On 3 November 2021, the FCA published its long-awaited Discussion Paper (DP) on the UK Sustainability Disclosure Requirements (SDR). While the overall SDR encompasses a broad range of disclosures, including sustainability disclosures for issuers, TCFD disclosures and the forthcoming UK Taxonomy, the FCA’s Discussion Paper focuses on the disclosure regime to be imposed on asset managers and the products they manage.
The regime set out in the DP includes the following key elements:
- A product labelling system
- Product level disclosures
- Entity level disclosures
We set out the detail of the UK disclosure regime below insofar as it relates to asset managers, along with our thoughts on the key questions firms and industry bodies should be considering as they formulate their responses to the DP and begin to plan for implementation.
We also highlight where the regime overlaps with and diverges from the EU’s Sustainable Finance Disclosure Regulation (SFDR). UK managers that have products in scope of SFDR will be hoping that some of the work carried out to implement SFDR can be leveraged to implement SDR. However, while the UK regime is still at an early stage of development, there are important differences emerging.
The FCA is proposing to introduce a new fivefold product classification and labelling system as set out below:
Not promoted as sustainable
Products that have not integrated consideration of sustainability risks and opportunities into the investment process.
Products that consider material sustainability factors on financial risk and return, but with no specific sustainability goals or objectives. Managers would be expected to evidence ESG integration in the investment process.
Products that aim to influence underlying assets towards meeting sustainability criteria over time, for instance through active and targeted investor stewardship.
Products with sustainability characteristics, themes or objectives and a high proportion of underlying assets that can be verifiably established to be sustainable, with minimum thresholds for asset allocation.
Products with the objective of delivering a net positive
social and/or environmental impact alongside a financial return, with the expectation that additionality can be verifiably measured.
SFDR Article 6
SFDR Article 8
SFDR Article 8
SFDR Article 9
SFDR Article 9
Products must meet the criteria for ‘transitioning’, ‘aligned’ or ‘impact’ products in order to be labelled as ‘sustainable’, whereas products with more modest ESG ambitions may be labelled as ‘responsible’.
In addition, the FCA is considering applying ‘entry-level’ requirements to managers wishing to use these labels based on the systems and controls, governance, ESG integration and stewardship practices in place across the manager’s business. The DP suggests that existing voluntary codes of practice such as the UK Stewarship Code and the UN Principles for Responsible Investment could pay a part in determining whether firms have met the entry-level requirements. If adopted, this would mean firms wishing to use the ‘sustainable’ product label would have to satisfy a twofold test:
- The product in question would have to meet the minimum criteria associated with one of the sustainable product labels (transitioning, aligned or impact); and
- The firm itself would need to be able to demonstrate that it has robust organisational arrangements in place around its sustainable investment activities.
This would be a significant departure from the EU’s SFDR, under which product categorisations are determined by the nature of the product, its investment strategy and the claims made about its ESG credentials in marketing materials, without reference to the manager’s own internal organisation.
Alignment with SFDR classifications
The FCA’s proposed product typology is also more finely grained than that contained in the SFDR, which will add some complexity and necessitate a separate product classification exercise. However, this is compensated for by the FCA’s labels being far more intuitive than the opaque ‘Article 8’ and ‘Article 9’ product categories that have become common parlance in the EU.
A noteworthy divergence from SFDR is that not all SFDR Article 8 products will qualify for the FCA’s ‘sustainable’ product label. While the mere promotion of basic levels of ESG integration is typically sufficient to bring a product within the scope of Article 8 of SFDR, this would not appear to meet the minimum criteria for the least ambitious sustainable product label within the FCA’s proposed typology, though such products could be labelled as ‘responsible’.
As a result, some Article 8 products that are currently described as ‘sustainable’ may require substantial updates to their offering documents and other marketing materials. Alternatively, managers may wish to make changes to the investment strategies of these funds to ‘upgrade’ them to sustainable products under the FCA framework.
