On 25 October 2022, the Financial Conduct Authority (FCA) published its Consultation Paper on UK Sustainability Disclosure Requirements (SDR) and investment labels (CP22/20).
In summary, the FCA proposes to introduce the following new requirements for UK asset managers that will complement the existing Task Force on Climate-Related Financial Disclosures (TCFD)–aligned reporting regime set out in the ESG chapter of the FCA Handbook:
- sustainable investment labels, across three categories underpinned by objective criteria — sustainable focus, sustainable improver, and sustainable impact;
- restrictions on how certain sustainability-related terms (such as “ESG,” “green,” or “sustainable”) can be used in product names and marketing as well as a more general anti-greenwashing rule for all regulated firms;
- consumer-facing disclosures relating to the key sustainability features of an investment product;
- more detailed disclosures for institutional or retail investors that want more information; and
- requirements on product distributors to ensure that the labels and disclosures are accessible and clear to consumers.
The consultation is open until 25 January 2023. The FCA intends to publish final rules by the end of the first half of 2023.
We set out five key takeaways below for asset managers — including U.S. and other non-UK asset managers — followed by a more detailed review of the FCA’s proposals.
KEY TAKEAWAYS FOR ASSET MANAGERS
1. Overseas managers are not in scope of the current consultation but are expected to be in scope of the eventual rules.
In December 2021, the FCA published final rules setting out a TCFD-aligned disclosure regime for UK-based asset managers requiring public-entity-level and product-level disclosures to be made (on a phased-in basis) from 2023 (see our previous Sidley Update). The FCA’s new SDR and investment labels will build on these existing TCFD disclosure obligations.
The new proposals in CP22/20 also focus on funds and portfolio management based in the UK. The scope of the draft rules on sustainability labelling, naming and marketing (ESG 3), and the disclosure of sustainability-related information (ESG 4) extends to UK alternative investment fund managers (AIFMs), UK Undertakings for Collective Investment in Transferable Securities (UCITS) management companies, and UK firms undertaking “portfolio management” (which, as noted in our previous Sidley Update, includes the activities of private equity firms that advise offshore general partners).
At present, the draft rules in CP22/20 do not extend to non-UK firms marketing funds to investors under the UK Alternative Investment Fund Managers Directive (AIFMD) national private placement regime (UK NPPR) (such as U.S. investment advisers, EU AIFMs, or EU UCITS management companies). Nonetheless, the FCA notes that overseas funds “form an important part of the overall regime,” and the FCA intends to follow with a separate consultation “in due course” as to how the new rules may be applied in respect of overseas funds.
Even under the current draft of the proposed rules, a key consideration for non-UK firms targeting UK retail investors (typically through a UK retail distribution platform) will be the extent to which the general anti-greenwashing rule will require them to change the marketing approach, or even the name, of their product (see further below).
In addition, it is possible that when the FCA consults further on the application of its SDR and investment labels to overseas firms, such firms are also brought into scope of TCFD-aligned disclosure requirements — at least at the product level for funds marketed in the UK, if not the entity-level reporting required under TCFD. Notably, the TCFD-aligned disclosure rules under the existing ESG chapter of the FCA Handbook are not conditional on the firm’s (or any of its products’) having a sustainability focus, meaning the current rules for UK firms (and any subsequent extension of the rules to non-UK firms) apply widely.
Finally, noting that the Consultation Paper proposes to amend the existing AIFMD pre contractual disclosure requirements in FUND 3.2 (which do currently apply to non-UK AIFMs under the UK NPPR, by virtue of FUND 10.5), it is possible that any non-UK firms wishing to promote a fund that exhibits sustainability characteristics in the UK will be able to do so only if they meet the requirements of ESG 4.3 and, as applicable, ESG 4.5.
2. The labelling regime and anti-greenwashing rule is primarily retail investor-focussed, but institutional funds could feel a knock-on effect.
The introduction of sustainable investment labels is intended to help consumers navigate better the investment product landscape, as well as to increase consumer trust in the integrity of the sustainability products they are offered, in light of concerns with historic “greenwashing” by firms making misleading sustainability-related claims about their investment products.
The FCA also notes that the lack of standardised product-level reporting on sustainability objectives and strategies can make it challenging for consumers to determine whether a product integrates ESG factors into financial risk/return considerations, has a specific sustainability goal with a real-world positive impact, or targets a particular sustainability-related asset profile or theme.
