The significant nexus between Consumer Duty and SDR…and how to tackle it

At A Glance 
 

There is a clear and significant nexus between the FCA’s Consumer Duty (“the Duty”) and its Sustainability Disclosures Requirements (“SDR”), given that both aim to encourage good conduct and prevent consumer harm.

 In our view, asset managers (“firms”) that implement SDR with a Consumer Duty lens, and take a joined-up approach to both regulations, will have an advantage in terms of benefitting from the demand for sustainable funds. This is because having carefully designed sustainable products with clear and understandable disclosures in an environment where retail investor understanding is often low will give firms a competitive edge. It will also help to keep regulatory risk at bay as we expect firms to be supervised for SDR under the Consumer Duty - so finding the nexus between the two regulations will prepare firms to respond to supervision.

We have taken each Duty Outcome in turn and explored the nexus with SDR. We have found important considerations for firms across all Duty Outcomes. In brief: 

• Products & Services Outcome: the Duty requires firms to design products in good faith and maintain appropriate distribution strategies. Products need to meet customers’ needs and have clearly identified target markets. Firms designing SDR-labelled products will need to ensure robust due diligence on data in order to mitigate greenwashing risk. Firms also need to be pro-active about understanding distributors’ level of knowledge on sustainability.
•  Consumer Understanding Outcome: the Duty requires firms to communicate in a way that is easily understandable for end consumers and allows them to make timely decisions in their best interest. Firms need to ensure that sustainability-related language in SDR disclosures is plain and intelligible, and provides consumers with information that is important for decision making
•  Price & Value Outcome: the Duty requires firms to carry out holistic value assessments. For sustainable funds, firms will need to consider carefully how to weigh up sustainability performance against financial performance and other features to be able to conclude on “fair” value.
• Consumer Support Outcome: the Duty requires firms to design support that meets the needs of consumers. In the context of sustainable funds, the most important support that should be provided is supplementary sustainability related information and clarification on any confusion about sustainability related terminology. 
  

Read our blog below for more insights. This blog is relevant to a wide range of staff, including COOs, CROs, CSOs, CCOs, product governance teams, ESG data teams, and regulatory programme teams. 

Overview
 

Those working in the asset management industry know only too well that the Duty and the SDR are at the top of the regulatory agenda. Whilst the Duty and the SDR are both wide ranging, they share a common aim i.e., for firms to engage in good conduct to ensure that end consumers receive good outcomes. In fact, in the final SDR rules, the FCA has specifically stated that the new SDR rules are consistent with the Duty and that, whilst not all firms in scope of the SDR will be in scope of the Duty, it still expects them to apply the SDR rules and guidance keeping the aim of the Duty in mind. The FCA has also provided an interpretation of the Duty’s “cross-cutting rules” for firms in the context of the SDR and sustainability as follows:

• act in good faith – to deliver sustainability-related products and services, taking into account the reasonable expectations of retail customers;• avoid causing foreseeable harm – including harm caused through greenwashing and buying unsuitable products; and 
• enable and support retail customers to pursue their financial objectives – including where customers have sustainability-related needs and preferences as part of their investment objectives.

Therefore, it is not surprising that there is an ongoing discussion in the industry about how firms can find synergies between the ongoing Duty implementation and upcoming SDR implementation.

In our analysis, we have found that all four Duty Outcomes are relevant for SDR implementation and, in this blog, we set out our insights.
 

Products & Services Outcome
 

Design & Data
 

The Duty requires that products’ features should be clear and straightforward, and should meet the needs of the target market. Firms are also required to act in good faith in relation to product design.Inaccuracies and limitations in sustainability data will affect fund design, and this may also mean that claims about the features of the fund and sustainability performance reporting may be misleading. Due diligence on sustainability data is a bare minimum – where firms use proxies, they should consider whether sustainability strategies or stock selection based on proxies might give rise to greenwashing. 

