UK Sustainable Disclosure Requirements (SDR) for Asset Managers

Introduction

On 12 January 2023, DLA Piper held its first UK IMF event of the year which focussed on the FCA’s consultation paper (CP22/20) on Sustainability Disclosure Requirements and investment labels (the SDR), which was published in October 2022. The consultation is open until 25 January 2023 and the FCA intends on publishing its policy statement and final rules by end of the summer 2023.

The naming and anti-greenwashing rules in the FCA SDR are intended to apply to all FCA-authorised firms whereas the labelling and disclosure requirements will apply to a narrow category of in scope firms (e.g. UK alternative investment firms, UK portfolio managers and UK UCITS management companies in respect of alternative investment funds and certain portfolio management services, as well as distributors of those products). Broadly speaking, the rules apply to in scope firms pursuing strategies and investing in assets that are focused on sustainability, but some of the labelling and disclosure requirements will apply to all in scope firms, even those without any sustainability focus.

Further consultations are expected in the coming months, which will consider whether the new regime should apply to overseas funds, financial advisers and pension funds, and the extent to which the labelling and disclosure requirements should be aligned with the (still to be developed) UK Green Taxonomy. In addition, the FCA is expected to provide further specificity and guidance on the product and entity level disclosure requirements. It will be important for firms to actively engage with the FCA throughout the consultation process whether individually or via industry groups to ensure that a sensible outcome is reached.  

In terms of timing, the anti-greenwashing rules will apply from the date that the policy statement is published. The naming and marketing rules, the labelling regime, the pre-contractual disclosures and rules for distributors will apply a year later. The sustainability product report and the entity level disclosure requirements will apply from 30 June 2025 (subject to certain phase in requirements).

We have set out below a high-level summary of the key points that were discussed at the event and we attach a link to our recent client briefing on the FCA SDR.

Observations on the FCA consultation paper

• The introduction of sustainability disclosure requirements alongside labels highlights that the UK has learnt lessons from the issues faced by firms implementing the EU SFDR. Although the EU SFDR Article 8 and Article 9 disclosure requirements are not meant to be labels, they are naturally treated as such. The UK’s approach of introducing labels at the same time as disclosure requirements is to make sure they are differentiated.
• The standards for KPIs in the qualifying criteria for the labels are high – the consultation paper makes it clear that firms will need to ensure that the KPIs remain credible, rigorous and evidence based, which may be challenging for some sectors and asset classes, in the context of evolving sustainability methodologies and data availability.
• Firms will need to review their governance and resources to ensure that they are appropriate to deliver the products sustainability objective and comply with the stated sustainability disclosures.
• Stewardship has a significant role to play in the qualifying criteria for the use of the labels. Firms will need to review their existing stewardship policies and procedures and determine what credible, rigorous and evidence based KPI’s they will need to demonstrate the role played by stewardship in achieving the sustainability objective. This is likely to prove quite challenging in practice, and engagement with the FCA on this point as part of the consultation proper will be critical.
• An application to the FCA will likely be required to update a fund’s objectives to include sustainability. It’s unclear from the consultation paper, whether the FCA will introduce a special fast track process to facilitate this.
• Firms will be required to notify the FCA that they are using a label within a month. The FCA has confirmed that they will provide a dedicated mailbox for this purpose.

Labelling Regime

The FCA had originally proposed five labels but following feedback to the discussion paper, they have settled on three: sustainable focus, sustainable improvers and sustainable impact. The FCA has said that there is no hierarchy between the proposed labels as each category is designed to deliver a different profile of assets and customer preference.

Firms can choose whether to apply a label to their investment products but if they do, it must first meet a set of objective threshold qualifying criteria, which will broadly consist of: 

• five overarching principles, covering: (a) sustainability objective; (b) investment policy and strategy; (c) key performance indicators; (d) resources and governance; and (e) investor stewardship;
• supplemented by cross-cutting criteria and category specific criteria. This is intended to clarify what firms need to do in order to meet the requirements under each of the overarching principles; and
• certain category‑specific key considerations relevant to each label.

