Sustainability Disclosure Requirements: FCA package of proposals on fund labels and disclosures raises new challenges for fund managers

At a glance
 

• On 25 October the FCA published proposals on sustainability-related labels and disclosures for UK fund managers, portfolio managers and distributors. The objective of the proposals is to prevent greenwashing. The final rules are expected to be published by 30 June 2023 and will come into effect between 12 and 24 months after this, depending on the proposal.
• The FCA also proposed a general “anti-greenwashing” rule that will apply to all FCA-regulated firms. This rule makes an existing FCA principle explicit in the context of greenwashing and will come into effect immediately when the final rules are published.
• The FCA’s proposals present several areas of challenge for firms:
  • Labels, names, and marketing: not qualifying for one of the new sustainable investment labels will mean that a fund cannot use an ESG-related term in its name. This will affect firms’ ability to compete in the sustainable funds market. Firms will have to consider carefully how they define their sustainability objective, strategy, KPIs and stewardship approaches to be able to qualify for a label, and the implications for the commerciality of their products.
  • Consumer facing summary disclosures: these disclosures, which are specifically aimed at retail investors and provide details of a fund’s key sustainability features, need to be made by all funds in-scope of the labelling regime mentioned above – even if the fund has no sustainability features. The two most challenging parts will likely be disclosing “unexpected investments” and providing “contextual information around KPIs”. Both aspects may lead many firms to be more cautious in their product offerings due to the increased regulatory risk. Due to the specific focus on retail investors, if these disclosures appear too technical or do not promote consumer understanding, they will be scrutinised both under the SDR and the FCA’s new Consumer Duty rules.
  • Detailed product and entity level disclosures: at product level these disclosures provide granular details on how the fund is complying with the criteria for labels and at the entity level they require sustainability risk disclosures and follow the format of the existing FCA TCFD-aligned climate risk disclosure requirements. Funds that do not qualify for a label but have sustainability features in their investment policy will still need to do these disclosures at product level. Key challenges firms will face are around defining what “sustainability” means, as the FCA has not been prescriptive, and consequently what E, S and G risks are pertinent to them. Lack of adequate ESG data will make granular disclosures difficult at both product and firm level, and the inevitable use of proxies will need to be carefully managed.

In summary, these proposals are significant and, in their currently proposed form, will be complex to adopt. They create a higher degree of regulatory risk around sustainability-related products. It is likely that firms will need to dedicate significant investment and management time to implementation. It is critical that firms make an early assessment of the requirements against current practices so that they fully understand the extent of changes required, and assess the commercial benefits of selling sustainable products against the regulatory costs and risks.

Read on for further insight on the implications of the labelling and disclosure proposals for fund managers. For a detailed summary of the proposed rules, see the slide-pack linked at the end of the blog. 
 

About the FCA’s package of proposals
 

On 25 October the FCA published its highly anticipated proposals on sustainability‑related labels and disclosures for UK fund managers, portfolio managers and distributors. The proposals are intended to prevent greenwashing i.e., the exaggeration or misrepresentation of the sustainability credentials of a product or service.

In this blog we mainly focus on the implications for fund managers.

The proposals introduce sustainable investment labels, consumer facing disclosures, detailed product level and entity level disclosures, restrictions on how ESG related terminology can be used in names of funds and rules for distributors. (See attached slide-pack for a detailed breakdown of rules.) The rules are expected to be finalised in June 2023 and would apply from 12-24 months after, depending on the rule.

An additional general “anti-greenwashing” rule has been proposed which will apply to all FCA regulated firms’ communications and marketing and is intended as a “catch-all”. This will come into effect as soon as the final rules are published. This general rule makes existing expectations found in FCA COBS 4.2.1, Principles for Businesses 7 and PRIN 2.1 explicit in the context of greenwashing and highlights the FCA’s intention that its anti-greenwashing campaign should be far-reaching. The FCA has specifically pointed out that it will use this rule to enforce against firms for sustainability‑related claims that do not stand up to scrutiny.