Firms are currently trying to determine what a “robust, evidence-based” standard for sustainability objectives is, and whether to use an industry standard or a proprietary one. Additionally, for the Improvers SDR label, firms will be at liberty to decide which assets have “the potential to improve environment and/or social sustainability” over time. Forward-looking metrics, transition plans or other “credible information” may be used for this. Similarly, for Impact labels, firms will need to specify a method for demonstrating the positive impact of their chosen assets on environmental and/or social outcomes. Determining how to design funds based on these requirements is a key focus area for firms currently. Applying the Duty lens would mean making clear records of exactly which parameters (evidence, standards, processes, metrics) have been used to substantiate the sustainability objective, ensuring these remain relevant over the period of time for which the fund is expected to be held, and conveying them to end investors in a coherent and simple way. This is because to prove “good faith” in relation to the design of products, fund managers need to be able to demonstrate the reasoning behind choosing the metrics, standards and other information that is used and, if limitations are present, to demonstrate why it was still the best decision to use them.
 

Distribution
 

Under the Duty, firms must maintain appropriate distribution strategies.Third party advisers and distributors will have variable levels of expertise on sustainability. This is complicated by the fact that, unlike the EU, the UK does not currently have any “sustainability preferences” rules. Hence there are no specific guardrails around how advisers should match sustainable funds with individual clients’ needs. The Duty requires manufacturers to provide all the information, and for distributors to seek all the information, required to enable distributors to understand the product and the target market and distribute the product appropriately. 

In our view, firms should be able to demonstrate that they have a strong understanding of distributors’ expertise on sustainability. Firms should also be able to demonstrate that they have provided distributors and advisers with training on SDR labels, sustainability-related objectives, strategies and metrics. Aside from this, firms should ensure that they educate distributors and advisers on common areas of misconception that may feature in their products e.g. the fact that transition funds are sometimes exposed to greenwashing claims because underlying strategies are less well understood by investors. Firms should also specify what common terms such as “environment” or “green” or “responsible” mean in the context of their products.
 

Consumer Understanding Outcome
 

Use of language 
 

The Duty requires firms to use plain and intelligible language, and present information in a logical way. It also encourages firms to utilise the practices of “layering”, “engaging” and “relevance” i.e. providing key information upfront and signposting to more details, designing communications in a way that engages consumers, and considering the appropriate level of detail for each communication. 

Where firms use SDR labels, they will have to make simple consumer-facing disclosures and detailed pre-contractual and ongoing sustainability performance reporting disclosures. These disclosures will contain technical information including on objectives, strategies, KPIs, governance and stewardship. Firms in scope of SDR are also subject to entity-level disclosures. Due to a combination of often low investor understanding and lack of universal definitions of sustainability related terms, detail-heavy disclosures can expose firms to greenwashing claims if not constructed using accessible language. 

Where such disclosures are concerned, firms must consider how to use the techniques suggested by the Duty, and other tools such as user-friendly charts and diagrams to convey technical information in a way that is comprehensible for people unfamiliar with sustainability related terminology. As an example, below we have set out the requirements for pre-contractual disclosures for SDR-labelled funds and provided suggestions on how the Duty could be applied for each disclosure requirement.

Testing communications
 

 The Duty requires firms to test communications to determine whether they are fit for purpose. 

Given that sustainability language will be generally unfamiliar to end-investors, this is particularly important for sustainable funds. Firms that wish to use SDR labels or sustainability-related terms in the name of funds, could use testing to determine whether there are biases around terms such as “green”, “impact”, “clean”, “social” etc. Test results could be used to name funds appropriately and inform language in SDR disclosures.
 

Anti-greenwashing rule
 

In the context of this Outcome, firms will be particularly concerned about the anti-greenwashing rule (which took effect in May) under the SDR which requires references to sustainability characteristics of products and services to be “clear, fair and not misleading”. The finalised guidance for the anti-greenwashing rule also sets out that whilst the rule applies to products and services, firms should consider whether any firm level claims or information contribute to an “overall representative” picture about the product or service – this means that firms will need to look at all their communications. All the narrative above in the “Consumer Understanding” section applies equally to this rule, however given that the FCA’s recently finalised guidance includes use of images, firms will need to consider carefully the colours and images used on their websites and marketing material. This might be particularly challenging as consumers’ interpretation of images and colours will be highly subjective. This is an area where consumer testing might help firms understand consumers’ biases in relation to images and colours.

