A lot of work has gone into developing the FCA's sustainability disclosure requirements, including contributions from a wide range of think tanks, committees, industry bodies, and commissioned research. It aims to reduce greenwashing by offering more consistent and clear investment-product labels for consumers and professional investors. This is further supported by a general anti-greenwashing rule to prevent misleading sustainability claims and give consumers greater clarity over investment products.
Responses to the FCA's consultation on the requirements are due by 25 January 2023, with final rules expected in June 2023 and a phased implementation from mid-2023 to 2025. We review the key changes, highlight who’s in scope and explain what to do next.
What's a sustainable investment product?
The FCA defines a sustainable investment product as one with ‘an explicit environmental and/or social objective’. These objectives may directly target positive outcomes for society or the environment. Or the product’s assets must have a sustainability profile with a ‘plausible, purposeful and credible link’ to positive outcomes for society or the environment. The FCA are keen to highlight that a ‘credible link’ doesn't in itself guarantee any positive real-world outcome.
When identifying these outcomes, it’s important to consider the role of both the enterprise and the investor:
- The enterprise contribution of the underlying assets is the positive outcome due to the issuer
- The investor contribution is the action taken by the investor in respect of a specific asset – this may include stewardship, influencing prices and the cost of capital, or through sustainable capital allocation
Currently, many firms focus on the positive outcomes of specific assets within a product (ie, the enterprise contribution). However, few firms describe the link between their investment activities and the eventual positive real world sustainability outcomes of its products.
Sustainable investment labels
In the sustainability disclosure requirements, the FCA has proposed three categories of sustainable investment products, simplifying its approach from five categories in the original discussion paper. These labels will help consumers and institutional investors navigate the different types of sustainable investment products available and distinguish between them. While this element of the regulation is optional, firms applying them must comply, in full, with the FCA’s expectations on their use. This includes applying relevant graphics, providing links to the appropriate disclosures, and reviewing their status annually.
Products will be classified based on ‘intentionality’, meaning the stated sustainability objective must be a deliberate goal. The three categories of sustainable products have no hierarchy between them, and each are underpinned by a set of specific criteria around objectives, policy and strategy, among others. Each label includes prescribed wording for investors, with a high-level description for retail investors/consumers. For portfolio management, 90% of the total value of the portfolio must meet qualifying criteria for the associated label. Under the sustainability disclosure requirements, there's currently no obligation for firms to seek external verification of their labels, but the FCA encourages it if beneficial.
The labels are mutually exclusive and qualifying products must meet the sustainability disclosure requirements’ general criteria:
- Five principles of; sustainability objective, investment policy and strategy, KPIs, resources and governance, and investor stewardship
- Cross-cutting considerations aligned with the above principles
- Specific considerations for each label category
Products in this category have a sustainability objective, primarily achieved by influencing asset prices and reducing the cost of capital in sustainable economic activities.
Asset managers have a key role to play here, by screening assets with good sustainable credentials and excluding those that don't. At least 70% of a product’s assets must meet a ‘credible standard of environmental and/or social sustainability’ or align with a specific environmental or social sustainability theme. The FCA hasn't given prescriptive guidance for how firms can demonstrate a ‘credible standard’ of sustainability, but highlights emerging standards such as the UK Green Taxonomy as one potential reference point. This may change over time to ensure greater market consistency.
As a secondary channel, investor stewardship aims to continually improve the sustainability performance of the underlying assets.
The FCA felt that it was important to include a label for products that are not yet environmentally or socially sustainable, but that have the potential to be over time. As such, sustainable improvers cover a broad range of assets that are transitioning to a more sustainable environmental or social profile. For any product with a sustainable improvers label, the issuing firm should explain how the sustainability potential of the asset will be realised. Targets to achieve this transition should be measurable, and be monitored through key performance indicators to improve accountability.
As a primary channel, sustainable outcomes will be achieved through investor stewardship. This includes advocating improvements in assets’ sustainability profile, and participation in market-wide initiatives. As a secondary channel, firms can focus on assets with the most potential to improve their sustainability profile when building products and portfolios. Over time this will influence asset prices and reduce the cost of capital.
Products with a sustainable impact label aim for a predefined ‘positive, measurable contribution to real world sustainability outcomes’. Firms must demonstrate this through robust KPIs and reporting processes to make sure these claims can be backed up.
The primary means of achieving this is by directing new capital to activities targeting environmental or social issues, generally in underserved markets or to address market failure. Products should have a selective asset selection process that supports a clear route for sustainable change. Stewardship activities would provide a secondary channel for sustainability outcomes, by driving continuous improvement. Not many UK funds will slot into the three labels easily. To do so will require changing investment objectives and require approval.
Disclosures and reporting
While firms are familiar with climate-related disclosures, sustainability disclosures are relatively new, with less developed metrics in place. As such, the FCA will update its disclosure requirements over time, specifically to include the ISSB’s upcoming standards on sustainability topics. Under SDR, sustainability disclosure requirements initially only apply to asset managers, but over time they will roll out to certain FCA-regulated asset owners.
Disclosures follow a two-tiered approach, reflecting the different potential audiences, as outlined below.
Consumer facing product disclosures
High level, easy to understand disclosures will help consumers invest in the product that is right for them. Disclosures will include details of sustainability objectives, the investment approach and details of success against the stated objectives. They should be stand-alone disclosures, prominently displayed on relevant web or app page, and listed alongside other key investor information. Crucially, they must be made regardless of any sustainability claims, marked with ‘no sustainable label’ if appropriate.
