Comparing ESG disclosure rules for funds in the EU, UK and the US - SFDR, SDR and SEC proposal
- Europe’s Sustainable Finance Disclosure Regulation (SFDR) has been followed by equivalent proposals in other jurisdictions, particularly the UK and US.
- The European regime and the UK and US proposals are not fundamentally inconsistent but there are clear differences in approach, particularly on labelling.
- Fund managers marketing products into each of the jurisdictions will be likely be set down a path of differentiated, not harmonised, disclosures.
- ESG strategies must remain true to identified objectives and not be overly calibrated to the regulatory requirements of any one jurisdiction or they risk non-compliance with the requirements of other jurisdictions.
The investment community continues to finalise arrangements ahead of the EU’s Sustainable Finance Disclosure Regulation (SFDR) product-level or “level 2” disclosure requirements taking effect on 1 January 2023. At the same time, it is keeping an eye on two sets of proposals in other jurisdictions. First, the Sustainability Disclosure Requirements (SDR) proposed by the UK’s Financial Conduct Authority (FCA) in a Discussion Paper issued in November 2021. Second, in the US, two ESG-related proposals from the Securities and Exchange Commission (SEC) in May 2022, which contemplate changes to the “Names Rule” and to a range of disclosure requirements (together SEC Proposals).
Fund managers have expended significant time and energy preparing for SFDR over the past three years, particularly since the entry into force of the entity-level or “level 1” disclosure requirements in March. But as other jurisdictions look to learn the lessons of SFDR, the challenge for funds marketing in more than one of the EU, UK and US will be to ensure that their ESG and impact strategies remain true to their objectives and comply with, but not be determined by, regulatory intervention. This challenge will be most acute where there are inconsistencies between regimes.
So are there any inconsistencies between SFDR, SDR and the SEC Proposals? Is there one approach to rule them all or are funds headed down a pathway of differentiated disclosures? If so, how might that affect ESG strategies? We look below at key features of each of the regimes, including their approach to ESG strategies, labelling and key disclosures.
Each of the regimes is clear that it does not dictate the application of any particular ESG strategy. Each acknowledges that there are a range of approaches to sustainable investing:
- SFDR invokes “sustainable products with various degrees of ambition”;
- the FCA offers an inventory of strategies, drawing on the Global Sustainable Investment Alliance’s Global Sustainable Investment Review 2020, including “ESG integration,” “corporate engagement and shareholder action,” “norms-based screening,” “negative/exclusionary screening,” “best in class/positive screening,” “sustainability themed/thematic investing” and “impact investing and community investing”; and
- the SEC notes the “variety of emerging approaches,” including “inclusion or exclusionary screen[s],” “focus on a specific impact” or “engagement with issuers to achieve ESG goals.”
In each case, regulators are at pains to stress that the intention is to intervene only so far as necessary to address “information asymmetries” (SFDR), to ensure consumers are “able to effectively navigate the market for sustainable financial products” (FCA) and to provide investors with “decision-useful information” (SEC).
But, in practice, there are elements of each regime that may influence ESG strategies. As noted below, certain elements of SFDR share features with labelling regimes which can, in certain circumstances, influence ESG strategies. These elements include the distinction between Articles 6, 8 and 9 and additional features such as the incorporation of “principal adverse impacts” (Articles 6, 8 and 9), minimum proportions of “sustainable investments” (Article 8 only) and EU Taxonomy-aligned investments (Articles 8 and 9).
Similarly, the distinction in the SEC Proposals regarding disclosure between “Integration Funds,” “ESG-Focused Funds” and “Impact Funds,” together with the requirement to nominate one or more specific strategies in a checkbox, has the potential to drive or at least sharpen strategic choices.
In the SDR context, the embrace of the five labels described below will almost certainly require funds that might otherwise straddle categories to refine their strategy so they clearly fall within one label or another.
