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SFDR: ESG is insufficient to comply with DNHS-principle

This article explains how ESG data is not sufficient to comply with the SFDR article 9 disclosing and reporting requirements.

The newest Regulatory Technical Standard of the SFDR.

In our previous SFDR article, we explained the value of creating environmental data on a portfolio-company level, which is much more valuable than classic ESG data. In this article, we’ll zoom in a bit more on compliance with the ‘do not significantly harm principle’ (DNSH).

The newest version of the Regulatory Technical Standard (RTS) of the Sustainable Finance Disclosure Regulation (SFDR) confirmed that article 9 financial products disclose their alignment with the OECD guidelines and UN principle. These guidelines state that portfolio-company level environmental measurement and management must be installed using environmental management systems and life cycle assessments. Hence, ESG ratings are insufficient to comply with the DNSH principle.

'Do not significantly harm' principle only for Article 9 financial products

The DNSH principle accounts specifically for the Article 9 financial products from the 2019/2088 SFDR proposal. Article 9 products are those financial products having sustainable investments as objective. For products to be able to be termed as sustainable investments, these must comply to disclosure requirement of DNSH reporting, as stated in the final version of the RTS:

“For financial products making sustainable investments, Chapter III also lays down requirements on compliance with the ‘do not significant harm’ principle referred to in Article 2, point (17), of the Sustainable Finance Disclosures Regulation in relation to the principal adverse impact indicators in Annex I. The report must also cover information on whether the investments are aligned with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights, including the principles and rights set out in the eight fundamental conventions identified in the Declaration of the International Labour Organization on Fundamental Principles and Rights at Work and the International Bill of Human Rights. The objective of this requirement is to bring the ‘ do not significant harm’ disclosures under Article 2, point (17), of the Sustainable Finance Disclosures Regulation in line with the minimum safeguards in Article 18 of the Taxonomy Regulation.”

In short, DNSH reporting must cover the ‘normal’ pre-determined Principal Adverse Impact (PAI) indicators. In addition, it must cover information that the investments in your portfolio align with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights.

The OECD Guidelines for Multinational Enterprises: Corporate tools & Approaches

Chapter 5 of the OECD Guidelines for Multinational Enterprises: Corporate tools & Approaches states that companies should take due account of the need to protect the environment, public health and safety. They must conduct their activities in such ways that these contribute to the wider goal of sustainable development. More specifically, the OECD lists and elaborates on seven guidelines that companies should follow to achieve these objectives on the environment, public health and safety. These guidelines generally entail the plan-do-check-act cycle by mentioning data collection, planning and implementing in regard to sustainability.

For the sake of this article, there is a specific focus on principles 1 and 3. These principles oppose the use of ‘simple’ ESG data from ESG raters. Rather, these principles state that the portfolio-company level environmental management systems should be established, and life cycle assessment must be performed to address decision-making.

Made in Brussels: EU's SFDR regulation

Principle 1: Environmental Management System (EMS)

The first principle mentions the establishment and maintenance of a system of environmental management appropriate to the company. This guideline specifically mentions:

a) collection and evaluation of timely and adequate information
b) establishment of measurable objectives
c) regular monitoring and verification

The OECD guidelines mention in this regard specifically the adoption of (parts of) the ISO 14000 series of environmental management systems.

To support the DNSH principle of your private equity portfolio, this typically involves active ownership. This is a  new incentive for involvement on portfolio-company level for private equity managers. However, with the right collaborations and the right approach, it will only raise the enterprise value of your portfolio-companies in the direction of the 2030 Paris Agreement commitments.

Principle 3: Life Cycle Assessment

This principle is to assess, and address in decision-making, the foreseeable environmental, health, and safety-related impacts associated with the processes, goods, and services of the enterprise over their full life-cycle. Typically, this type of data is gathered and assessed at company-level. Moreover, the quality of this type of assessment improves when more company-specific data is collected from partners in the supply chain.

Performing LCA studies over your complete portfolio does take some time. However, thinking back to our first principle, it is about the implementation of an EMS (environmental management system). LCAs in combination with the EMS means our data collection and assessment is a dynamic process over time.

So, what does compliance with the DNSH-principle mean for my firm?

As stated in the RTS, a financial market participant must disclose according to the PAI indicators. Subsequently, to term an investment as a ‘sustainable investment’, must prove it does not significantly harm any of these indicators. In addition, report on the alignment with, amongst others, the OECD Guidelines for Multinational Enterprises.

This portfolio-company level environmental management system and the data assessment with organizational- or product life cycle assessments do consume some time and effort. However, typically for our investors (PE, VC, etc) the goal is to retain (partial) ownerships of a company for about 5-10 years, managing improvements in the meantime.

Please take into account that it is the year 2030 in just eight years. The first target year of the Paris Climate Agreement and many resulting environmental legislation in the EU. The year of 40% greenhouse gas emission reduction. The year of 32% share of renewable energy. The year of sector-specific circular economy targets, with a general objective of 30% improvement of resource efficiency. All of which is facilitated with our environmental management system on company and portfolio level.

Hence, by investing in the environmental performance of your investee companies now, you will raise their enterprise value. For this, you will receive your financial reward when divesting future-proof and environmentally compliant companies near or in 2030.

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