More detailed disclosures at product and entity level
These disclosures give greater detail on sustainability products, at professional investors or consumers wanting further information. They cover three types:
1 Pre-contractual disclosures
These disclosures set out the sustainability related features of any product where those features are integral to their investment strategy. They must be available before issuing an investment product, ideally in the fund prospectus or prior information document, or alternatively in the sustainable product report if the other two aren't available.
2 Sustainability product report
These disclosures are split into part A and part B. Part A will cover pre-contractual disclosures if appropriate. Part B will cover ongoing sustainability-related performance information for all products using a sustainable label. These disclosures will build on the TCFD product report, covering the climate-related financial disclosures and the disclosure must be included (or linked to) in client communications. In time the reports will also build on the ISSB standards, once available.
3 Sustainability entity report
At an entity level, firms must disclose how they are managing sustainability-related risks and opportunities. This is essential, regardless of whether or not the product has a sustainable investment label. It will help consumers and other organisations identify which firms align to their own sustainable value and priorities. These disclosures will also move the conversation forward on sustainability within the firm itself.
There will be a phased implementation, starting with larger asset managers (> £50 billion assets under management) from June 2025, and smaller ones (<£50 billion assets under management) making disclosures from the following year. Sustainability-entity reports must appear in a prominent place on the website, and will include disclosures under TCFD rules or link to them.
This is a general tightening up around the use of sustainability-related claims, including an anti-greenwashing rule that applies to all FCA regulated firms. As such, the ESG Sourcebook will be updated to directly link the requirement for client communications to be ‘clear, fair and not misleading’ to sustainability claims. This rule is likely to apply from June 2023.
Naming and marketing rules
The FCA has also proposed specific terminology for greater consistency and clarity in marketing to consumers, making sure products accurately reflect sustainability-related objectives. This includes prohibiting firms from selling in-scope products, that don't have a label, using sustainability-related terms such as ‘ESG’, ‘social’ or ‘responsible’, among others, in their naming or marketing. However, firms can use these terms factually, for example in pre-contractual disclosures, such as referencing an ESG-tilted benchmark used for a tracker fund that doesn't qualify for a label.
Similarly, for products that qualify for sustainable improvers or sustainable focus labels, firms can't market these or name these using the term ‘impact’ to avoid confusion.
Requirements for distributors
When the FCA talks about distributors, it means those that ‘offer, sell, recommend, advise on, arrange, deal, propose or provide a product or service’. This includes financial advisers and investment platforms, which are specifically targeting consumers in this instance. Distributors must prominently display sustainability investment labels, as assigned by the issuing firm, on the appropriate product web or app page. Regardless of the product’s label status, distributors must also provide access to the consumer facing disclosure.
Proposals are in the works to protect consumers from greenwashing through overseas products, but in the short term, distributors must prominently display a disclaimer that the product isn't currently ‘subject to FCA sustainable investment labelling and disclosure requirements’.
When implementing the new naming and marketing rules, it’s important to consider the interaction with the new Consumer Duty rules. These require in-scope firms to ‘act to deliver good outcomes for retail clients’ through appropriate cultures and behaviours. Firms should look for synergies when implementing these regulations to prevent duplication and manage costs.
What are the implementation timelines?
The Sustainability Disclosure Requirements applies to UK firms carrying out portfolio management, UCITS management companies, UCITS ICVCs without a separate management company, full‑scope UK AIFMs and small authorised UK AIFMs.
The FCA will finalise its rules by mid-2023, with the following implementation timelines:
- The anti-greenwashing rule will most likely be effective from the policy statement release date on 30 June 2023
- Labels, naming and marketing rules, consumer facing and pre-contractual disclosures and distributor rules apply from 30 June 2024
- Sustainability performance-related disclosures are due from 30 June 2025
- Large firms will make entity-level disclosures from 30 June 2025
Over time, the FCA will build on the consultation paper to include new standards, such as the UK Green Taxonomy, and consider issues such as pension products and overseas products. In scope firms may also extend to include financial advisers.
What are the overlaps with other regimes?
The FCA has tried to align the regime with other approaches such as the EU’s Sustainable Finance Disclosure Regulation (SFDR) and recent proposals from the US’s Securities and Exchange Committee (SEC). That said, there are significant differences:
- While the SEC has also categorised products to inform disclosures, the FCA’s disclosure requirements are not as prescriptive in terms of the format they should take.
- The SFDR aligns to the EU Taxonomy, and sustainable investments must work towards selected objectives within it, while doing ‘no significant harm’ to the remaining goals. This is not the case under the SDR, as the FCA will align to the UK Green Taxonomy once it’s finalised, and the FCA consider the ‘do no significant harm’ principle to be too restrictive at this stage.
Sustainability Disclosure Requirements is a far-reaching regulation that aims to build trust in the market, maintain integrity, and protect consumers. Implementing the changes will require significant work to identify and monitor the sustainability credentials of all in-scope products. This must be supported by appropriate sustainability data, metrics, reporting and enhancements to processes, frameworks and controls.
The most immediate focus is the anti-greenwashing rule, which affects all FCA-regulated firm and will most likely come into force next year. Although the rules themselves are nothing new, it will take time to review current practices and apply them directly to sustainability claims. Firms that get this wrong should expect to face regulatory enforcement and legal action.
All FCA regulated firms should:
1 Revisit their current approach to ESG and sustainability across all products and disclosures, taking into account the new Consumer Duty rules
2 Conduct a gap analysis against the current and proposed requirements
3 Identify the priority areas for improvement and develop a plan
4 Obtain necessary resources and 2023 budget
5 Quickly enhance your current sustainability and anti-greenwashing control frameworks across all product types and services
6 Gain third-party assurance and peer group/market benchmarking
7 Provide regular briefings to senior management, board and reputational risk committee;
Firms can respond to the FCA consultation here.
For more insight and guidance, get in touch with Rashim Arora.