Investors face technical difficulties with DNSH SFDR requirement

Following the widespread reclassification of Article 9 funds to Article 8 funds as financial markets strive to comply with SFDR reporting, one criterion is emerging as a tricky beast. The Do No Significant Harm (DNSH) principle is particularly important to investors, as it affects the investments that qualify as sustainable under both SFDR and Taxonomy criteria, although there are slight nuances in the way it’s defined. This article explores the DNSH principle as referred to in the SFDR, the complications in its application, and how investors should approach DNSH compliance under SFDR, given existing ambiguities.

What is DNSH?

DNSH is the principle that an investment should not create negative environmental or social impacts. The SFDR outlines three criteria for an investment to qualify as sustainable, one of which is the DNSH:

1. The investment supports an economic activity that contributes to an environmental or social objective
2. The investment does not significantly harm any environmental or social indicators (not to be confused with the Taxonomy’s six environmental objectives) 
3. Good governance is practised by the investee company, particularly with respect to management structures, employee relations, remuneration, and tax compliance

The rationale behind the DNSH is to ensure that no externalities are created or overlooked during the process of contributing to an investment’s primary objective, and that every investment meets minimum social and environmental standards. This means that even impacts beyond the main sustainability objective of the fund must be considered – an extensive undertaking that puts demands on the ability of financial market players to measure and collect the right data.

Challenges of DNSH application

At its core, DNSH is a simple concept. In practice, however, it is a challenging requirement for asset managers to fulfil. For one, investors are required to conduct a ‘DNSH test’ demonstrating compliance, which involves assessing a list of Principle Adverse Impacts (PAIs) outlined in Annex I of the Regulatory Technical Standards (RTS) for the SFDR. The PAIs cover a range of ESG indicators for climate and environment as well as social and employee matters, human rights, and anti-corruption and anti-bribery. Financial market players are mostly acquainted with these PAI aspects and the disclosure process as it reflects similar endeavours in pre-SFDR reporting, including measuring and collecting the relevant data points.

Lack of quality ESG data aside, the problem arises when it is time to determine whether or not a firm has passed the DNSH test. The RTS does not define the thresholds for compliance with the DNSH principle, thus leaving the decision entirely subjective to the investor. There are some reasons why this is the case, at least for now. Setting thresholds is tricky in itself since a threshold too low can allow rampant greenwashing while a threshold too high can discourage EU goals to promote sustainable finance.

The lack of clarity on PAI thresholds and what constitutes DNSH compliance remains to be addressed by policymakers. The only advice so far has been to compare test results with similar metrics in relevant delegated acts such as the Climate Delegated Act, and to benchmark thresholds from there. 

Further complications are found in the technicalities of the required disclosures. For example, financial products with a sustainable investment objective, such as Article 9 funds, must be assessed for DNSH for all its investments. This is at odds with the disclosure requirements for pre-contractual and periodic reports, which requires the DNSH test to be conducted only for the sustainable investment proportion of a portfolio. 

DNSH compliance

Financial market players seeking to qualify a sustainable investment must carry out the DNSH assessment accordingly:

• Article 8 financial product: explain how the adverse social and environmental impact indicators in Table 1 of Annex I of SFDR Final Draft Level 2 and any relevant indicators from Tables 2 and 3 are taken into account 
• Article 9 financial product: ensure the alignment of Sustainable Investments with Article 18 of the Taxonomy Regulation on minimum safeguards

A firm must disclose the information for the DNSH test in all pre-contractual, periodic, and website materials. The RTS stipulates that investments must be aligned with the OECD Guidelines for Multinational Enterprises and the UN Guiding Principles on Business and Human Rights, so investors should ensure that these are benchmarked against. Additionally, investors can identify the relevant delegated acts for each PAI and use that as the basis for determining DNSH compliance.  

*IMPORTANT: The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Trackinsight. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A FINANCIAL PROFESSIONAL IS STRONGLY ADVISED.