European authorities have been adamant that SFDR is “not a labelling regime,” with the European Commission going so far to include an express statement to that effect in the explanatory memorandum accompanying the final version of the “level 2” disclosure requirements. As the Commission sought to explain, SFDR establishes differentiated disclosure pathways based on whether a product pursues the objective of “sustainable investments” (Article 9 of SFDR) or “promote environmental or social characteristics” without necessarily making “sustainable investments” (Article 8 of SFDR).
But beyond these terms of art, the market continues to use terms such as “dark green” to refer to products disclosing in accordance with Article 9 and “light green” to refer to products disclosing in accordance with Article 8, or to a graduated hierarchy of funds (ie 8, 8.5, 9 and 9.5), based on attributes including the extent to which “principal adverse impacts”, “sustainable investments” and EU Taxonomy alignment are taken into account. The net result, as has been noted by a number of commentators including Eurosif in a set of policy recommendations from June this year, “despite assertions to the contrary,” SFDR is “not purely disclosure based as, in places, it shares features with a product standard or labelling regime.”
The threat in Europe then is that supervisors in individual member states seek to develop individual minimum standards, as has already started to arise, including in France, and with proposals in Germany and Spain.
Seizing on the European experience, the UK regulator has been much more express about its approach to labelling. Its SDR Discussion Paper - as if to underscore its understanding of the critical distinction between disclosure and labelling - included separate chapters on each. Sceptical of the claims by European authorities’ disavowal of SFDR as a labelling regime, the FCA asserted that the distinction between Articles 8 and 9 of SFDR “has become a de facto classification and labelling system for sustainability-related investment products.” In contrast, SDR proposes a classification and labelling system consisting of five labels:
- “Not promoted as sustainable” - Products that do not integrate ESG considerations (or sustainability risks) in the investment process.
- “Responsible” - Products that integrate material ESG considerations (or “material sustainability factors”) in the investment process but do not have specific sustainability goals.
- “Sustainable-Transitioning” - Products with sustainability characteristics, themes or objectives that do not have a high proportion of underlying assets meeting the sustainability criteria in the forthcoming UK Taxonomy (but which increase over time).
- “Sustainable-Aligned” - Products with sustainability characteristics, themes or objectives that have a high proportion of underlying meeting the sustainability criteria in the forthcoming UK Taxonomy.
- “Sustainable-Impact” - Products with the objective of delivering net positive social and/or environmental impact alongside a financial return.
Conscious that SDR will follow SFDR, the FCA provided an “indicative mapping” of each category against SFDR:
- Not promoted as sustainable - Article 6.
- Responsible - Article 8.
- Sustainable-Transitioning - Article 8.
- Sustainable-Aligned - Article 9.
- Sustainable-Impact - Article 9.
In the US, rather than prescribe labels, the SEC has proposed a more principles-based approach. It notes the proliferation of labels including “socially responsible investing,” “sustainable,” “green,” “ethical,” “impact” and “good governance,” all of which it considers encompassed by the term “ESG.” The SEC’s proposed approach to reshaping the Names Rule focuses on three key elements:
- ESG factors have potential to be determinative - ESG-related terms in a fund name will be “materially deceptive and misleading” where “ESG factors are generally no more significant than other factors in the investment process, such that ESG factors may not be determinative in deciding to include or exclude any particular investment.”
- ESG focus must be fundamental policy and apply to at least 80% of value of assets – Similar to the SEC’s current approach to industry- or geographic area-specific funds, ESG-related terms in a fund name will suggest a similar specificity in investment strategy. The fund must then focus on investments that have, or whose issuers have, particular ESG-related characteristics and adopt a “fundamental policy” (as filed in accordance with the Investment Company Act of 1940) to invest at least 80% of the value of its assets in investments in accordance with that focus.