This package of proposals is part of a wider drive by the UK government to re-allocate capital towards sustainable activities. The SDR will eventually be linked to provisions under the ISSB and UK Green Taxonomy when they become available. Moreover, the FCA’s proposals follow a series of regulations already proposed or finalised by other regulators to mitigate sustainability-linked conduct risk, including the EU SFDR, the EU Taxonomy and the US SEC’s proposed disclosure rules. The FCA itself published a Dear AFM Chair letter in July 2021 setting out its greenwashing concerns and expectations for fund managers, on which the new proposals now build.
 

Comparison to the EU SFDR
 

The two disclosure regimes are broadly similar in that they both require disclosure of sustainability risk at firm and product level, together with granular details of sustainability‑related objectives, strategies, and ongoing performance. However, the regimes diverge in the details. The FCA notes in its consultation that whilst the SFDR was only intended as a disclosure regime, the SDR labels are intended to protect consumers as well. The FCA has made the criteria for the SDR labels - “Sustainable Focus”, “Sustainable Improvers”, “Sustainable Impact” - more prescriptive than for SFDR article categories. The SDR labels are also more prescriptively pinned to strategies, whereas the SFDR has less prescription around strategies for Article 8 funds and Articles 6, 8 and 9 are seen by some as forming a “hierarchy” order (i.e., more or less “sustainable”). The FCA’s intention with pinning the SDR labels to strategies and purposefully avoiding the impression that its labels are hierarchal, is to encourage retail investors to understand the nuances of the strategies associated with each label.  In our view, the prescriptive criteria connecting SDR labels to strategies and the associated disclosures will allow retail investors to learn about the various strategies that can be used to design sustainable funds. This might potentially prevent the type of situation that has occurred in the EU whereby the term “Article 8” is now automatically seen by many as less robust in terms of sustainability strategies and outcomes than Article 9 and at times associated with greenwashing (due to the broad range of investments that can be included in such funds). The SDR also requires more granular disclosures on investment policies (asset selection) and stewardship but does not require disclosure of principal adverse impacts.

For those firms subject to both the SFDR and the FCA SDR, interoperability and whether existing resources and processes put in place for SFDR will be sufficient for SDR purposes, will be key questions. The ESG data requirements and complexity of implementation are likely to be similar in the EU and UK, however firms will need to ensure they have the right expertise to deal with the nuanced differences between them.
 

Challenges for firms and key things to note
 

The slide-pack linked below summarises the details of the FCA’s proposal. There are three key areas that firms should focus on as they consider the strategic implications of the new rules:

• Labels, naming and marketing

The three sustainable investment labels have been proposed for authorised funds, unauthorised AIFs (including investment trusts) and portfolio managers (in some instances). For a product to qualify for a label, firms will need to comply with five principles and associated “key cross-cutting considerations” around: clear sustainability objectives, investment policy and strategies, KPIs, governance and resources, and stewardship.

The FCA seems to have taken lessons from gaps in existing disclosure regimes and points of debate in the industry by making clear that purely “ESG integration” and “negative screening” strategies without sustainability objectives do not qualify for any of the labels. This clarification will be welcomed by those that were concerned about whether marketing such funds as “sustainable” would be akin to greenwashing and would provoke regulatory scrutiny.

In the same vein, the ongoing debate around the challenges of how to market transition funds/strategies will be settled by the FCA’s proposal that such funds/strategies should meet stringent and specific requirements around disclosing stewardship KPIs to qualify as a “sustainable Improvers” (transition) fund.

Additionally, the FCA has a particular concern about misleading fund names and has specified a non-exhaustive list of terms that cannot be used in the names of funds that do not qualify for a sustainable investment label, including “ESG”, “impact”, “sustainable”, “Paris-aligned” and “net-zero”. In a further step, those that only qualify for the “Sustainable Focus” and “Sustainable Improvers” label are also banned from using “impact” in the fund’s name.

The prescriptive nature of this proposal suggests that firms will have to consider carefully how they define their sustainability objective, strategy, KPIs and stewardship approaches to be able to qualify for a label. Without a label, it is clear that funds will not be able to compete in the sustainable funds market. At the same time, firms will need to weigh up the commercial benefit of marketing sustainable funds with the increased regulatory risk associated with inadequate disclosures and poor self-assessment against label criteria.

• Consumer facing summary disclosure

All firms in scope of the sustainable investment labelling regime need to make a specific disclosure for retail investors for in-scope funds. The disclosure should provide a digestible summary of the sustainability features of the product. Even if the product has no sustainability features, the firm still has to make the disclosure, with “N/A” in the contents.

