A gold standard? The UK’s proposed Sustainable Disclosure Regulation

The UK has ambitions to be a world leader in Green Finance. This includes how sustainable investment funds should be presented to consumers based on their sustainability characteristics. One of the stated objectives in this area is the importance of building trust and integrity in sustainable instruments, products and the supporting ecosystem

Welcome to the UK’s proposed Sustainable Disclosure Regulation (SDR). The FCA has published its delayed SDR consultation paper, which will mandate the disclosures that different sustainable funds need to make in the UK. The consultation period ends on 25 January this year. A final decision on the disclosure requirements is expected in June, with an expected implementation date of June 2024.

The FCA’s strategic framework provides the industry with important insight into how regulation will develop. Some key areas include:

• High-quality climate and wide sustainability-related disclosures, helping consumers choose sustainable investments,
• A focus on consumer facing disclosures to build trust and integrity in the market,
• Clear governance arrangements for more complete and careful considerations of material ESG risks and opportunitie,
• Active investor stewardship.

What’s somewhat unique is that the Financial Conduct Authority undertook a programme of behavioural research on sustainability disclosures, which formed the basis of the labelling proposals and ensured that these were considered through the lens of the consumer. The research found that there was a ‘tendency for people to mistakenly believe that all funds with sustainable goals aimed to make a real-world impact, whereas in reality ‘Impact’ funds are the only ones that do so’. People also tended to overestimate the sustainability credentials of the ’Transitioning‘ (now called ‘Sustainable Improvers’) labelled product, ‘incorrectly believing that it invested mainly in companies or assets that maintain sustainable characteristics’. One of the other interesting parts of the research was confusion around the term ‘transitioning’ – all these inputs have had an influence      in the labelling proposals. Not surprisingly, 80% of consumers would like their money to ‘do some good’ as well as providing a return, according to the FCA’s Financial Lives Survey^[1].

We also held a roundtable recently with asset managers and it was commented that ‘The combination of a focus to build a ‘gold standard’ in sustainability disclosures, and the behavioural research backing that went into informing the SDR proposals means that SFDR compliant Article 8 and Article 9 funds do not align themselves into one of the three classification buckets proposed under SDR’. However, Article 9 for SFDR maps loosely across to SDR ‘Focus’. The former mandates it should make ‘only’ sustainable investments, while the SDR ‘Focus’ category is proposing a threshold of 70%. As a result, one could argue that SFDR Article 9 funds would not have too much difficulty in labelling themselves in the SDR ‘Focus’ category.

The FCA’s behavioural research found that consumers are increasingly demanding financial products 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 of fund is investing in companies that are clearly transitioning to better outcomes. The main concept of this category is stewardship. It means asset managers evidencing how they are engaging with and monitoring the companies they are investing in to validate if they are on the expected path to reduce their carbon emissions.
• Sustainable Focus: The fund has a sustainable focus.
• Sustainable Impact: This means a fund has a clear objective of delivering a positive environment 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 the requirement for a minimum percentage of sustainable investments in its focus category, which is 70%.

Any funds that fall outside of the relevant criteria will not be able to use sustainability-related terms in product naming and marketing. For funds adhering to one of criteria above, asset managers will have to develop robust sustainable governance processes to substantiate the ESG approach and this means getting hands on good, robust data.

It’s worth noting, however, that the FCA expects all firms to consider ESG and climate risk as part of their fiduciary duty - this applies to all funds, even those falling outside of the categories mentioned above. 

Finally, another interesting development is that these rules will apply to alternatives, looking at factors such as how short selling contributes to positive sustainability outcomes. The focus is very much on transparency and it’s here that firms must explain how short selling aligned with a product’s sustainably objective.

Getting prepared

Some preparation work can be done ahead of SDR implementation. For example, asset managers with UK-based funds that have not been subject to SFDR should begin to develop a broad understanding of SFDR in preparation for the UK’s SDR regulation because some similarities will exist between the two. Becoming familiar with the SFDR requirements and thinking about the data required to demonstrate governance with the SDR proposals will be an important first step. We’ve highlighted some of the similarities below:

Source: https://www.fca.org.uk/publication/consultation/cp22-20.pdf

Furthermore, regulatory and public scrutiny around greenwashing will increase in 2023. We recognise that some of the greenwashing challenges are unintentional given the lack of access to data. We also recognise that there is a lack of comparability in data – especially across the different sustainability providers. Governance, therefore, becomes more critical especially in helping to mitigate the perception of greenwashing.

This can be tackled by developing robust decision-making processes. There might be a lot of interpretation of data and having an audit trail on the decision-making around the robustness of information that’s going to be used to reinforce a fund’s ESG or climate approach will be critical. Root and branch governance around reporting on ESG and climate risk is going to be crucial.

Some of the challenges under consultation

One of the proposals under SDR is the requirement that ‘unexpected investments’ are disclosed. This relates to investments made by a fund that fall outside of the stated objective under the three criteria mentioned above. Although the purpose behind the proposal is to increase transparency, which is key to driving trust around sustainability, practical considerations in developing reporting on ‘unexpected investments’ every single time are probably a source of discussion in this consultation period.

Another consideration that was raised during our recent roundtable relates to multi asset or fund of funds. As they may invest in all kinds of funds across the ESG spectrum, selecting one of the SDR labels for reporting purposes is likely to be a challenge. These vehicles might not fit into one of the three categories, which means they cannot be badged or marketed as sustainable investments, even if they might invest in a combination of funds that are SDR compliant. For example, if a fund of fund is comprised of three funds (one impact, one focus and one improver), what label should that fund be given? This is especially tricky given the FCA's insistence that the labels are mutually exclusive and non-hierarchical.

The ‘sustainability improvers’ category also brings its own set of challenges. No clear definition has been set around what will be an acceptable target to measure transition. If no guidelines exist when the SDR regulations are finalised, asset managers will need to develop robust governance processes and frameworks to clearly define how they are measuring a successful transition.

And for the ‘impact’ category, asset managers will need to develop a sustainable impact report. However, more clarity is still required in what this must contain. It’s here that the concept of ‘additionality’ might pose some challenges as asset managers will need to disclose how they are working with ‘impact’ companies to support them to become more sustainable.

The SDR proposals also don’t require a ‘do no significant harm’ test. This is contained in Europe’s SFDR regulations, where one of the biggest challenges for fund groups is getting access to good data, and mapping this data correctly. And there is no requirement to include any reference to Taxonomy alignment, which is unsurprising given the UK’s recent announcement of its delay on consulting on the UK taxonomy.

Regardless of the final outcome of the rules relating to the UK’s Sustainable Disclosure Requirements, smaller asset managers who have not yet had to comply with the EU’s SFDR regulations and want to consider sustainability, can start to familiarise themselves with them in preparation for SDR. A good starting point is to speak with your service providers to see what solutions and insights they have available so you can begin developing a governance framework around sustainability and be ready for SDR.

Pat Sharman - Managing Director, CACEIS Bank, UK Branch

Matthew Ives - Business Development Director (Asset Managers and ACDs), CACEIS Bank, UK Branch

[1] FCA 2020 Financial Lives Survey