- ESG focus must reflect plain English or industry usage – ESG-related terms in a fund name that suggest an ESG-related focus must be “consistent with those terms’ plain English meaning or established industry use.” An investor must have a “reasonable expectation of a fund’s investment focus” simply by looking at the fund’s name. Some key words the SEC identified that may flag a fund’s name or marketing materials include “ESG,” “green,” “sustainable,” and “socially conscious.”
But despite an intention to avoid labels, the SEC’s disclosure proposal differentiates between each of the following for the purposes of framing disclosure requirements:
- “Integration Fund”, being a fund that integrates, but does not provide additional weighting to, ESG factors. Such funds consider one or more ESG factors alongside other, non-ESG factors in investment decisions.
- “ESG-Focused Fund”, being a fund that focuses on one or more ESG factors “as a significant or main consideration” in selecting investments or its engagement strategy (including a fund that has a name, or advertises in a manner, that indicates that its decisions “incorporate one or more ESG factors by using them as a significant or main consideration in selecting investments”).
- “Impact Fund”, being an ESG-Focused Fund that seeks to achieve a specific ESG impact or impacts. These funds have a stated goal (ie they seek to achieve a specific ESG impact that generate specific ESG-related benefits).
In particular, the SEC’s proposal contemplates that Integration Funds will only be required to “summarise in a few sentences how the fund incorporates ESG factors into the investment selection process” in a prospectus. But ESG-Focused Funds (including Impact Funds) will be required to disclose (i) the applicable ESG strategy, (ii) how the fund incorporates ESG factors in its investment decisions, and (iii) how the fund votes proxies and/or engages with investee companies about ESG issues in a specified tabular form. Impact Funds must also disclose the particular ESG impact that the Fund seeks to generate with its investments.
There are similarities between the approach adopted by the SEC and the European authorities in that while both disavow labelling, in practice the use of differential disclosure pathways - whether for Integration Funds, ESG-Focused Funds and Impact Funds or Article 6, 8 and 9 - run the risk of creating labels by default. If, as has been the European experience, this gives rise to debate over minimum standards for ESG-Focused Funds in particular, the question arises as to whether it mightn’t be preferable to more directly engage with labelling.
|Not promoted as sustainable
Disclosure pathways/labels in the EU, UK and US
Types of disclosure
As alluded to above, SFDR contemplates:
- entity-level or “level 1” disclosures focused on the policies and practices of applicable “financial market participants” (including certain insurers, investment firms, AIFMs, pension providers, qualifying VC funds, qualifying social entrepreneurship funds, UCITS management companies and certain credit institutions) and “financial advisors” (including certain insurers, credit institutions, investment firms, AIFMs and UCITS management companies when providing applicable advice); and
- product-level or “level 2” disclosures setting out, both pre-contractually and periodically, relevant attributes of applicable products.
Like SFDR, SDR contemplates both entity-level and product-level disclosures. In both cases, the FCA contemplates building on existing requirements on climate-related reporting at each level to include “other sustainability factors.” But unlike SFDR, SDR contemplates two “layers” of disclosure, the first targeting consumers and the second aimed at institutional investors and other stakeholders. And, as discussed further below, unlike SFDR, SDR expressly contemplates a set of labels, which ultimately sit over the top of the disclosure layers.
The SEC Proposals similarly contemplate amendments to existing disclosures required to be made by advisers and in registrations for open-ended and closed-end funds, effectively also adopting the entity/product level distinction shared by SFDR and SDR.
Content of product-level disclosures
The form of detailed product-level disclosures under SFDR are set out in prescribed forms that require, among other things, details of:
- the environmental and/or social characteristics promoted by the product (Article 8) or the sustainable investment objective of the product (Article 9);
- whether or not the product takes into account “principal adverse impacts,” a set of specified indicators;
- the binding elements of the investment strategy used to attain the environmental and/or social characteristics (Article 8) or sustainable investment objective (Article 9);
- the extent to which investments will be allocated to “sustainable investments”; (Article 8 only); and
- the extent to which investments will be aligned with the EU Taxonomy (both Article 8 and 9).