The sustainability labels are not mandatory, but any consumer-facing product that does not qualify for (or chooses not to apply) a sustainability label will be restricted from using sustainability-related terms in the naming and marketing of products. As the FCA notes, this would include (but is not limited to) the following terms: “ESG,” “climate,” “impact,” “sustainable,” “sustainability,” “responsible,” “green,” “SDG”/“Sustainable Development Goals,” “Paris-aligned,” and “Net Zero.”
We note that terms such as “ESG” and “sustainability” are in common use as product names for funds that predominantly target ESG integration from a financial risk/return perspective and that would not otherwise meet the labelling requirements (particularly regarding the need to exhibit a “plausible, purposeful, and credible link to an environmental and/or social outcome”). As such, firms managing such products with a consumer focus may need to reassess their marketing strategy and/or increase the “intentionality” of their sustainability strategies.
The requirement for communications to be fair, clear, and not misleading is a longstanding principle that firms are already familiar with, and firms’ disclosures regarding sustainability are already covered by it. However, the introduction of a general “anti-greenwashing” rule will serve to emphasise this requirement and will provide the FCA with an explicit rule on which to challenge firms, and take enforcement action where necessary.
Although the labelling regime is not specifically targeted to institutional investors, there is no restriction on institutionally focussed funds’ opting to use the labels provided that such products meet the relevant criteria. Noting that institutional funds are not subject to the same restrictive naming rule as retail products (where they do not meet the labelling criteria), the level of optional adoption of the sustainability labels by institutional funds will likely depend on the level of credibility and market worthiness of the FCA’s regime.
Given that much of the current criticism of the EU’s Sustainable Finance Disclosure Regulation (SFDR) stems from a perception that many “Article 8 funds” lack sufficient sustainability ambition (indeed, the European Commission and European supervisory authorities are considering the introduction of minimum sustainability standards), adoption of the FCA’s sustainability labels could prove to be useful in helping a product to stand out in the context of an EU offering as well as in the UK. This would be true for institutional funds as well as for retail funds.
The proposals in CP22/20 do not extend to UK pension funds. However, the FCA aims to provide investors with greater transparency on sustainability-related matters with respect to both their direct investments (i.e., those covered by the current proposals) and their savings (including pension products), and Chapter 8 of the consultation seeks views as to how the regime could apply to other products, including pension products, in the future. Any future extension of the SDR and investment labels to UK pension products would be likely to increase the pressure felt by asset managers with relationships with UK pension providers, as UK pension providers offering labelled products would likely require further information from underlying funds and/or their allocation decisions may be more restricted.
3. Overseas sub-advisers to UK asset managers (particularly for retail products) are likely to be subject to the rules indirectly, and their strategies and product names may be influenced as a result.
Although non-UK firms are not directly in scope of the current draft of the rules, non-UK firms that act as sub-advisers to UK asset managers may find that the requirements are “pushed down” by the delegating UK manager. This is particularly true for retail funds (e.g., UK UCITS) that are currently marketed as having ESG integration characteristics, as these will need to be reviewed in light of the labelling criteria and naming rule.
Noting that UCITS funds are predominantly invested in public securities and need to meet diversification requirements, it seems more likely that such funds would target the “Sustainable Focus” or “Sustainable Improvers” labels rather than the “Sustainable Impact” label, which would require products to have a “positive, measurable contribution to sustainable outcomes” and be invested in assets “that provide solutions to environmental or social problems, often in underserved markets or to address observed market failures.”
Likewise, sustainability-labelled UCITS funds would need to demonstrate a “plausible, purposeful, and credible link to an environmental and/or social outcome” through one of the channels identified by the FCA. As such, funds are unlikely to direct new capital into underserved markets based on a “theory of change,” firms will either need to demonstrate active investor stewardship and engagement and/or that their asset allocations have a material influence on asset prices and the cost of capital for investee companies. For overseas sub-advisers, whose current UCITS mandates reflect an existing strategy operated by the firm outside the UK, significant process changes could be required to justify the continued use of ESG or sustainability-related product names and marketing materials.
