The UK Financial Conduct Authority (FCA) has released its long-awaited consultation paper on Sustainability Disclosure Requirements (SDR) and investment labels. The paper sets out the proposed rules with which UK-regulated firms will need to comply when marketing investment products with a sustainability label.
Overview to SDR: https://www.gov.uk/guidance/uk-sustainability-disclosure-standards#:~:text=UK%20Sustainability%20Disclosure%20Standards%20
The FCA categorises a more rigorous approach to impact measurement than the EU Sustainable Finance Disclosure Regulation (SFDR), or the current Securities and Exchange Commission (SEC) proposals in the United States. It also moves away from environmental, social, and governance (ESG) approaches to investing, and stresses the importance of measuring social and environmental outcomes to evidence sustainability results.
In an evolving space with regulatory advances in multiple geographies, it can be challenging for investment managers to keep abreast of – let alone comply with – changing standards. Below, we have broken down the key takeaways and highlights for each proposed label.
What the FCA says about SDRs and investment labels On 25th October, the UK’s Financial Conduct Authority (FCA) released its consultation paper on Sustainability Disclosure Requirements (SDRs) and investment labels (CP22/20). This follows the FCA’s discussion paper, released at the end of last year, which outlined its preliminary views on priorities around ESG, and the regulation of sustainable products in order to tackle greenwashing. The new consultation paper sets in motion a number of proposals for UK-regulated firms. The key proposals include:
A new, three-tier labelling system for sustainable products;
Five overarching principles to which products must demonstrate their alignment in order to qualify for the new labels;
Product and entity level disclosures; and
Naming and marketing rules.
Product labelling The FCA’s proposed system establishes three sustainable investment labels:
'Sustainable Focus';
'Sustainable Improvers'; and
'Sustainable Impact'.
This labelling seeks to align with but does differ from the current requirements under the EU’s SFDR. The SFDR distinguishes between:
Article 6 funds that do not integrate sustainability into the investment process;
Article 8 funds that promote environmental or social characteristics; and
Article 9 funds that have sustainable investment as their objective.
Both Article 8 and Article 9 funds could potentially qualify for any of the FCA’s proposed labels – though the FCA notes that it is unlikely that an Article 8 product could meet the requirements for the ‘Sustainable Impact’ label.
Product principles
The FCA also sets out five key principles by which products will be assessed in order to qualify for the sustainable investment labels. Those principles are:
Sustainability objective;
Investment policy and strategy;
Key Performance Indicators (KPIs);
Resources and governance; and
Investor stewardship.
There are a number of cross-cutting considerations associated with each of the principles and certain label-specific considerations that businesses will need to take into account. The FCA’s proposal does not include any immediate application of the concept of ‘Do No Significant Harm (DNSH)’ or ‘Principal Adverse Indicators (PAIs)’. However, the independent UK Green Technical Advisory Group (GTAG) has outlined its considerations on the implementation of the ‘DNSH’ concept, and will release further guidance this year. It is expected that GTAG’s recommendations will form the basis for how UK regulators design and implement its requirements around DNSH.
Despite the current lack of formal guidance around DNSH, the FCA’s proposal does require products to set measurable targets and to assess their performance against these on an ongoing basis. The FCA also declares a strong allegiance for aligning with the work of the International Sustainability Standards Board (ISSB) which should release guidance for measurements of social and environmental outcomes similar to PAIs.
Disclosure and marketing rules Disclosure plays a critical role in the implementation of the proposals. There will be requirements for consumer-facing disclosures to help consumers understand the key sustainability-related features of a product. There will also be more detailed pre-contractual, ongoing product performance and entity-level disclosure requirements targeted at a wider audience. In addition, naming and marketing rules will be introduced, restricting the use of certain sustainability-related terms in product names and marketing materials for products that do not have a sustainable investment label.
The FCA has ensured that there will be, at minimum, a one year runway for regulated firms to interpret and implement their proposals. The consultation period will close in January 2023 with the policy statement due to be issued in June 2023. From there, the planned timeline will be implemented as shown below. Provisionally, UK firms will be expected to implement sustainable labels by June 2024.
