The MiFID (Markets in Financial Instruments Directive) ESG Regulation envisages three categories of sustainability for investment products:

• Investments with a sustainability component in accordance with Article 3 of the EU Taxonomy Regulation. (EU TR)
• Investments with a sustainability component as regulated in article 2 of EU SFDR or disclosure.
• Investments that include sustainability factors and take into consideration PAIs according to client-selected quantity and quality factors.

Environmentally sustainable investment as defined by the EU TR

According to the EU TR, a sustainable investment is an investment in an economic activity that aligns to a limited number of recognised sustainable objectives and activities, and is subject to a technical screening criteria.

The EU TR specifies six EU environmental objectives:

1. Climate change mitigation
2. Climate change adaptation
3. Sustainable use and protection of water and marine resources
4. Transition to a circular economy
5. Pollution prevention and control
6. Protection and restoration of biodiversity and ecosystems

Broadly, an economic activity may be considered “environmentally sustainable” under the EU TR if it meets the following conditions (known as the technical screening criteria):

1. Makes a substantial contribution to at least one of the EU’s six environmental objectives
2. Does not cause significant harm to any of the other EU environmental objectives to which it is not aligned
3. Meets prescribed minimum ESG safeguards
4. Meets the technical screening criteria set out by the EU TR

Sustainable investments defined by the EU SFDR

The EU SFDR definition of a sustainable investment is broader and accommodates investments outside the EU TR definition subject to base conditions being met. These include:

1. A measurable contribution of an environmental and/or social objective

1. From an environmental perspective, this could include key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land; or similar measurements of the production of waste or greenhouse gas emissions.
2. From a social perspective this could include an investment that contributes to tackling inequality or that fosters social cohesion, social integration and labour relations; it could also include an investment in human capital or economically or socially disadvantaged communities.

2. No significant harm to any other environmental and/or social objective

3. Good governance practices at investee companies, the MiFID definition does not recognise those investments that only have environmental and/or social characteristics as sustainable investments.

The Consideration Of Principal Adverse Impacts (PAIs) On Sustainability Factors

PAIs look at the material effect investments can have on a wide range of environmental and social considerations, regardless of any financial impact. PAIs are essentially a set of mandatory indicators and metrics which aim to show financial market participants how certain investments pose sustainability risks.

The EU SFDR does not provide one comprehensive definition for PAIs but instead identifies specific Principal Adverse Impact Indicators (PAIIs), which are based on actual metrics for measurement.

The core indicators for Principal Adverse Sustainability Impacts Statement are:

Climate and other environment-related indicators
(1) GHG emissions
(2) Carbon footprint
(3) Green House Gas (GHG) intensity of investee companies;
(4) Exposure to companies active in the fossil fuel sector;
(5) Share of non-renewable energy consumption and production;
(6) Energy consumption intensity per high impact climate sector;
(7) Activities negatively affecting biodiversity-sensitive areas;
(8) Emissions to water;
(9) Hazardous waste ratio;

Social, Human Rights and Governance Indicators
(10) Violations of UN Global Compact principles and Organisation for Economic Cooperation and Development (OECD) Guidelines for Multinational Enterprises;
(11) Lack of processes and compliance mechanisms to monitor compliance with UN Global Compact principles and OECD Guidelines for Multinational Enterprises;
(12) Unadjusted gender pay gap;
(13) Board gender diversity;
(14) Exposure to controversial weapons (anti-personnel mines; cluster munitions; chemical weapons and biological weapons);

Indicators Applicable To Investments In Sovereigns And Supranationals
(15) GHG intensity;
(16) Investee countries subject to social violations;

Principal Adverse Impacts (PAI) is widely considered as the most challenging aspect of SFDR. While financial market participants do their best to collect and compile market data to inform decision making and fulfill regulatory compliance, FMPs lack access to investee-reported data. PAI data is often not readily available and is difficult to collect.

It is challenging to find data sources that cover a broad and extensive universe of companies worldwide and to streamline the process of aggregating and reporting PAI indicators. The lack of directly reported quantitative data represents one of the main issues, this is often the case for private companies, SMEs and emerging markets. This can make it difficult to comply with regulatory requirements and attract funding from ESG-conscious investors.