4. Article 8 or Article 9 SFDR status may not be sufficient to obtain a UK sustainability label.
As highlighted above, the EU’s SFDR does not currently impose any minimum sustainability standards on “Article 8 funds” (other than the requirement for all investee companies to exhibit good governance), although this is currently under consideration by the European Commission and the European supervisory authorities.
According to guidance from the European Commission, a product will “promote” an environmental or social characteristic for the purpose of Article 8(1) of the SFDR even if it merely creates “an impression that investments pursued by the given financial product also consider environmental or social characteristics in terms of investment policies, goals, targets or objectives or a general ambition …”.
Given the subjectivity of this standard, there is a reasonably low bar to triggering the application of the Article 8 disclosure requirements under SFDR. However, provided sufficient transparency is given regarding the product’s aims and methods and the sustainability indicators it uses to measure the attainment of environmental and/or social characteristics, there will be no breach of the SFDR, even if the product is subsequently unable to demonstrate a high level of ambition or intentionality in the environmental or social characteristics it has been identified as promoting.
The FCA’s focus on the intentionality (and, in particular, the “investor contribution” discussed in Section 4 of CP22/20) of products carrying a sustainability label is, therefore, a significant differentiator from the SFDR framework.
Products otherwise falling within Article 8 of the SFDR that do not demonstrate sufficient intentionality (or that do not meet the principles or criteria under the FCA’s SDR) will not qualify for a UK sustainability label. In particular, Article 8 products with ESG negative screening or basic ESG tilts would not (in the absence of more) plausibly contribute to positive sustainability outcomes and so cannot qualify for a sustainable investment label.
This result may also apply to Article 9 funds if their sustainable investment strategy relies only on the “enterprise contribution” of the underlying assets — that is, the “additional outcomes contributed by the issuer of the asset, independently of actions by the investor.”
The FCA notes that funds classified as “ESG-Focused” and “Impact” funds under the U.S. Securities and Exchange Commission (SEC) proposals can qualify for the UK sustainability labels if they meet the cross-cutting and category-specific criteria.
As noted above, the UK sustainability labels may, therefore, be a useful differentiator for investment products with a high level of ESG ambition and intentionality — whether retail or institutional.
As would be expected, the FCA also states that Article 6 SFDR funds and U.S. “Integration” funds cannot qualify for the sustainability labels, and so products without a sustainability objective but that may use strategies such as “ESG integration” (i.e., ESG risks) would not qualify for a sustainable investment label.
5. The SDR does not require the disclosure of principal adverse impacts (PAIs) of investment decisions on sustainability factors, and the labelling regime does not apply the concept of ‘do no significant harm’ (DNSH).
As discussed above, the EU SFDR is a disclosure regime without minimum sustainability standards. However, the regime does require disclosures (on a comply-or-explain basis for most firms) as to PAIs of investment decisions, and the concept of a “sustainable investment” incorporates a consideration of DNSH (both under the SFDR and for environmentally sustainable economic activities under the EU Taxonomy Regulation).
Neither of these concepts is present in the SDR or investment labelling criteria proposed by the FCA (although Sustainable Impact products should seek to avoid unintended negative environmental or social effects). The FCA indicates that it regards the concept of DNSH as too restrictive, and rather than impose a PAI disclosure requirement, the FCA will further develop the SDR in line with the development of standards to be published by the International Sustainability Standards Board (ISSB). The FCA’s TCFD-aligned disclosure rules already contemplate disclosure of Scope 1-3 GHG emissions by inscope UK firms. By indicating that the SDR will align with the ISSB standards, the same result could be expected to apply to product-level disclosures by overseas firms once the SDR are extended to apply to them.
While the product-level disclosures under SFDR and SDR share many of the same disclosure items, the SDR require more granular information in a number of areas, particularly with regard to asset selection processes and criteria.
Conscious of the difficulties that will arise for firms as a result of the differences between the SFDR and SDR regimes (as well as proposed SEC rules), the FCA has undertaken a mapping analysis, which is set out in Annex I of the consultation paper, to which firms should have regard.
While firms are likely to find a delta between the SDR and SFDR requirements, the FCA is not proposing to introduce product-level templates for pre-contractual and periodic disclosure requirements (such as will be required from 1 January 2023 for Article 8 and Article 9 products under the SFDR).
