FCA’s Sustainability Disclosure Requirements (SDR)

At a glance

• The FCA published the final rules for its Sustainability Disclosure Requirements (SDR) regime on 29 November. The FCA is concerned about the risk of greenwashing posed by the increase in sustainable funds available in the market. The various proposals that make up the SDR aim to mitigate greenwashing.
• Key changes made to the rules as compared to the proposals in the consultation have brought helpful clarity on a number of aspects . However, firms will still face several challenges in implementing the rules, including in relation to: determining what “sustainability” means for their products; sourcing ESG data to produce detailed disclosures on an ongoing basis; and ensuring a consistent use of the right sustainability-related terminology across their operations and business.
• Now that the rules are finalised, firms need to prepare for implementation. In the immediate term, firms need to consider their overall sustainability strategy in light of the new rules. This will include an assessment of whether to qualify for labels, and if not using labels the extent to which to use sustainability-related terms in the names of funds.
• Also in the immediate term, it would be prudent to undertake an assessment of whether existing product documents and general vernacular used by staff would pass the “clear, fair and not misleading” test under the anti-greenwashing rule
  

Key changes in brief:

• Scope: portfolio managers and financial advisers are not currently in scope. The treatment of overseas funds has not yet been clarified.
• Anti-greenwashing rule: The rule will now become applicable from 31 May 2024. The FCA is consulting separately on guidance in relation to what “clear, fair and not misleading” means in the context of sustainability. Notably it has clarified that images are included, and the rule applies to claims about social issues too.
• Sustainable investment labels: There is now a fourth fund label for funds with blended strategies called “Sustainability Mixed Goals”. The requirement to investment at least 70% of a fund’s value into sustainable investments, which previously only applied to the Sustainable Focus label, has now been extended to all labels.
• Naming and marketing rules: Funds that do not qualify for labels CAN use sustainability related terms in their names as long as they do not use variations of the words “sustainability” or “impact”. Such funds will be subject to all the product level disclosures that funds that do use labels are required to do.
• Disclosures: The requirements to disclose the causal link between stewardship activities and improvement in the sustainability profile of investee companies, and to disclosure “unexpected investments” have been removed. There is a new requirement to disclose any instances of material harm to environmental or social issues.
  

Key changes to the SDR regime

As a recap, the SDR consultation consisted of several proposals including a “sustainable investment label” regime, several product- and firm‑level disclosures, naming and marketing restrictions, rules for distributors and a stand-alone anti-greenwashing rule (applicable to all FCA-regulated firms). Investment managers raised a number of concerns about various aspects of the consultation – particularly around the application of the sustainable investment label regime and the naming and marketing restrictions. In the final rules the FCA has addressed some of the industry’s concerns, but firms will continue to face challenges in relation to demonstrating that they qualify for labels and getting the disclosures right.

Anti-greenwashing rule

• This rule requires that sustainability‑related claims (i.e. those that refer to environmental and/or social characteristics) made by all FCA authorised firms about their products and services should be fair, clear and not misleading, and are consistent with the sustainability characteristics of the product or service.
• The anti-greenwashing rule will become applicable on 31 May 2024.
• Having previously not elaborated on what fair, clear and not misleading mean in the context of sustainability, the FCA has now published a consultation on guidance in this regard.
• This draft guidance provides clarity in some key areas:

o the rule applies to (but is not limited to) statements, assertions, strategies, targets, policies, information and images;

o the rule applies to (but is not limited to) claims about the environment, climate or climate change, biodiversity and nature, social issues, or corporate social responsibility; and

o clear, fair and not misleading can be interpreted as: correct and capable of being substantiated, clear and presented in a way that can be understood and complete. Any comparisons to previous versions of products or services, or to competitors’ products or services, should be fair and meaningful.

So What? The draft guidance provides much needed clarity (including on many of the issues that we identified in our earlier anti-greenwashing blog). However, the wording of the rule suggests that firms will still need to be very careful in how they use and present sustainability-related terms across the board in all their communications. This will require serious work to educate staff on what such terms mean for the firm’s products/services, ensure that the firm’s culture enables the right use of language and enhance controls to prevent instances of misuse of language. The inclusion of images in the guidance may be a particular challenge for firms – they will need to think carefully about the connotations of any images used in marketing, from various perspectives.

Sustainable Investment Labels

• The Sustainable Investment Label regime consists of four labels: “Sustainability Focus”; “Sustainability Improvers”; “Sustainability Impact”; and “Sustainability Mixed Goals”.
• Fund managers can qualify for these labels if they are able to comply with (i) general criteria based around sustainability objectives; investment policies/strategies; KPIs; resources/governance; and stewardship and (ii) specific criteria for each label.
• Label names have been changed slightly since the consultation. The labels were called “Sustainable Focus”, “Sustainable Improvers” etc. “Sustainable” will now be replaced with “Sustainability” to recognise that some assets might be transitioning and not fully sustainable already.
• There is a new fourth fund label: “Sustainability Mixed Goals” for multi-asset/blended strategy funds that do not neatly fall within one of the three other labels. These funds will have to make the disclosures against the specific criteria under each of the labels they could fall under – e.g. if a fund uses the Sustainability Mixed Goals label, and has some assets that qualify under the Focus label and other assets that qualify under the Improvers label, it will have to disclose against the label-specific criteria for both those labels (in addition to the general criteria).
• Previously, one of the criteria for the Focus label was that 70% of the portfolio had to be invested in assets with a “credible standard” of sustainability – the 70% threshold has now been applied to all labels as a minimum and “credible standard” has been replaced with “robust, evidence‑based standard”. This means that firms will need to determine a standard that aligns with their product’s sustainability objective and select assets that meet it – and 70% of the gross value of the product should meet its sustainability objectives. Any other assets must not conflict with the sustainability objective.
• The FCA has stated that there is no need for third party verification of what is “robust and evidence‑based” – firms can choose to involve third parties or use internal verification. In either case, the individuals responsible for carrying out the verification must be appropriately skilled.
• The proposed requirement under the Sustainability Improvers label to prove the “causal link” between stewardship activities and actual improvements/outcomes in the sustainability profile of investee companies has been removed.
• For the Sustainability Impact label, the FCA encourages firms to use industry frameworks to the extent relevant for their product’s sustainability objective. Also, previously, the FCA had emphasized that the use of the Impact label would be best suited to investments in new capital and “underserved” markets. Following industry feedback, it has clarified that as long as other criteria are met, investments in public markets do qualify for use of the label, in line with industry practice and frameworks.