The FCA proposes to introduce a ‘transitioning’ label for products with sustainability ambitions beyond merely integrating financially material ESG considerations into investment decisions, but which stop short of having the large majority of funds allocated to sustainable investments. According to the DP, the expectation would be the proportion of sustainable investments in the portfolio to increase over time, partly as a result of stewardship activities on the part of managers.
We believe that many firms will welcome the inclusion of a product label designed to recognise products that have greater ESG ambitions than the mere integration of financially material ESG considerations into investment decisions by aiming to encourage and accelerate the adoption of sustainable practices on the part of their investee companies.
However, further clarity is required on the criteria that must be met in order to qualify for the ‘transitioning’ label. For example, it is unclear from the DP how the expectation of progress towards a higher allocation to sustainable investments is to be incorporated into the labelling criteria, if at all. Nor is it clear how products that incorporated sustainability characteristics through substantive negative exclusions or a degree of positive tilt would qualify for the label if demonstrable increases in allocation to sustainable activity over time was required.
The purpose of the distinction between ‘responsible’ products and products ‘not promoted as sustainable’ in the DP is not entirely clear. The FCA has said that it wants the labels to be based on objective, descriptive criteria about how a product is managed. For example, based on the proportion of sustainable investments in the product or the nature of the objective or investment strategy.
However, parts of the DP suggest that the FCA wishes to use the ‘responsible’ label to distinguish products that have a more sophisticated and rigorous approach to the integration of financially material ESG risks and opportunities and investor stewardship. Moreover, the term ‘responsible’ itself clearly holds some evaluative meaning – being responsible is a good thing!
As the FCA’s proposals develop, it will be important to make clear whether the ‘responsible’ label is intended to be a kitemark of quality or a merely descriptive label. The lack of clarity on this point during the early phases of SFDR implementation has caused a great deal of inconsistency in product classifications across Europe.
Product level disclosures
The DP envisages two layers of product level sustainability disclosures. An initial layer targeted at retail investors focused on the most salient sustainability disclosures, and a more detailed supplementary layer aimed at more sophisticated and institutional investors, as well as wider stakeholders such as policy makers and NGOs.
The DP suggests the consumer facing disclosures could include the following items:
- Investment product label
- Objective of the product, including specific sustainability objectives
- Investment strategy pursued to meet the objectives, including sustainability objectives
- Proportion of assets allocated to sustainable investments (including alignment with the UK Taxonomy)
- Approach to investor stewardship
- Wider sustainability performance metrics
While the DP is silent on the specific metrics to be included, the FCA is considering prescribing a baseline set of indicators. This goes beyond SFDR, which mandates the disclosure of specific sustainability indicators only at an aggregate level across all portfolios and not product by product.
The FCA is also considering whether mandatory disclosure templates should be used, as is the case under SFDR. Based on our experience helping firms to implement SFDR, we think that it is essential for the UK regime to offer flexibility in view of the wide range of products that will be in scope. To this end, the FCA should avoid being overly prescriptive on the form and content of the disclosures.
Detailed underlying disclosures
In addition to the consumer-facing disclosures, the DP proposes supplementary product level disclosures aimed at sophisticated and institutional investors. The FCA envisages these disclosures to include the following information:
- Information on data sources, limitations, data quality etc.
- Further supporting narrative, contextual and historical information
- Further information about UK Taxonomy alignment
- Information about benchmarking and performance
In addition to product-level disclosures, the DP envisages entity level disclosures to help prospective clients and consumers choose between managers and hold their managers to account.
Little detail is provided on the precise content of the planned entity-level disclosures, but the FCA suggests that they should build on the TCFD disclosure regime, which requires disclosures in connection with climate-change across four areas:
- Risk management
- Metrics and targets
The intention is to expand the scope of the disclosures across these four areas beyond climate change to encompass a broader set of environmental, social and governance matters.
To date, the predominant industry position on SFDR has been that only EU licensed firms are within scope of SFDR’s extremely onerous entity level disclosures on the principal adverse impacts associated with a manager’s investee companies. This means that UK based managers have generally not been required to make prescriptive entity level disclosures to date. UK SDR will bring these firms within the scope of entity level disclosures to some degree.