OVERVIEW OF FCA’s PROPOSALS
Sustainable investment labels
The FCA proposes three optional sustainable investment labels (rather than the five labels that had been proposed by Discussion Paper DP 21/4) that will be classified on the basis of intentionality and, according to the primary channel (see below), by which a product can “plausibly contribute” to positive sustainability outcomes.
In particular, the FCA seeks to emphasise the importance of actions taken through a product’s investment strategy to contribute to positive outcomes for the environment and/or society (“investor contribution”) as distinct from the “enterprise contribution” of underlying assets (i.e., the outcomes contributed by the issuer of the asset, independently of actions by the investor). This would include the value that the firm adds through asset selection, portfolio construction, and investor stewardship across three main “channels” of active investor stewardship and engagement, influencing asset prices and cost of capital, and seeking a positive sustainability effect by allocating capital to underserved markets or addressing market failures.
All labelled funds must comply with overarching principles and meet certain qualifying criteria laid out by the regulator (“cross-cutting criteria” and “category-specific criteria”).
The labelling regime will come into effect from June 2024 and is intended to be used primarily for consumer products, although it will also be possible for institutional-focused funds to adopt it. Products qualifying to use a label will also need to display an associated graphic.
1. Sustainable focus
- Products will invest mainly in assets that are sustainable for people and/or the planet.
- Sustainability goals are achieved primarily via the market led channel (see below) of influencing asset prices, thereby reducing the relative cost of capital of sustainable economic activities/projects and secondarily through investor stewardship.
- At least 70% of a “sustainable focus” product’s assets must meet a credible standard of environmental and/or social sustainability or align with a specified environmental and/or social sustainability theme.
- Products are expected to typically be actively managed and highly selective, although passive index-tracking strategies may also meet the criteria.
2. Sustainable improvers
- Products will invest in assets that may not be sustainable immediately but that aim to improve their sustainability for people and/or the planet over time.
- Products may be invested broadly across sectors, with the firm playing an important role in embedding and accelerating improvements in the sustainability profile of assets, including through its stewardship activities.
- Clear and measurable targets for improvements in the sustainability profile of assets must be reflected in key performance indicators (KPIs).
- Sustainability goals are achieved primarily via the channel of investor stewardship and secondarily through influencing asset prices.
- Some index tracking strategies may meet the criteria, where they track tilted benchmarks that embed such criteria, and where the firm also engages proactively with the assets.
3. Sustainable impact
- Products will invest in solutions to problems affecting people or the planet to achieve real-world impact.
- Products will invest in line with a clearly articulated theory of change and show how they select assets that align with this, while also seeking to avoid unintended negative environmental or social effects.
- Products are expected to apply industry standard approaches to performance measurement, reporting against rigorous, evidence-based KPIs that capture the investor contribution to positive sustainability outcomes.
- Firms will, typically, be better able to demonstrate and measure the additionality of their contribution to real-world outcomes if the products invest new capital, via either private or primary markets.
Firms that meet the criteria for their investment products and seek to use the label must publish on their website details of the sustainability labels that have been applied to relevant products and details as to where the consumer-facing disclosure pertaining to such products can be easily accessed. The product’s sustainability label must be included in the consumer-facing disclosures, pre-contractual disclosures, and the product’s sustainability report. Firms must notify the FCA within one month that they are using a sustainable investment label.
The FCA is not proposing that firms should seek independent verification of their labelling, although the FCA encourages firms to do so if firms consider that it would be helpful to their clients and consumers.
Firms must review their use of sustainable investment labels at least annually, as well as prior to any proposed changes to a labelled product, and revise the use of a label as appropriate.
The FCA proposes that firms undertaking sustainability in-scope business must prepare, and publish on their websites, consumer-facing disclosures for retail clients in relation to both labelled and non-labelled products (albeit products that are not engaged in any sustainability-related strategies will inherently have more limited disclosures).
As consumer-facing disclosures are intended to represent a subset of more detailed product-level information, providing the most salient sustainability-related information to consumers in an accessible way, they will be limited to two sides of A4 when printed (although they must be accessible in digital format) to cover information under the following headings:
- basic information;
- product label;
- sustainability goal;
- sustainability approach;
- unexpected investments;
- sustainability metrics; and
- signposting to other disclosures.
