The Financial Conduct Authority’s (FCA’s) proposed Sustainability Disclosure Requirements (SDRs) are creating considerable debate in the asset management industry. CACEIS recently held a roundtable with asset managers and host authorised corporate directors (ACDs), together with the Investment Association and Clarity AI, to debate the new proposals as part of the FCA’s recent consultation on SDR.
In short, the FCA is putting a regulatory structure into the ESG space in the UK through the SDR proposals, which should not be seen as equal to Europe’s Sustainable Finance Disclosure Regulation (SFDR). Observers have noted that the FCA looked at the SFDR regime as a starting point, but the more SDR diverged from SFDR, the more regulatory fragmentation between the two increased.
What challenges does this create? And what will be next for SDR?
Broad-based objective
The UK Government’s green finance strategy focuses on the entire investment value chain and is supposed to be ‘economy-wide’. There are obligations for issuers and corporations to incorporate and provide non-financial disclosures, in line with the International Sustainability Standards Board (ISSB). 
This information will then flow to asset managers, who will need to provide SDR reporting. This flows to institutional investors, who already have specific reporting requirements from the Task Force on Climate Related Financial Disclosures. The process requires a lot of sequencing to work well. However, sequencing is out of step because there are different timelines for the implementation of SDR and ISSB.
SDR is a good example of how the FCA is looking to set a high bar for what is deemed to be ‘sustainable’, but it is important that the proposals serve the needs of consumers.
A gap exists between the existing shape of the market and the SDR proposals, which could lead to widespread changes in the market and narrow choice — especially considering how portfolio managers construct their funds.
Furthermore, multi-asset funds and fund of funds are vulnerable because they may not receive a label — even if they have sustainable objectives. They could be investing in individual funds that meet the labelling criteria for SDR but, when aggregating everything at portfolio level, they might fail to meet the SDR requirements even though they are sustainable.
There are also numerous funds in the market with ESG tilts or exclusions. These are ‘lighter shades of green’ and could fall outside of the labelling definitions, despite demand from investors for such funds.
To date, the FCA has issued a policy statement on SDR indicating that it is “clarifying how different products, asset classes and strategies can qualify for a label, including multiasset funds and blended strategies.” The FCA has confirmed that the SDR proposals will now be published this autumn.
At a glance, there are key differences between SDR and SFDR. For SFDR, Articles 6, 8 and 9 represent disclosure levels, which means it is very difficult to assess what the sustainability objective of a fund is.
In contrast, SDR allows investors to carefully choose what they want their money to do when it comes to sustainability. However, recent reports have highlighted that the European Commission is considering axing the Article 9 fund category.
Meanwhile, in the US, proposals are underway to develop fund categories that mirror the UK’s SDR requirements more closely, with these rules expected to be published later this year.
There will still be tweaks around the edges for SFDR — there is a current consultation to introduce thresholds for Article 8 funds that want to include sustainability or ESG-related terms in their name.
A balancing act
According to one of our roundtable participants, investors have more to consider and more that they might not understand. Industry opinion differs around the potential virtues of broadening labels. “End investors are now becoming more mindful about where their money is invested and the SDR labels will help investors to filter how they choose to invest their money for sustainability,” noted another attendee.
If labels are expanded to have different shades of green, this could be more confusing for the end investor. “I don’t think adding more options to SDR will make it easy for end investors,” said the attendee. “There needs to be greater transparency around how a fund is meeting its sustainability goals.”
The term ‘sustainability investing’ means different things to different people, so proper and transparent reporting as well as communication around a fund’s sustainability goals becomes much more important.
Challenges remain. “I don’t know if end investors know what they want,” said another roundtable participant. “The SDR proposals are already determining certain levels of sophistication and narrowing of views — investors want something that is more sustainable than they have now, but they might not necessarily want to invest in an impact fund.”
It appears that the term ‘impact’ is not always well understood by investors, but tags such as ‘light green’ or ‘dark green’ will make it easier for end investors to make choices. Focusing on the end investor has been the watchword for the industry. Some investors may just want to invest in sustainable funds without getting into the nitty-gritty, while others will be more ‘sophisticated’. This is where the use of tags becomes particularly relevant. From an end investor perspective, some may specify that they want a fund to have specific ESG characteristics. Education will play an important role to ensure that investors are well equipped to interpret the SDR label — especially given consumer duty and the focus on accessibility and comprehension.
Education will also be key for the industry — particularly to shape how labels are used as a marketing tool across the distribution chain. One potential consequence is that this may narrow access or visibility for end investors to funds that do not have a label, meaning that end investors could miss out on good investment opportunities as distributors concentrate their efforts on funds that have a sustainability label.
How complex is the ‘improvers’ category’?