It is important to note that, whilst the rules focus on the environmental and social outcomes contributed by the underlying assets, the actions taken by the fund and the fund manager in order to contribute to positive ESG outcomes are also an important consideration and factor. So the FCA SDR requirements are looking at the value that the fund and the manager adds through asset selection, portfolio construction and investor stewardship, across what the FCA describes as the following three core channels: (a) active stewardship and engagement; (b) influencing asset prices and costs of capital; and (c) seeking positive sustainability effect by allocating capital to underserved markets or addressing market failures.

It should be noted that the criteria for each label must be met in full and continue to be met on an ongoing basis for the product to use the relevant label. This means that firms will need to assess and apply the relevant criteria at each stage of the product development process and ensure that this is monitored on an ongoing basis.

During the session the following high-level points were noted:

• The labels introduced do not have to be used. However, the consultation does mention that if the product has ESG design features that are integral, disclosures still must be made. This is one of the worrisome features of the consultation as it is unclear which features fall under the scope and what would be considered as proportionate disclosure.
• The FCA is clear that “ESG Integration” is business as usual. This differs to the discussion paper where it was unclear where the “ESG integration category” sat. The FCA has stated that it is increasingly considers that integration is integral to the concept of “fiduciary duty”.
• Focus: this is a versatile category and includes products that have sustainability characteristics and look to maintain these. The products must hold managing assets to a specified standard (that must be a credible, robust, third-party standard with 70% of assets allocated towards that objective) or towards a particular theme. There are concerns around the thematic approach given its ambiguity. The primary influence in this category is asset allocation and stewardship is secondary.
• Improvers: includes products that are making a transition from brown to green. There must be a framework for reasonable improvement over time with a clear set of metrics. It was noted that there was strong support in the market for a transitional style label. The primary influence in this category is stewardship and relative asset allocation is secondary.
• Impact: includes products which have pre-defined environmental and social outcomes which are positive and measurable and engage with market failures. The primary influence here is bringing on new capital that wouldn’t otherwise be available with stewardship as secondary.

Within the categorisation, it was noted that Improvers is a useful category to have; impact is consistent in terms of its approach. However, Focus is the one that causes some concern given the distinction between the standard and theme limbs.

Disclosure Regime

The FCA consultation paper proposes three categories of disclosures: (a) consumer facing disclosures; (b) product level disclosures (pre-contractual and ongoing sustainability); and (c) entity specific disclosures. Whilst the FCA does not propose to introduce a standardised template for these disclosures (at this stage), the consultation paper contains general rules and guidance on the scope, format, content, location and frequency for each type of disclosure. Firms should consider whether there is value in developing an industry disclosure template, which can be tailored to reflect different sectors and assets classes.

During the session the following high-level points were noted:

1. The FCA intends to add greater specificity to both the product and entity level disclosures, which will take account of standards that are being developed by the international sustainability standards board. As was the case with the SFDR, there is some concern that the disclosure requirements may take effect before the detailed requirements have been fully fleshed out and finalised, which may cause confusion, uncertainty and unnecessary costs. In addition, to the extent that changes are made to the disclosure requirements to take account of international standards, it is hoped that the FCA will provide firms with sufficient time to implement the changes and embed them into their internal processes and procedures. 

2. Firms providing portfolio management services will not be required to produce their own consumer facing and product facing disclosures, rather they will be required to provide an index of the underlying products and a link/easy access to the label and the relevant disclosures for the product. Some potential issues include:

• It is unclear from the consultation paper, whether such firms will be required to conduct due diligence on the underlying disclosures from a regulatory perspective, although it is likely that such firms will need to conduct due diligence on the underlying disclosures from a commercial and investor expectations perspective. There does not appear to be any acknowledgment of the potential risks and liabilities that such firms may be exposed to when relying on such disclosures.
• Furthermore, the consultation paper is silent on what such firms are expected to do, if they disagree with the assigned label or statements in the underlying disclosures.
• As is the case with the SFDR, there is some concern over whether sufficient data will be made available across the investment chain. It will be important to ensure that the disclosures are appropriately sequenced to mitigate this risk.