The consumer-facing disclosure will be presented alongside documents that present other key investor information such as the Key Information Document (KID) produced for packaged retail investment and insurance-based products (PRIIPs).
This proposed disclosure requirement is to come into effect from June 2024, and information must be updated at least annually.
In complying with the consumer-facing disclosure rules, firms must also comply with the consumer understanding outcome under the new FCA Consumer Duty.
Detailed product-level disclosures
The FCA proposes that all products that use a sustainable investment label or that adopt sustainability-related features that are integral to their investment policy and strategy be required to make additional detailed pre-contractual product-level sustainability disclosures from June 2024. The intention is that such disclosures will be for a wider audience, including institutional investors.
Pre-contractual disclosures must include information relating to:
- the product’s sustainability objective;
- the product’s investment policy and strategy; and
- the firm’s approach to stewardship.
In addition, firms using a “sustainable investment” label will be required to produce a “sustainability product report” to assess ongoing performance and progress towards meeting the product’s stated sustainability objective (a “Part B report”). The Part B report will build on the TCFD product report. The first disclosures under Part B must be published no later than 24 months after the FCA’s rules enter into force (i.e., provisionally from 30 June 2025). The FCA proposes that in time, the Part B report will be extended to all in-scope products, not just those using a label.
The Part B report must include information relating to:
- the product’s investment policy and strategy;
- the product’s performance against its sustainability KPIs; and
- where stewardship plays an important role in the product’s investment policy and strategy, the performance of the product’s stewardship KPIs and the outcomes of the product’s stewardship activities.
The Part B report should be published in a prominent place on the firm’s website unless the nature of the client relationship would make public disclosures inappropriate, such as where firms provide discretionary portfolio management services to individuals or institutional investors, or for UK AIFMs managing unauthorised AIFs that are not listed on a recognised investment exchange. In these cases, firms may make disclosures on demand to clients that require sustainability information to satisfy their own sustainability-related disclosure obligations. The FCA proposes that on-demand disclosures be made to the client upon request, once a year (from July 2025 onwards).
Detailed entity-level disclosures
The FCA proposes that all in-scope asset managers be required to produce a sustainability entity report that builds on the FCA’s existing TCFD-aligned, entity-level disclosure requirements such that entity-level disclosures would enable clients and consumers to understand the firm’s approach to sustainability-related risks and opportunities across the same four pillars used in TCFD (i.e., governance, strategy, risk management, and metrics and targets). Firms’ TCFD disclosures must either be incorporated or linked to from the sustainability entity report.
The FCA is intending for its proposals to be developed over time so as to add specific disclosure requirements on other sustainability-related topics in a manner consistent with future international reporting standards. In the initial phase, the FCA suggests that firms should have regard to the ISSB’s proposed general sustainability-related disclosure requirements (IFRS S1) and that the Sustainability Accounting Standards Board’s sector-specific standards may also be a helpful reference.
The sustainability entity report will be phased in using a similar way to the TCFD entity disclosures such that larger firms (above £50 billion assets under management, or AUM) will be required to make their first disclosures by 30 June 2025, and smaller firms (£5 billion+ AUM) from 30 June 2026. Sustainability entity reports must be updated at least annually.
The sustainability entity report will be required to be published in a prominent place on firms’ main websites (such as with a link from the homepage).
Naming and marketing rules
The FCA proposes to restrict the use of certain sustainability related terms in consumer-focused product names and marketing materials unless the consumer product uses a sustainable investment label. However, this restriction will not apply to institutional products.
The FCA also proposes to introduce a general anti-greenwashing rule to apply from June 2023, to all regulated firms, that reiterates existing rules to clarify that sustainability related claims must be fair, clear, and not misleading. The rule will provide the FCA with an explicit basis on which to challenge firms and take enforcement action where necessary.
The somewhat lengthy consultation paper demonstrates that the FCA is trying to grapple with some of the difficult reputational and credibility critiques facing ESG investing at present. It is helpful that the FCA has given thought to the compatibility of the SDR with the EU SFDR and with the U.S. SEC’s proposals. The asset management industry, particularly those with international asset management businesses that will be affected by multiple ESG regimes, will need to consider how best to respond to the FCA’s consultation. Sidley lawyers are on hand to assist as the rules and ESG framework in different jurisdictions continue to evolve globally.
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