So What? In general, these changes should make it easier for fund managers to understand how to qualify for a label. However, the challenges around sourcing the right ESG data and KPIs to be able to prove that funds are performing according to their objectives will remain an ongoing issue. Firms will also still face the challenge of determining the right terminology that aligns with their objectives/strategies and then presenting it accurately and clearly in their disclosures. Firms will also be ultimately responsible for demonstrating why they chose certain frameworks/standards on which to base their sustainability objectives. In relation to the Sustainability Mixed Goals, whilst the issue of there not being a label for multi-asset funds appears to have been resolved, the disclosure burden for funds using this label will be significant. The mix of disclosures in relation to multiple assets with different sustainability goals may be difficult to convey clearly. Firms will need to be particularly careful to achieve clarity. In relation to verification of whether sustainability objectives are robust and evidence based, firms that choose to do this in-house will need to invest in training relevant individuals and/or recruiting the right expertise.

Disclosures, Naming and Marketing

• Previously funds that did not qualify for any of the sustainable investment labels were not allowed to use any ESG‑related terms in their names.Such funds may now use some ESG‑related terms in their names, subject to the following conditions:

o the names should not consist of any variation of the terms “sustainable”, “sustainability” or “impact”;

o the funds should make the same product-level disclosures as funds using labels - the annexes in the final rules set out exactly what these funds should disclose in each of the disclosures. The disclosures are less onerous than for those funds with labels, but they will still require firms to dedicate resources towards using the right language very carefully and evidencing the terms used in fund names;

o firms must produce and prominently publish a statement (in the relevant digital medium for the product and in the product-level disclosures) to clarify that the product does not have a label and the reasons why; and

o in the case of a feeder fund, the product must only include terms in its name which are consistent with those used by the master fund.

• Firms are no longer required to disclose “unexpected investments” in the simple consumer facing product-level disclosure, but the disclosure must include, in the “sustainability approach” section, details of any types of assets held for reasons other than to pursue the sustainability objective.
• Also in the simple consumer facing product‑level disclosure, firms should disclose any material negative environmental and/or social impacts that may arise (or have arisen) in pursuing the sustainability objective.
• No changes have been made to the entity-level disclosures and the FCA encourages firms to refer to ISSB, SASB and GRI standards as a starting point when deciding what information is decision-useful for investors.

So What? Firms wanting to market funds with sustainability‑related terms in their names but without using labels will need to consider the additional burden of disclosures as well as ensuring that they comply with the general anti‑greenwashing rule. In some cases, it may be more cost-effective for firms to do the extra work to qualify for a label, given they will have to make all the product-level disclosures anyway. Not having to disclose “unexpected investments” is helpful, but firms will still need to disclose assets held for reasons other than to pursue the sustainability objective. In addition, firms have the new task of disclosing “material negative environmental/social impacts” – clearly firms will have to consider very carefully how to define this.

Rules for Distributors

• There are no changes in relation to the rules for distributors.
• They are required to communicate the label and consumer-facing disclosures (for labelled and unlabelled funds) to retail investors – this may be done by displaying the label prominently on the relevant digital medium (e.g. product webpage) and by providing access to the consumer-facing disclosures, or otherwise communicating them through their usual channels.
• Distributors must ensure they are displaying the most up-to-date labels.
• Distributors must provide a notice on overseas products to clarify that they are based overseas and are not subject to the UK’s SDR.

Who is out of scope for the Sustainable Investment Label regime and disclosure requirements currently?

• Portfolio managers, including managed portfolios and discretionary wealth management services.
• Financial advisers.
• Overseas funds.
• Pensions and other investment products
  

The FCA or HMT (where appropriate) will consult on the future treatment of all of the above. Pensions and other investment products will come into scope in due course. Note that the anti-greenwashing rule will still apply to all FCA-authorised firms from 31 May 2024.

So What? Portfolio managers and advisers will still need to be careful about the language they use and satisfy themselves that funds they include in clients’ portfolios or advise on are not being greenwashed. Where they are unclear about the sustainability‑related characteristics of funds they need to gain clarity through discussions with manufacturers of funds, discuss this with end clients where possible and/or add disclaimers about limitations on their websites.

Immediate Next Steps Firms that want to structure and market sustainable funds have a significant task ahead of them – in the immediate term they need to consider the gap between the current level of maturity they have in terms of ESG data, KPIs, governance, stewardship and other label criteria and what is required to qualify for a label on an ongoing basis.

Separate to this, firms will need to look at all their sustainability‑related communications about their products or services through the lens of “fair, clear and not misleading” – and consider what steps they need to take to ensure a consistent understanding of sustainability-related terms in-house.

Distributors should consider what arrangements they might need to ensure that they always receive the up-to-date disclosures on time. Both distributors and advisers should consider how they will conduct due diligence and what level of training they need on sustainable investing to make sure that they are able to spot inconsistent or unclear messaging in fund disclosures.

Implementation Timeline

The FCA’s timetable for implementation is as follows: