The Financial Conduct Authority (“FCA”) has published its long-awaited consultation paper (“CP22/20”) on Sustainability Disclosure Requirements (“SDR”) and investment labels. CP22/20 sets out the core elements of the SDR, initially focusing on UK-based funds and portfolio management. The FCA intends to follow CP22/20 with a further consultation on expanding the scope to overseas products and additional consultations to extend the scope and content of the regime over time.  Stakeholders are asked to respond to CP22/20 by 25 January 2023.  The FCA states that it expects to publish final rules by the end of H1 2023.   The FCA acknowledges that the labelling, naming and marketing and initial disclosure requirements will require some adjustments by firms so these rules are not expected to come into effect until at least 30 June 2024.

Background to the SDR

The UK government’s Roadmap to Sustainable Investing published in October 2021 set out plans to introduce the UK’s counterpart to the EU Sustainable Finance Disclosure Regulation (Regulation (EU) 2019/2088) (“EU SFDR”), the SDR. CP22/20 follows on from FCA discussion paper (“DP21/4”) published on 3 November 2021 setting out the FCA’s proposals for the SDR and its sustainable investment labelling scheme.  DP21/4 indicated that a consultation paper would follow in Q2 2022 (this date was subsequently delayed to Autumn 2022). DP21/4 and FCA consumer research have helped to inform the proposals set out in CP22/20. In addition, in other workstreams on ESG, the FCA issued a Dear AFM Chair letter in July 2021 to authorised fund managers. This letter set out a series of guiding principles for the design, delivery and disclosure of sustainable investment products.  The FCA is currently carrying out supervisory work to check how well firms have responded to the FCA’s expectations.

The SDR measures detailed in CP22/20 are amongst several potential new rules which aim to protect consumers and improve trust in sustainable investment products. They also form part of the commitments made in the FCA's ESG Strategy and the FCA Business Plan to build trust and integrity in ESG-labelled instruments, products and the supporting ecosystem.

Objectives of UK SDR  

The key objectives of the SDR include:

• protecting consumers and improving trust in the ESG and sustainable investment products market;
• enhancing transparency for end consumers;
• meeting the information needs for institutional investors; and
• helping to combat potential 'greenwashing' by requiring firms to evidence the ESG claims they make. 

Tackling greenwashing is a core regulatory priority for the FCA.  In a bid to clamp down on greenwashing activity, the FCA sets out its concerns regarding the growth in the number of investment products marketed as ‘green’ or making wider sustainability claims. The FCA states that exaggerated, misleading or unsubstantiated claims about ESG credentials damages confidence and erodes trust in these products. In proposing rules around greenwashing, the FCA wants to ensure that consumers and firms can trust that products have the sustainability characteristics they claim to have. 

Key takeaways from CP22/20

The FCA is proposing to introduce:

• Sustainable investment product labels that will give consumers the confidence to choose the right products for them and navigate the investment product landscape as well as enhancing trust.

There will be three categories for sustainable investment products:

1. sustainable focus (for products investing in assets that are environmentally or socially sustainable)
2. sustainable improvers (for products investment in assets to improve the environmental or social sustainability over time, including in response to the stewardship influence of the firm); and
3. sustainable impact (for products investing in solutions to environmental or social problems to achieve positive, measurable real-world impact). The labels are all underpinned by objective qualifying criteria and assess products on the sustainability objective they are seeking to achieve. The criteria are also designed to provide flexibility to accommodate different sustainability objectives for continued evolution and innovation in the market within clear guardrails.

• Naming and marketing rules - restrictions on how certain sustainability-related terms – such as ‘ESG’, ‘green’ or ‘sustainable’ – can be used in product names and marketing materials for products which do not qualify for the sustainable investment labels.
• A general anti-greenwashing rule which will reiterate requirements for all regulated firms that sustainability-related claims must be clear, fair and not misleading. This rule will come into effect immediately on publishing the final rules at the end of H1 2023 given that it aims to clarify existing rules.
• Consumer-facing product disclosures to help consumers understand the key sustainability-related features of an investment product – this includes disclosing investments that a consumer may not expect to be held in the product. 
• Detailed disclosures, targeted at a wider audience (e.g. institutional investors or retail investors) that want to know more including the following:
  • Pre-contractual disclosures (e.g. in the fund prospectus), covering the sustainability-related features of investment products
  • Ongoing sustainability-related performance information including key sustainability- related performance indicators and metrics, in a sustainability product report
  • A sustainability entity report covering how firms are managing sustainability-related risk and opportunities
• Requirements for distributors of products, such as investment platforms, to ensure that the labels and consumer-facing disclosures of products are accessible and clear to consumers.

Alongside CP22/20, the FCA published the results of the FCA’s consumer research which helped inform and supports the proposals set out in CP22/20.   A key finding from the research was that behaviourally informed sustainability factsheets, especially when provided for all funds, can help consumers better navigate the sustainable investment landscape.

Potential divergence in approach from other international regimes

Key feedback from DP21/4 included the fact that UK firms already subject to the EU SFDR wanted any future UK SDR system to map to the same product categories used in the EU SFDR. In CP22/20,  the FCA acknowledges that firms and products that may be in the scope of its proposals operate internationally and it states that it has sought, where possible, to achieve international coherence with other regimes, notably the EU SFDR as well as the sustainability proposals by the Securities and Exchange Commission (“SEC”) in the US.

In Annex 1 and Chapters 4 and 5 of CP22/20 the FCA sets out how its proposals differ from these international regimes, and it appears that the FCA’s approach as anticipated is likely to differ significantly in certain respects.  Notably, the FCA states that the UK framework is designed as a labelling regime with detailed criteria to determine eligibility. Therefore, its starting point differs to both the EU SFDR (which is positioned as a disclosure regime) and the SEC’s proposals.

Significantly, the FCA confirms that products that do not meet the qualifying criteria under the FCA’s proposals will not be able to use any of the sustainable investment labels under the FCA’s proposed SDR.  Firms will need to carefully consider how a product categorised under the EU SFDR or under the SEC’s proposals would be treated under the FCA’s SDR. Key areas of divergence include the proposals around classification and labels and disclosures set out below.

Classification and labels

The fundamental aim of the FCA’s classification and labelling regime is to:

• help consumers distinguish between products on the basis of their sustainability characteristics, themes and outcomes
• help them distinguish between different types of sustainable investment product

One of the key attributes of a sustainable investment product is an explicit environmental and/or social objective (“sustainability objective”). The sustainability objective must be part of the product's investment objectives (i.e. sitting alongside the product’s financial return objective) and expressed in specific and measurable terms. A sustainability objective may target either: 

• a particular sustainability profile for the product’s assets, where it can be demonstrated that this profile has a plausible, purposeful and credible link to positive outcomes for the environment and/or society; or
• directly positive outcomes for the environment and or society.

The EU SFDR introduced the following three disclosure categories of products – these have become a de facto classification and labelling system despite the EU SFDR Regulatory Technical Standards explicitly stating that the SFDR is “not a labelling regime”.  As a recap:

• Article 6 – funds that do not integrate sustainability into the investment process
• Article 8 – funds that promote, among other characteristics, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices
• Article 9 – funds that have sustainable investment as their objective

In Annex 1, the FCA sets out a method for considering how to treat a product that discloses under one of the above categories under the EU SFDR for its proposed regime as follows:

• Article 6: will not need an SDR sustainable label.
• Article 8 or Article 9: that meet the FCA cross-cutting criteria and category-specific criteria may be eligible for one of the 3 SDR sustainable labels.

CP22/20 also sets how you would categorise a product under the FCA’s proposals that already fall within the SEC’s proposals.

Disclosures

The FCA’s proposals on entity-level disclosures (in respect of how the firm takes sustainability-related matters into account in managing investments on behalf of clients and consumers) are built from the TCFD’s four pillars in order to remain consistent with the International Sustainability Standards Board (“ISSB”) standards.  The FCA acknowledges that this approach means that the entity-level disclosure requirements are not fully aligned with EU SFDR or US requirements for fund advisers.  The key difference is the FCA is not requiring disclosure of principal adverse impacts (“PAI”). Rather, the FCA intends to update its disclosure requirements, as appropriate, to be in line with the development of more specific ISSB standards. To reduce the burden for firms in relation to disclosures, the FCA proposes that firms can make entity-level disclosures in a group or affiliate report that includes other sustainability-related disclosures, provided that the cross referencing and other requirements (as set out in Chapter 5 of the proposed rules) are met. CP22/20 includes a non-exhaustive list of examples of the type of information that can be presented in sustainability entity reports which must also include a compliance statement confirming that a firm’s disclosures comply with FCA requirements.

Unlike the EU SFDR, the FCA is not proposing to introduce pre-contractual, website and periodic template disclosures for the SDR, instead it "encourages" each industry to do so if helpful for firms. There are also some disclosure items required under the EU SFDR disclosures that the FCA is not proposing for the SDR in CP22/20. These include: ‘do no significant harm’ (DNSH), which the FCA considers too restrictive at this stage; taxonomy-alignment, which the FCA will consider once a UK-equivalent regulation has been developed in the UK; and PAI, as the FCA will consider introducing a baseline of sustainability metrics that all products will be required to disclose in line with the development of ISSB standards. 

Next steps

The FCA have asked for comments on CP22/20 by 25 January 2023. The FCA intends to review feedback received on CP22/20 and will set out the final rules in a Policy Statement by the end of the first half of 2023. The FCA also intends to build on the proposals in CP22/20 and follow with further consultations in due course – including to expand the scope of the regime to overseas and pension products (further detail contained in Chapter 8 of CP22/20).

Authored by Rita Hunter, Julia Cripps, and Melanie Johnson.