Price & Value Outcome
 

Weighing up financial and sustainability performance to determine value
 

Both the Duty and the FCA COLL value assessment rules set out that value is not entirely derived from price and that any benefits and special features should be factored into value assessments. Under the Duty, firms will also need to consider the cross-cutting rules when assessing value (see “Overview”).

To comply with the Duty, firms will need to determine how to factor in sustainability performance and features into overall value. This will partly depend on how integral the sustainability features are to the product, and the claims made in marketing. Financial performance and sustainability performance may vary over time, and firms should be cautious about always using the better performing area to conclude on fair value. One way to prevent this might be to allocate pre-determined weights to various types of performance and then weigh them accordingly in value assessments. 
 

Determining value holistically for funds marketed under SDR
 

 The FCA’s Finalised Guidance on the Duty states: “A product or service that meets all of the other elements of the Duty (for example if it is designed to meet the needs of its target market, is transparently sold….[and if customers] are properly supported) is therefore more likely to offer fair value”. Due to the aforementioned challenges in this blog around distribution and technical language, this is likely to be a particular challenge for SDR-labelled funds or funds with sustainability-related terms in their names.

 As firms develop their handling of these challenges, during value assessments they could consider what actions they can take to move towards better value. Some solutions might be as follows: 

• A lack of sustainability preferences rules might mean that sustainable products may be mis-matched to clients’ preferences – this would affect value. Firms could create their own ESG questionnaires to fill this gap to ensure more precise matches
• Technical sustainability related language in SDR disclosures may make it difficult to be clear and transparent about key sustainability-related features. This may in turn affect value. Firms could address this by using language that they have tested for accessibility and clarity
• Firms not monitoring trends in complaints about sustainable products may not be able to make the changes that allow them to support consumers. Frequent analysis of complaints trends will allow firms to make the changes required, e.g. by providing additional supplemental material on websites.

Regulators are more likely to agree with fair value conclusions if firms show awareness of challenges and pro-active action towards addressing areas of possible customer harm.

Consumer Support Outcome
 

Going above and beyond to support on sustainability 
 

The Duty requires firms to design support that meets the needs of customers and allows them to use products as reasonably anticipated. 

In the case of SDR-labelled funds or funds with sustainability-related terms in their names, inadequate support may mean that consumers may not be able to clarify various aspects of the funds, including objectives, strategies and metrics. This could occur due to cluttered websites with no clear signposting to basic sustainability information, and staff not being sufficiently trained. This might result in consumer harm and may also increase the risk that consumers may make greenwashing claims or complaints due to confusion. 

Firms should ensure staff are well trained on greenwashing concerns and the various attributes of any sustainable funds marketed by the firm, and that supplementary information is easy to find on websites.

Conclusion
 

There are multiple aspects of SDR that need to be viewed with a Duty lens. Ultimately, firms that have a joined-up approach across the two regulations will benefit most from the demand for sustainable funds. This is because carefully designed products with clear disclosures are likely to be more competitive in an environment with low investor education and significant regulatory scrutiny of conduct related matters. Furthermore, with SDR being a complex regulation to implement, not applying the Duty lens will expose firms to significant regulatory risk.

The design and disclosure aspects of SDR-labelled funds clearly carry significant scope for consumer harm and greenwashing risk to the firm, due to low sustainability-related knowledge across the investment value chain. Applying the Duty meticulously to SDR implementation in these areas will help firms prepare for both Duty and SDR supervision. 

Determining value for sustainable funds will be an iterative process and firms can facilitate this by being very aware of the challenges and pro-actively including information on remedies in value assessments. Whilst the Consumer Support Outcome is often seen as less challenging, in the context of sustainable funds it could end up being the thin end of the wedge and lead to concerns around greenwashing if supplementary information and clarifications are not available.