How to qualify for the FCA’s sustainable product labels A summary of the FCA’s proposed investment labels is detailed below. 1. Sustainable Focus A ‘Sustainable Focus’ product must constitute at least 70% of assets that either: a. meet with a credible standard of environmental and/or social sustainability; or b. align with a specified environmental and/or social sustainability theme.
Highlights According to the FCA, this category of product ‘would pursue its sustainability goals primarily via the market-led channel of influencing asset prices’. This explicitly recognises strategies in listed markets to reduce the relative cost of capital for companies delivering sustainable economic activities and projects.
While the FCA does not expand on what it considers a ‘credible’ sustainability standard, it requires a consistent, transparent, and evidence-based approach to assessing products’ alignment with sustainability goals. It also explicitly states (Section 4.24) that products without a sustainability objective, but which may use strategies of ‘ESG integration,’ would not qualify for a sustainable investment label.
2. Sustainable Improvers A ‘Sustainable Improvers’ product aims to invest in assets that, while not objectively environmentally or socially sustainable at present, have the potential to deliver measurable improvements in their environmental and/or social sustainability over time. Alongside its financial risk/return objective, this product will have an objective to deliver measurable improvements in the sustainability profile of its assets over time, including through investor stewardship.
Highlights Active engagement and stewardship play a vital role in our transition to a sustainable future. In addition, transitioning “unsustainable” activities is as essential as investing in sustainable ones for the world to meet global goals. Under the EU SFDR, this critical activity was less clearly prioritised, so it’s encouraging to see the FCA foreground transition strategies and investor engagement through this investment label.
What differentiates ‘Sustainable Improvers’ products is the requirement to set clear and measurable targets for improvement over time. This is unlike products that only integrate ESG analysis into the investment process, which the FCA emphasises is insufficient, and not warranting receipt of any sustainable investment label.
The key to evaluating performance improvement in this category will be the ability to track performance on defined sustainability metrics over time. Those metrics will need to demonstrate a direct contribution to sustainability goals, and be reported by investments on a frequent enough basis to track over time. We are encouraged by this guidance as a way to implement advances in company disclosure on quantitative metrics that do measure direct contribution to sustainability goals. We expect specific guidance on metrics to evolve as the work of ISSB continues.
3. Sustainable Impact A ‘Sustainable Impact’ product, alongside a financial risk/return objective, will carry the objective to achieve a pre-defined, positive and measurable environmental and/or social impact. A firm seeking to use the sustainable impact label commits to deliver and report on its contribution to a positive environmental and/or social sustainability outcome through financial and other types of investor additionality. This product will invest in sustainable solutions to environmental and/or social problems, often in underserved markets.
Highlights Sustainable impact products will be required to articulate a theory of change to show how assets have been selected that align with that theory of change, while also seeking to avoid unintended negative environmental or social impacts. To evidence this, managers will be expected to apply industry-standard approaches to performance measurement, reporting against rigorous, evidence-based KPIs that capture portfolio impact and, subject to additional guidance, investor contribution.
The FCA highlights that sustainable impact strategies will typically be investing new capital in businesses, either via primary issuance or primary markets, to more easily demonstrate additionality, but that other strategies, including for example closed-end Exchange Traded Funds (ETFs) are also eligible. The defining requirement will be to establish a clear theory of change, and run investment selection against that theory of change.
Furthermore, the FCA highlights the importance of capturing evidence-based KPIs to measure performance against a theory of change, and to measure investor contribution. This guidance seems to align to the Global Impact Investing Network’s definition of impact investing which emphasises intentionality, and the IFC Operating Principles for Impact Management which emphasises intentionality and investor contribution. We expect to see clearer guidance on measuring investor contribution which remains a challenging theme.
Conclusion
The new SDR investment labels proposed by the FCA will see products differ in their portfolio composition, objectives, and priorities – but what is central to them all is the requirement for investors to set clear sustainability objectives, and to track performance against those objectives using measurable metrics.
This article is from: https://www.netpurpose.com/blog/UK-FCA-Sustainability-Disclosure-Requirements-SDR
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