Every field, from accounting to sports to manufacturing, has its own vocabulary and acronyms that shorten otherwise cumbersome descriptions. If you know football, you know what a “Hail Mary” is – no need to explain.
The sustainable investment field hasn’t been around all that long but it has already generated a rather impressive collection of insider terms and acronyms. Those of us who are immersed in the topic keep absorbing the new vocabulary but sometimes forget that those who only visit this arena now and then may not know what we’re talking about. “Scope 1, 2, and 3,” “SFDR,” “carbon offsets,” “DEI,” “Article 9,” “GHG,” “GRI,”… the list goes on.
ESG’s Alphabet Soup
In this article, we discuss two fairly new additions to the alphabet soup of ESG terminology, “PAI” and “DNSH,” which are part of the SFDR (that’s four acronyms in one sentence). They stand for “Principle Adverse Impacts” and “Do No Significant Harm,” respectively. Ready to dive in?
Wait – before we dive in we have to define “SFDR.” The European Union’s Sustainable Financial Disclosure Regulation is a set of rules that apply to financial market participants within the EU in pursuing strategies that they want to market as “sustainable.” Even financial market entities that are not located in the EU are likely to be impacted if they provide their services in the EU, either directly or through subsidiaries. So the SFDR is a big deal in the world of ESG.
Principal Adverse Impact Indicators
Okay, now we’re ready. Principle Adverse Impact indicators (acronym PAI, or more precisely, PAI Indicators) help to define a requirement in the SFDR. In the EU, to qualify as a sustainable fund the investments held in the fund (let’s say stocks of corporations) that intend to pursue a given ESG objective must Do No Significant Harm (DNSH) with respect to other environmental, social, or governance factors. Think of it this way: if you switch to a vegan diet to improve your health but then drink a bottle of vodka every night to help you forget how much you miss eating cheeseburgers, you’re doing significant harm despite taking steps to eat a healthier diet.
Under the SFDR, financial market participants (we could have said “FMPs” but we refrained) must show that investment funds labeled as “sustainable” Do No Significant Harm in terms of ESG behaviors. Thus, if a company has cut its carbon emissions but is dumping chemicals in rivers, it would fail the DNSH test and funds that hold that company’s stock would have a problem.
How do funds show they comply with the DNSH requirement? They are supposed to start reporting on 14 mandatory PAI indicators plus a choice of two others from a list of 46 voluntary indicators. The alphabet soup gets thicker here, as the specific disclosure requirements depend on whether a fund is classified as Article 8 or Article 9, but that is beyond the scope of what we’re covering in this article.
Here are the 14 mandatory PAI categories:
|Climate and other Environment-related Indicators||Social and Governance Indicators|
|GHG emissions (Scope 1, 2, 3, and Total)||Violations of the UN Global Compact (UNGC) principles and OECD guidelines|
|Carbon footprint||Lack of processes and mechanisms to monitor compliance the UNGC and OECD principles|
|Fossil fuel sector|
|Non-renewable energy consumption and production||Gender pay gap|
|Energy consumption intensity per high impact climate sector||Board gender diversity|
|Biodiversity sensitive areas||Exposure to controversial weapons|
|Emissions to water|
The challenge of disclosing Principal Adverse Impact Indicators
If this looks daunting, that’s because it is. Reporting on PAI indicators is considered to be the most challenging aspect of the SFDR. Companies do not report data on these things in a standard, easily consumable way, if at all. That means the data is not easy to find or collect, and data sources that contain some of the information needed are likely to cover only a subset of companies worldwide. Needless to say, this can make it difficult to comply with the SFDR and may interfere with a fund manager’s ability to appeal to ESG-conscious institutional investors.
Things will start to get easier for investors as large, listed European companies will need to self-certify compliance with the DNSH tests starting in January 2023. Investors in such companies will thus be able to use this information for their own reporting.
That only applies to large companies, so if a fund holds shares of smaller companies that are not required to self-certify compliance with the DNSH tests, that’s still a problem. Even private equity funds must show that their portfolio companies comply.
We also note that “self-certification,” even if it is done with honesty and integrity, may not tell investors what they want to know. Satisfying the DNSH criteria is a good thing, and being able to see that via some type of certification is helpful, but what if you want to know more? For example, you might want to know how a company determined that it does no significant harm with respect to its carbon footprint or gender pay gap.
And does it create perverse incentives? For example, one could imagine a scenario in which a company can, in good conscience, decide that it meets the DNSH criteria with respect to 12 of the 14 mandatory PAI indicators. For the remaining two, will it actually work to correct the problem or will it “stretch the truth” and hope no one notices? Disclosing more data to back up the self-certification would be extremely useful, but doing so requires time and resources. It is easy to say that companies should do something until we consider the cost of doing that thing.
Having said that, just because something is difficult doesn’t mean you shouldn’t try to do it. Measuring and disclosing information about the PAI Indicators will be helpful not only to investors but to the companies themselves – you can’t manage what you don’t measure.
As a final note, the information presented in this summary is simplified, intended to explain the basics of the PAI and DNSH requirement. If you need or want to understand the details, we recommend going directly to this SFDR document which explains it all. Unfortunately, the document is almost 200 pages long but may be worth bookmarking.
OWL ESG is devoted to providing investors, asset managers, investment management platforms, and companies with the data they need to evaluate and comply with regulations and reporting requirements in the sustainability landscape. We can help you meet your ESG data needs in a customizable way that suits your purpose – contact us to learn more.