This proposal has been informed by FCA research on improving consumer comprehension and the FCA has high expectations for the usability of this disclosure. The FCA also encourages firms to carry out their own consumer testing. In our view, disclosures that appear too technical, too complicated, or that do not carry the information a retail investor may need to know are likely to face intense regulatory scrutiny from both an SDR and a Consumer Duty perspective.

The FCA has prescribed the content for this disclosure. The two most challenging parts of this will be disclosing “unexpected investments” and providing “contextual information around KPIs”. Disclosing upfront investments that may conflict with a sustainable fund’s strategy along with the rationale might be one way for firms to pre‑empt these challenges and mitigate future greenwashing claims. However, with no prescribed threshold for what might be a conflict, firms will be left to determine what the “reasonable investor” would consider a conflict.  This will in turn depend on the target market for the fund, the fund’s strategy, and other factors. In our view, this will lead in many cases to firms taking a cautious view about what investments are included in a fund, with the aim of ensuring that they are all “expected”.

Separately, KPIs will need to be disclosed alongside contextual information explaining them.  In our view, in order to avoid greenwashing claims, firms will need to ensure these are disclosed in a non-technical manner and that any additional information is not overwhelming. Firms may also need to be prepared to explain why they have chosen certain metrics. The FCA expects KPIs to be “credible, rigorous and evidence-based” – this is a high hurdle and the FCA encourages firms to use industry best practice. In this regard the FCA has specifically suggested that firms look at the International Capital Market Association’s registry of illustrative KPIs and the Climate Financial Risk Forum’s industry guide on climate data and metrics.

• Detailed product and entity level disclosures

Product level disclosure is in two parts. The first part is a pre-contractual disclosure which covers details of a fund’s sustainability objectives, investment policy and strategy, and stewardship efforts. Pre-contractual disclosures apply not only to funds that use a label but also to those that do not qualify for a label but have ESG features associated with their strategy. This might to some extent mitigate “green bleaching” – a reportedly emerging trend whereby firms are reluctant to market themselves as sustainable due to disclosure requirements.

The second part is an ongoing sustainability performance reporting disclosure, which applies to all funds using labels. This disclosure has a specific focus on how the firm is making investment decisions according to the investment policy, sustainability performance against KPIs and outcomes of stewardship activities. Contextual information around KPIs will be required again. The FCA acknowledges the challenges with ESG data and has said that data limitations and proxies used must be disclosed. In our view, firms will need to ensure they have internal guardrails around methodologies used to create proxies and that they subject proxies to careful review and validation.

Both parts of the product level disclosures will require detailed disclosures on stewardship. Firms may face a challenge in disclosing the outcomes of stewardship, particularly because there is a requirement to make clear how the firm’s individual contribution improved the invested asset’s sustainability profile.

Detailed entity level disclosures follow the same format as the TCFD climate-related entity level disclosures i.e., sustainability risk disclosures need to be made against the four pillars of governance, risk management, strategy and metrics/targets. The key challenge here will be that, in the absence of the UK Green Taxonomy, the FCA has not been prescriptive about what “sustainability” means. This could mean firms need to undertake a significant exercise to determine which sustainability risks and issues are pertinent for them at a firm and product level and what severity of sustainability risk from particular E, S or G factors warrants disclosure. Whilst the flexibility afforded by the lack of a definition will likely be welcomed by some firms, they will also recognise that an inadequate definition will invite regulatory risk. The FCA has promised more specificity in due course, and in the meantime has encouraged firms to refer to the ISSB and SASB to glean an understanding of sustainability disclosures.
 

Conclusion
 

Firms in scope of the FCA’s new proposals face clear challenges around defining, assessing and disclosing their funds’ sustainability features and objectives in a way that is credible and evidence-based. The challenge of doing this will be compounded by the absence of an accepted definition of sustainability and of industry-wide best practice on KPIs.

It is likely that firms will need to dedicate significant budget and management time to implementing the proposals. With the final rules due to be published in June 2023, it is critical that firms make an early assessment of the requirements against current practices so that they understand the extent of changes required, and can weigh up the commercial benefits of selling sustainable products against the regulatory costs and risks.

Please click here for more detailed information on the proposals.