What is it?
In an attempt to clamp down on greenwashing, protect consumers and improve trust in sustainable investment products, the UK’s Financial Conduct Authority (FCA) is proposing a set of rules on how terms such as ‘ESG’, ‘green’ or ‘sustainable’ can be used in investment product marketing, as well as introducing more consumer-friendly labels. These rules are under consultation until 25 January 2023 with the aim of being implemented mid-next year. New fund applications will have to comply immediately, and existing funds have a year from regulatory implementation to do so.
Broadly speaking, the sustainable investment labels would help to distinguish the aims of the funds as follows:
- Sustainable focus: Hold exclusively environmentally and/or socially sustainable assets
- Sustainable improvers: Encourage their holdings to become more sustainable over time, such as through stewardship
- Sustainable impact: Focus on having a positive, real-world impact
These proposals form a large part of the UK’s upcoming Sustainability Disclosure Requirements (SDR) and the FCA’s ESG Strategy, which intends to harmonise sustainability-related reporting for corporates and financial institutions.
The growth in demand for responsible investment funds has been significant. The UK responsible investment funds market grew by 64% in the UK in 2021 to reach £79 billion, and a third of net inflows into UK retail funds went into responsible investment products, according to the Investment Association.
This growth, with a lack of strict fund labelling standards, has led to accusations of greenwashing. As a regulator, not taking greenwashing seriously is simply not an option if the UK is to remain attractive for ESG capital. These measures act as a confirmation of the UK’s intention to crack down on greenwashing in a similar manner to the EU and US.
The UK is seeking to set a gold standard for ESG reporting and sustainable finance, while progressing its own Net Zero agenda. Climate-related reporting in the UK is already mandatory under the Taskforce for Climate-related Financial Disclosures (TCFD) disclosure guidelines. These proposed rules will help to broaden disclosure requirements across E, S and G.
How will it impact investors?
Investors will have been well aware this was coming down the track, having received the FCA’s warning shot in July last year.
The FCA is making efforts to demonstrate that these proposals will fall under a different regime and therefore look different to those already in play in the EU – principally due to the focus on labelling as opposed to disclosure. However, aside from the obvious headache, and cost, these proposals will cause for compliance and product marketing teams, the requirements appear broadly aligned with disclosure requirements in the EU’s Sustainable Finance Disclosure Regulation (SFDR) and the US SEC proposals.
The FCA’s proposed measures have a few notable divergences, though, from the EU’s Sustainable Finance Disclosure Regulation (SFDR) and the US SEC proposals, such as:
- The proposed rules focus heavily on impact and engagement, as opposed to simply how ESG factors are integrated into investment decision making – something that the SEC proposals give weight to. Strategies that only consider ESG as part of their investment approach (ESG integration) do not meet the proposed standards.
- This will mean that UK-domiciled ESG funds will have to be very clear on the ‘theory of change’ behind their sustainable investments, how the assets they invest in make a genuine positive societal impact, and how they are engaging with companies to improve their sustainability performance. This encourages further clarity on the definition and measurement of impact through improved data, and will lead to a greater delineation between ‘impact’ and ‘ESG’.
- In response to the demand from UK retail investors for sustainable investment products, the FCA’s proposed rules also have a stronger focus on consumer protection and consumer-friendly labelling (‘consumer’ was referenced 420 times in the FCA’s 179-page consultation paper). The FCA proposes using the Sustainability Accounting Standards Board (SASB) standards as a guideline for disclosure.
- What is classified as ‘sustainable’ will be based on a different taxonomy to that of the EU. Disclosure items such as “Do No Significant Harm” have been deemed “too restrictive” at this stage, for example. Unlike SFDR and the SEC proposals, the FCA is not planning to provide a template for how these disclosures should look, which they have put to the industry to solve for.
- While the UK green taxonomy will be largely similar to the EU, one of the unintended consequences that may arise from the use of different labels based on different regimes is the potential for ambiguity on the sustainability credentials of funds across jurisdictions. Sacha Sadan, Director of ESG at the FCA, has been clear that he is “not calling one label better than the other”. However, he also states that not every Article 8 fund under SFDR would meet the FCA’s criteria for a sustainable investment product label. In turn, this could unintentionally result in greater consumer confusion when looking for the best-in-class sustainable investment products across borders.
Outcomes for the UK sustainable finance agenda
In an ideal world, these measures will help to curb greenwashing and allow consumers to better distinguish between responsible investment/ESG products on the basis of their sustainability characteristics and outcomes – building trust in the UK’s sustainable finance market. Many consumers have felt misled once realising that some of the responsible investment funds they have invested in contain high-emitting companies within the fund’s top holdings. That said, fossil fuel assets are not excluded under the FCA’s proposed rules – but a clear explanation for the rationale behind their inclusion is required.
The knock-on effect for corporates will be that they should disclose information in a way that helps investors meet these disclosure requirements. This means there will be more focus on demonstrating impact and the sustainability of the company’s assets with robust data, as opposed to simply disclosing ESG metrics.
Lastly, it is open for debate as to whether this will ultimately support the UK’s competitiveness in the global sustainable finance market and attract greater ESG capital. It is perhaps premature to call which jurisdiction will have the most desirable set of rules, but ultimately rule making without a deep pool of capital is unlikely to be enough to be declared the winner. At the very least, the industry will hope that these proposed rules will help to refine what global best practice ultimately looks like and give impetus for other jurisdictions to enhance their own frameworks.