Some asset managers and ACDs remain concerned that end investors will struggle to understand the ‘improvers’ category. This raises complex questions, and even institutional investors may require further information before they are comfortable with what this classification involves. To begin with, there is a question around timeframes — how long can an improver be an improver before it needs to exit a fund’s portfolio?
As part of the SDR guidance, asset managers will be required to provide key performance indicators to hold their funds accountable against their sustainability objectives. This will also require escalation plans to address fund holdings in investments that are not meeting their sustainability goals or targets.
Additionally, there is the challenge of data, especially around the assessment of Scope 1, 2 and 3 emissions and testing the robustness and validity of transition plans. This requires strong evidence of stewardship and provision of supporting data to monitor how companies are improving their sustainability goals.
In this respect, transparency is key. It is not just a question of ensuring a consistent methodology across each asset manager — it is also essential that this methodology is transparent. Two distinctly different funds may say they can comply with this category, but they may apply very different methods to define ‘improvers’.
Are fund boards ready?
Expectations continue to rise regarding the role that fund boards will play in challenging sustainability criteria. For fund boards, it is critical to have access to the right information — setting key performance indicators that measure performance against objectives, helping them to challenge how the fund is being run. Again, education remains an essential factor — recognising that some fund boards may not have the knowledge in areas such as ESG and climate risk to ask the right questions.
Similarly, in providing oversight, host ACDs must have access to the right data to ensure that the asset managers they oversee are meeting sustainability objectives.
Sustainable focus category
An important consideration for policymakers, and for the industry, is whether the 70 per cent threshold for the SDR’s Sustainable Focus category is too high. Opinion currently differs on whether this is the case.
One respondent reflected on how it is difficult to explain to a retail investor that a fund is sustainable, but that it has a lower percentage of sustainability-type investments than funds with a Sustainable Improvers or Sustainable Impact label.
Another indicated that the 70 per cent threshold is welcomed — recognising that SFDR lacked specifics — and that “managing the 70 per cent threshold should be fine for asset management firms from a compliance and risk perspective, given that they already have systems and controls to manage elements like investment parameters.” Further, there are practical issues to consider. Fluctuations in the underlying assets can tip funds above or below this threshold.
Significantly, the FCA does not specify how firms should define sustainability, although it is widely recognised that some form of guidance is necessary. In the SFDR regulations, Article 2 (17) attempts to define sustainable investments across three areas — a contribution to social or economic objectives, a commitment to the ‘do no significant harm’ (DNSH) principle and good governance.
It is for asset managers to decide how they navigate around this framework. However, more needs to be done to define sustainability for UK-based institutions.
SDR is already here in spirit
There are still questions around how the FCA will police SDR. Participants in the CACEIS SDR roundtable indicated that asset managers who are launching new funds are already being held to the standard of the SDR consultation paper for new fund authorisations. The FCA already has a wide range of tools to monitor SDR through its thematic reviews. Elements of SDR might also find their way into the Assessment of Value regime, which remains firmly on the FCA’s radar.
We should also reflect on unintended consequences that may result from SDR, including the possibility that sustainability labels may re-engineer the way that funds are managed.
Could a track record for funds (relating to SDR labels) inadvertently contribute to stagnation in securities markets as asset managers aim to maintain equity and bond holdings that meet SDR criteria? Many are already doing this, and for much longer periods, to give them time to demonstrate their sustainability record.
Finally, will asset managers weigh up the challenges of fitting their funds into one of the labels and simply opt to remain outside of these categories?
Recently, many SFDR Article 9 funds have been downgraded because asset managers decided that they did not wish to fulfil the requirements applied to an Article 9 fund.
Looking forward
The route to SDR is now well travelled.
The recent FCA update on its SDR and investment labels consultation highlighted that the regulator intends to publish the policy statement in Q3 2023, and that “the proposed effective dates will be adjusted accordingly.”
It is encouraging that the FCA is still firmly seeking to introduce robust standards to ensure that the UK ‘remains at the global forefront’ of sustainable investment.
A recap of the SDR’s three categories
The FCA’s behavioural research found that consumers are increasingly demanding financial products that take sustainability into account — and this has been a key factor shaping the SDR proposals. Here, investment products must meet one of the three clearly defined criteria:
Sustainable Improvers: the investment product or fund invests in companies that are clearly transitioning to better outcomes. The essence of this category is stewardship. It requires asset managers to provide evidence to show they are engaging with and monitoring the companies they invest in to validate whether these are on the expected path to reduce their carbon emissions.
Sustainable Focus: the fund has a sustainable focus.
Sustainable Impact: the fund has a clear objective of delivering a positive environmental or social impact.
These three labels are a change from the earlier expectation that the regulation would stipulate five categories. Furthermore, the key difference between SDR and SFDR is a requirement in the Sustainable Focus category that a minimum 70 per cent of a fund’s assets must meet credible sustainability standards.