3. There are seven categories of disclosures to be included in the customer facing disclosures including “unexpected investments”, which are “types of holdings that the firm would reasonably expect consumers of the product to find surprising" (i.e., inconsistent with the sustainability objective). Firm will be required to identify such holdings and explain why they have been selected. If firms do not have access to this data, they are expected to undertake a “customer testing” survey. Some issues arising from this include:

• As firms are already required to identify the investible universe including the key sustainability characteristics of the assets in which the product will and will not invest and the firm’s approach to stewardship under the “sustainability approach” heading, the unexpected investments disclosure requirement seems to add an unnecessary layer of complexity to the data collection and disclosure process, without any material corresponding benefit to the investor.
• In addition, there is no guidance on the scope, composition, and the size of the “customer testing” survey and what firms should do if customers do not respond in sufficient numbers to the survey.

4. Some of the disclosure requirements are intended to apply not only to firms that will use a label but also to firms that adopt sustainability related policies and strategies. As some of the disclosure items are linked to the label and classification criteria, it is not entirely clear how such firms should comply with these requirements and how this will interact with the anti-greenwashing rules.

5. The product and entity level disclosure requirements are intended to build on the existing FCA Task Force on Climate-related Financial Disclosures (TCFD) disclosures, however, the TCFD disclosure have only been recently introduced and there has not been sufficient time to properly bed in.

“Anti-greenwashing” and Naming and Marketing Rules

The FCA has also proposed “naming and marketing” rules to protect consumers from greenwashing by requiring communications to be clear, fair and not misleading, and consistent with the sustainability profile of the product or service. In other words, sustainability claims must be proportionate and not exaggerated.

Key points to note:

1. The “naming and marketing” rules will prevent firms marketing products that do not qualify for any of the three sustainability labels from using certain sustainability-related terms such as ‘ESG’, ‘climate’, ‘green’ or ‘sustainable’, 'Paris-aligned', and 'net zero'. The naming rule is likely to be manageable and achievable with respect to new products, however it may be more problematic for existing products, that contain potentially prohibited terms. Particularly as the FCA has not given a comprehensive list of the terms that it considers would fall foul of this rule.

2. Products that qualify as ‘Sustainable Focus’ or ‘Sustainable Improvers’ will be prohibited from using the term ‘impact’ in the naming and marketing of these products. This is designed to avoid any potential confusion that such products meet the standard set for ‘Sustainable Impact’ products. However, it is not clear how the rules will work in practice. It is worth noting that a limited carve out has been included for the purposes of including factual information in pre-contractual disclosures, summarising information in consumer-facing disclosures; and complying with other disclosure requirements that a firm is subject to. However, it remains to be seen how the prohibition will work, particularly when factual statements are required to be included in marketing documents such as a private placement memorandum.

3. The anti-greenwashing rules do not currently include a transition period for compliance and will come into effect as soon as the FCA publishes its policy statement (which is expected in June 2023), and therefore we would suggest that firms take the time now to review their marketing materials in relation to existing products to ensure compliance when the rules come into effect.  

4. Other concerns in respect of this particular proposal are:

• funds may no longer be able to properly describe the investment and governance actions that are being taken as part of an ESG integrated investment strategy. Given that firms are being encouraged to actively consider and take positive steps in this area, this seems to undermine the wider ESG agenda.
• Due to the limited application of the rules, there is a danger of inconsistency between both retail and institutional funds and UK and offshore funds (particularly those that are already compliant with the SFDR). The result being that UK retail investors may end up receiving less information in relation to the relevant product than their EU or institutional counterparts.

Please do reach out if you have any comments or observations on the proposals, or if you need any advice about the impact which the new proposals may have on your business.