Published: 6 Jul 2022 · Last updated: 30 Sep 2022
In our second blog of the Sustainable Finance Disclosure Regulation (SFDR) series, we went into more detail regarding the Principal Adverse Impact Indicators (PAIs). We also examined the many challenges faced by fund managers and private equity (PE) firms. In this blog, we take a deep dive into the Principal Adverse Impact Indicators associated with greenhouse gas (GHG) emissions and the resulting requirements placed on portfolio assets.
SFDR is a European regulation that seeks to improve transparency with regard to sustainable investment products. Greenwashing has become increasingly prevalent, and financial market participants often share claims that they cannot substantiate. SFDR therefore aims to correct companies' reporting methods. The regulation sets out "what the obligations are for manufacturers of financial products and financial advisers towards end-investors". (Source: EU European Commission)
Principal Adverse Impact 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.” (Source: European Securities and Markets Authority ESMA).
The EU has identified 64 adverse impact indicators (PAIs). As outlined in our previous blog, there are 9 core environmental Principal Adverse Impact Indicators applicable to investee companies, all of which are mandatory. These indicators cover a range of environmental criteria, from water quality to hazardous waste production. However, 3 of these 9 indicators relate to the GHG emissions of the investment company. It is therefore crucial that portfolio companies are able to gather the relevant emissions data for funds that wish to classify under Articles 8 or 9 according to SFDR.
This will likely be the first time that most portfolio companies take action to measure their GHG emissions. In this blog, we highlight the key challenges and the first steps these companies should take to ensure they provide the necessary 2022 data in time for the first PAI report, due June 2023. With less than a year to go, preparation should start now.
To help companies understand ownership of emissions, the GHG Protocol defined three scopes of emissions. Scopes 1 and 2 are often prioritised in reporting frameworks, as they pertain to emissions due to activities that can reasonably controlled by the company. Scope 3 emissions extend across a company’s value chain, and are more challenging to quantify.
The scopes are as follows:
Direct GHG emissions stem from sources owned by a company. This can range from emissions due to vehicles and machinery to emissions due to refrigerant usage in air conditioning.
This scope pertains to emissions arising as a result of purchased (rather than generated) electricity used by the company, whether for general electricity usage or electric vehicles.
This scope covers all indirect emissions not considered in scope 2 that are produced as a result of activities along the company’s value chain (usually split into upstream and downstream). A key example of scope 3 emissions is business travel, such as flights.
The most recent version of the SFDR exposure drafts were updated earlier this year. They suggest that scope 3 emissions should be reported alongside scopes 1 and 2 *.
This requirement is relatively new in comparison to prior drafts. However, there is a lack of clear guidance regarding the measurement of scope 3 emissions. (Particularly given the broad remit of scope 3 emissions and the resulting challenges when quantifying these emissions).
Modifications to regulations are likely to continue up until the end of this year. We therefore recommend starting with asset-level measurements of scope 1 and 2 emissions. This gradual approach is less likely to receive pushback from portfolio companies, as it makes gathering the relevant data more manageable. This flexibility is reinforced by the regulation’s encouragement to use “best efforts” where data is not initially available. This can take the form of third-party data, external experts, or making reasonable assumptions.
It is rarely the case that companies will have emissions data immediately available. Instead, it is more likely that constituent pieces of information required to calculate emissions will be found from different departments within the company across different sites. The type of information required to calculate emissions can also vary depending on industry-specific context. However, it is important that data collection and calculation methodologies are carried out consistently and according to SFDR requirements to ensure comparability, both across different assets and different funds.
Our software simplifies the data entry process for portfolio companies by breaking down scope 1 and 2 emissions into categories, following GHG Protocol methodology. For each of these categories, there are often multiple ways to calculate a final emissions value. Key ESG’s software integrates different sets of conversion factors for each calculation method to appropriately convert a range input data to the same output emissions data, providing one source of truth for fund managers.
For example, emissions due to non-electric vehicles owned or leased by the company (a scope 1 emissions category) can be calculated based on distance travelled by different vehicle types, fuel consumption, or the amount spent on fuel (these methods are listed in order of decreasing accuracy). Data required for these methods could come from fuel card reports, mileage claims, mileage capture software, vehicle telematics/trackers, or other operational/financial data sources.
Emissions data is reused for 3 core environmental Principal Adverse Impact Indicators: GHG Emissions, Carbon Footprint, and GHG Intensity of Investee Companies. Each PAI uses financial data to weight the emissions of portfolio assets differently **. The following formula show how asset-level emissions data is used to calculate GHG Emissions for the fund/firm, where there are n number of portfolio companies included in the calculation.
KEY ESG software allows portfolio companies to enter the data that is available to them. The software then translates this into the relevant outputs which, in this case, is emissions data and the resulting Principal Adverse Impact Indicators.
If portfolio assets are not sure where to start, we offer detailed guidance for each data entry point organised by our software. This allows every portfolio company to successfully collect and enter the relevant information for the private equity fund manager to view.
We also provide industry-specific benchmarking data, so that companies can compare their performance with that of their peers. This way, companies and fund managers can set targets for improvement.
* For further detail on the definitions of scopes 1, 2, and 3 emissions, please visit this link.
** Full regulatory detail on the PAIs can be found here.