With effect from 1 January 2023, disclosures are required to be made pre-contractually (ie at the time of offer) and on a periodic basis (ie annually).
Similarly, the SEC Proposals contemplate product-level disclosures, including in prospectuses and annual reports, which include details (for ESG-Focused Funds, including Impact Funds) of:
- the fund’s ESG strategy, providing a series of check-boxes, including “tracks an index,” “applies an inclusionary screen,” “applies an exclusionary screen,” “seeks to achieve a specific impact,” “proxy voting,” “engagement with issuers” and others;
- how the fund incorporates ESG factors in its investment decisions; and
- how the fund votes proxies and/or engages with companies about ESG issues.
Like SFDR, details of applicable methodology and data sources are required, although the SEC Proposals are less prescriptive than SFDR, which preference disclosures made in accordance with, or which are equivalent to disclosures made in accordance with, the EU Non-Financial Reporting Directive, NFRD (soon to be augmented by the Corporate Sustainability Reporting Directive, CSRD).
The SDR Discussion Paper gives less detail about the content of product-level disclosures, save that it indicates it will draw on a range of inputs, including the UK TCFD Implementation (eg in the FCA’s ESG Sourcebook), IOSCO’s Recommendations on Sustainability-Related Practices, Policies, Procedures and Disclosure in Asset Management, the FCA Guiding Principles and the standards published by the ISSB. The delay of the ISSB standards has been cited as a reason for delaying further consultation about SDR.
Cognisant of SFDR, the FCA indicated that it was “exploring the extent to which content of the disclosure requirements under SFDR is relevant for the UK market” while recognising that “in some respects the UK regime may require more information than SFDR,” citing the example of “product-level metrics.”
Must the ESG strategy be binding?
A key feature of SFDR, and one that has become more express over time as a result of various clarifications, is the requirement that only binding elements of an ESG strategy should be included in relevant disclosures and should form the basis for marketing communications.
While SDR is silent on this point, in the US the proposed application of the 80% requirement under the Names Rule to funds with an ESG-related name, and the associated “fundamental policy” requirement performs a similar function.
Happily, SFDR, SDR and the SEC Proposals are not fundamentally inconsistent. But there are clear differences in approach between each - particularly in relation to labelling – that appear to mean that fund managers marketing products into each of the jurisdictions will be set down a path of differentiated, rather than harmonised, disclosure.
One key takeaway is that ESG strategies must remain true to identified objectives, and not be overly calibrated to the regulatory requirements of any one jurisdiction, or they may find themselves unable to comply with the requirements of other jurisdictions.
But for present purposes, only SFDR is in force - with the product-level disclosures starting on 1 January 2023. In the meantime, the FCA has indicated it will consult further “in the autumn,” while the SEC is continuing to consider feedback received on the SEC Proposals. Other jurisdictions including the Philippines, which is consulting on a proposed ASEAN standard, will also continue to develop their own frameworks, ensuring that funds active across multiple jurisdictions will face an increasingly complex patchwork of disclosure obligations.
Key features of SFDR, SDR and SEC Proposals
|EU – SFDR
|UK – SDR (Proposed)
|US – SEC Proposals (Proposed)
|Yes, although influenced by disclosure categories and additional features
Yes, although may be influenced by proposed labels
Yes, although may be influenced by disclosure categories and check-box identification of approach required
No, but distinction between:
as disclosure categories with additional features of:
Yes, five labels:
No, but distinction between:
|Types of disclosure?
|Entity and product
|Entity and product
|Adviser (entity) and product
|Content of product-level disclosures?
Includes details of:
including details of methodology, metrics and data sources
|TBA but aligned with FCA, IOSCO and ISSB guidance, and cognisant of SFDR requirements
Includes details of:
including details of methodology and data sources
|Must the ESG strategy be binding?
Yes, 80% and “fundamental policy” requirements