Further, the SFDR regime includes a significant degree of proportionality for smaller firms on most onerous quantitative entity level disclosures, with only firms with more than 500 employees required to make these disclosures. The FCA DP does not reference any size threshold below which the entity level disclosures could be disapplied, but we would hope to see similar measures to be included in the UK regime.
In addition to the issues highlighted above, a number of questions remain unanswered by the Discussion Paper. These will be key areas for firms and industry associations to address as they engage with the FCA on the proposals.
The precise scope of the disclosure requirements is to be determined. For example, it is unclear if the consumer-facing disclosures will be required to be produced for products made available exclusively to institutional investors or if discretionary managed account services and segregated mandates will also be in scope.
It is also unclear as of yet whether funds managed by non-FCA regulated firms will be subject to the regime if they are marketed into the UK. The DP notes only that the FCA and HM Treasury are “considering how overseas funds marketing into the UK would be treated”.
The FCA’s DP is silent on the specific data requirements for disclosures at both an entity and a product level. Any divergence between the sustainability data that firms are collecting to comply with existing frameworks such as SFDR and TCFD and the data required to comply with UK SDR is likely to contribute the bulk of the additional burden of implementing SDR.
To the extent that particular sustainability indicators are to be mandated, we would encourage the FCA to look to metrics that are already required under existing disclosure frameworks. The regulator should also ensure that any mandatory indicators are relevant to as wide a range of asset classes and investment strategies as possible with the option to apply proportionality where mandatory indicators are not relevant to the product or are unavailable.
In practice, this should mean a very short set of high-level mandatory metrics based on existing global standards such as TCFD and the SFDR principal adverse impact indicators. Adopting an overly prescriptive approach and failing to apply due proportionality is likely lead to an onerous, one-size-fits-all regime that is difficult for managers to apply while being of questionable value to investors owing to a surfeit of largely irrelevant sustainability data.
The package of sustainability regulations proposed by the EU over recent years includes specific disclosure requirements for financial advisors and requires a product’s SFDR classification to be taken into account as part of the suitability process. These EU rules were not incorporated into UK law as part of the Brexit process. However, while the FCA’s Discussion Paper does not address distributors in detail, it flags that the FCA is minded to adopt the same approach as the EU.
Derivatives and short-selling
There is an ongoing debate over the role of derivatives and short-selling in connection with ESG given neither involve directly financing sustainable economic activities nor offer fruitful avenues for engagement with issuers (though clearly the former is true of all secondary market transactions while the latter is largely true of fixed income strategies). The EU authorities have been notably silent on how such positions should be treated under SFDR.
The FCA is seeking views on this issue alongside whether restrictions should be placed on stock lending activities in connection with sustainable strategies. We understand the FCA to be open minded on this point. Managers that make extensive use of derivatives and short-selling as part of their sustainable strategies should use their DP response as an opportunity to showcase sustainable products that use these techniques.
Verification and supervision
The DP suggests that third party verifiers could play a role providing assurance on product labelling and disclosures. The paper notes that the FCA expects to challenge firm on product categorisation and disclosures as part of the fund authorisation process and ongoing supervisory activities.
The FCA’s Discussion Paper is open for response until 7 January 2022, with a consultation paper containing detailed policy proposals and draft rules in Q2 2022. Firms should take note of the proposals and engage with their industry bodies and the FCA to help ensure that the final policy proposals brought forward by the FCA work in the best interests of the industry and investors.
Ultimately, the final rules are likely to require significant resource to implement. Firms will need to carry out an in-depth scoping exercise to determine which products are in scope and how they will be categorised under the new product typology, as well as work to identify and fill any data gaps and ultimately produce a new set of sustainability disclosures. Additionally, ongoing product oversight arrangements will be required to ensure that products continue to meet the relevant product classification criteria on an ongoing basis and deliver on their intended consumer outcomes.
Please get in touch if you would like to discuss your response to the Discussion Paper.