disclosure Regulation (SFDR), one of the EU Action Plan on Sustainable Finance’s landmark regulations. PAI is defined as “Negative, material or likely to be material effects on sustainability factors that are caused, compounded by or directly linked to investment decisions and advice performed by the legal entity.”* In the SFDR, there are both narrative and quantitative disclosure requirements for financial institutions around PAI.

As part of the SFDR level 1 regulation that came into force last March, financial market participants are required to make a statement of how they incorporate Principal Adverse Impact in their investment decision process.ⁱⁱ This is a narrative disclosure in the form of a statement, good examples include Robeco’s statement and Nordea’s PAI statement. A similar policy disclosure is required for financial products by the end of 2022.

By June 2023, financial market participants are requiredⁱⁱⁱ to report on a set of Principal Adverse Impact indicators, aggregated at entity level across its investments in a given period. These PAI indicators are essentially a set of environmental, social and governance indicators and metrics, ranging from carbon emissions, water emissions, biodiversity impacts, social violations, and gender parity on the board. The regulatory technical standards provide a table with mandatory indicators, and two tables with voluntary indicators of which a financial undertaking needs to pick one of each. PAI indicators were established for corporate, sovereign, and real estate holdings. There is no requirement to report on PAI indicators on fund/portfolio/financial product level in the regulation (but as mentioned above, a narrative disclosure is required for products).

The PAIs are a comprehensive list; however, the definitions are not always clear and may not always lead to the desired outcome, which is to provide transparency on adverse impacts to the end investor. The list is long, and much of the data will be hard to grasp or benchmark for a non-ESG specialist (how do you compare absolute carbon emission figures between two entities of entirely different sizes? What level of hazardous waste emissions is acceptable?). Furthermore, as EUROSIF also pointed out, some of the proposed definitions and calculations would ideally be improved as they are  incorrect or don’t make a lot of sense. In the EU’s new sustainable finance strategy, reviewing these definitions is foreseen for later in 2022, which seems to recognize that their design is not flawless.

Delay to Level 2 Regulation may also impact PAI reporting

While the SFDR level 1 regulation took effect in March 2021, the level 2 regulation, the one that specifies technical standards for implementation, was further delayed recently to June 2022 (see our previous blog for more information on this). Reporting on Principal Adverse Impact indicators (PAIs) is also part of the level 2 regulation.ⁱ  We assume that this reporting, due in June 2023, is also impacted by this delay; however, ‘how’ is not yet clear.

Momentum for PAI data very strong

Despite the shifting timelines, we observe that the market momentum around PAIs is not diminishing, quite the contrary. Investors in the scope of the regulation are using the fourth quarter of this year to get acquainted with PAI data and set up their systems. Most investors we speak with want to be prepared in time to be able to monitor PAIs throughout 2022 and adjust their portfolios to boost their PAIs (or rather mitigate the downside, as these are adverse impact indicators). This means that PAIs may significantly impact stock selection and portfolio construction by fund managers keen to have ‘good’ PAI scores.

Principal Adverse Impact Indicators to have substantial impact

PAIs may have a larger impact on portfolio compositions than the EU Taxonomy^iv in the short- to medium-term. Taxonomy alignment figures^v are expected to be low for some years since the availability of Paris-aligned real-world investment opportunities is still very limited and the Taxonomy itself is not yet fully developed. The market is aware of this fact, and it seems unlikely that the Taxonomy will strongly influence portfolio compositions in the short term, except those explicitly seeking high alignment scores. PAIs, however, present a relatively straightforward (though far from flawless) set of indicators and metrics on which to base stock selection and fund comparison. In looking to improve or optimize their PAI scores, fund managers may rank investee companies based on PAIs, engage those that don’t rank well, and even divest (as can be read in for example, Nordea’s PAI statement mentioned earlier).

Besides an impact on stock selection, it is conceivable that distributors and financial advisors will similarly rank funds based on PAIs or require funds’ PAIs to meet certain thresholds. While the regulation doesn’t require funds to publish their PAIs, we observe in the market that distributors and financial advisors will likely require fund managers to provide them, and we see fund managers already preparing for this. And while the regulation doesn’t set limits, standards or benchmarks for PAIs – e.g., the SFDR does not specify what constitutes ‘high’ or ‘too high’ for carbon emissions or the number of social violations, for instance. However, the market will inevitably start comparing and benchmarking PAIs as soon as reporting commences.

Partner with Sustainalytics and Morningstar for EU Action planning

The combined expertise of Morningstar and Sustainalytics makes serves financial professionals looking for the data coverage, trustworthy research, and flexible reporting capabilities they need to respond to the regulatory demands of the EU Action Plan.

We have recently expanded our SFDR PAI data package covering the corporate and sovereign PAI indicators. Holistically approaching SFDR, clients have access to a full suite of ESG solutions across the investment value chain. Beyond PAI indicator data, we have a broad suite of ESG data, research and services that can support compliance with key aspects of the SFDR:

• ESG research on sustainability risks with supporting screening tools can assist with the policy statements on integrating sustainability risks in investment decisions and risk management.
• Research on corporate governance, a foundation for the definition of ‘sustainable investment’ in SFDR.
• ESG data and metrics for reporting on the attainment of ESG characteristics of article 8 products or the sustainable investment objectives of article 9 products.
• Engagement Services, an important way to take action related to principle adverse sustainability impacts.
• Global Standards Screening and EU Taxonomy Solution to support the ‘do no significant harm’ principle and the requirement to disclose which international standards and norms are adhered to.
• Morningstar ESG indexes can support the attainment of environmental or social characteristics or objectives.
  

For more information, please reach out through your preferred client service contact, visit our EU Action Plan Resource Center and stay tuned for Sustainalytics’ upcoming on-demand video on EU Action Plan products and solutions.

<sub>Sources / Comments:
* Principles Adverse Impact indicators are the predefined list of ESG indicators and metrics (such as carbon emissions, wastewater emissions, social violations, etc.) that are considered to always have a negative impact.</sub>