New social metrics to be added to EU sustainability reporting regime

European financial regulators have set out new mandatory requirements for asset managers to report on social aspects of their investment holdings, including such metrics as the share of their portfolio firms’ earnings held in tax havens or tobacco production, share of employees earning less than adequate pay, and any interference with trade unions.

In addition, the European Securities and Markets Authority, the European Banking Authority, and the European Insurance and Occupational Authority have proposed six further opt-in metrics, including:

• • • average share of employees on zero-hours contracts;
    • average share of employees on temporary contracts;
    • share of zero-hours/temporary employees as a percentage of total workforce;
    • average share of disabled employees in the workforce;
    • lack of complaints procedure for customers; and
    • lack of grievance procedure for communities affected by businesses in the portfolio.

These moves are additional indicators that the S in environmental, social & governance (ESG) issues are increasingly of interest to the investor community. Indeed, persistent social inequalities and the urgent need for a fair transition to a more sustainable economy have bolstered the argument for measuring and reporting social risks and impacts.

Europe gets on board

The European Supervisory Authorities (ESAs) proposed the changes in a consultation published on April 12, following a mandate given to them by Commission Delegated Regulation 2023/363 in February. It will mean that all financial firms reporting under the European Union’s Sustainable Finance Disclosure Regulation (SFDR) will have to disclose the information in their principal adverse impact (PAI) statements.

At present there are 14 mandatory PAI items that firms must report. Lawmakers always intended to add more, and the consultation brings the SFDR into line with those required by the Corporate Sustainable Reporting Directive (CSRD) and set out in the draft European Sustainable Reporting Standards, published in November 2022.

The ESAs have also taken the opportunity to refine the existing PAI requirements based on feedback from stakeholders, including financial firms. Among the changes is a requirement for financial firms to state the percentage of data used to calculate their PAI that has come directly from investee companies, versus the data that is sourced from third-party data providers.

Data gaps have been a concern of financial services industry since the regulation was first proposed. The time lag between the SFDR and the CSRD coming into force meant that financial firms were required to produce data on firms in which they invested before the investee companies were themselves required to produce it by law. The proposed breakdown should help illuminate where data gaps remain and where corporations are being slow to produce their own data.

Derivatives & shades of green

The ESAs are proposing to amend how derivatives are allowed for when calculating carbon intensity of a product or portfolio. The inference is that some firms have been using derivatives to artificially mask the carbon emissions of their investments.

“Without appropriate rules concerning the inclusion of derivatives within PAI calculations, financial market participants could be incentivized to achieve long exposures through derivatives, resulting in an underestimation of the principal adverse impacts of their investment decisions,” the ESAs stated in its consultation.

The regulators further noted that derivatives should be netted at individual counterparty level for the purposes of PAI calculations. The ESAs are also proposing to remove the ability of asset managers to choose what shade of green they use in illustrative diagrams in their disclosure documents. This was after regulators observed that some firms were abusing flexibility to imply their products were greener than was the reality.

Investment styles & carbon credits

The regulators are proposing changes to disclosure documents to increase investor understanding. Asset managers will have to set out in a fund’s objectives whether they intend to reduce the greenhouse gas (GHG) emissions by divestment, exclusion, or by working with investee companies to reduce emissions.

Likewise, investment firms will have to explain if, and to what extent, they intend to achieve their GHG emission targets by using carbon credits. “Plans to purchase such carbon credits and their use over time should be disclosed separately. Given the greenwashing concerns surrounding these carbon credits, it is critical that investors are fully informed regarding the use of such credits and regarding their quality,” the ESAs stated.

This change brings SFDR reporting into line with that of CSRD. Among the 43 consultation questions is one asking about financial firms’ preferences with regards to making SFDR reporting requirements machine-readable. The consultation closes on July 4.

The specificity of these moves by European regulators adds to the momentum building for including social metrics into regulatory reporting requirements. The connection between the environment and people is evident; and institutional investors maintain a long-term investment horizon.

This inclusion takes a multi-decade view of how the transition to a sustainable global economy impacts people internally and externally, the main component of the social part of ESG. For companies to thrive into the future, flourishing workers in thriving communities on a healthy planet are all required.