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Discussion Paper DP21/4 - Sustainability Disclosure Requirements (SDR) and investment labels

  • United Kingdom
  • ESG
  • Financial services and markets regulation - ESG
  • Investment funds and asset management
  • The future of funds - ESG
  • ESG
  • Financial services

04-11-2021

Introduction

FCA discussion paper DP21/4 “Sustainability Disclosure Requirements (SDR) and investment labels” (the Discussion Paper or DP), published on 3 November, alongside the FCA’s revised ESG strategy, sets out the FCA’s proposals around Sustainability Disclosure Requirements (SDR) and a sustainable investment labelling scheme, as recently trailed in the UK Government’s Roadmap to Sustainable Investing.

The FCA’s aim in introducing these initiatives is to build trust in the market place, to enhance transparency for end consumers and to meet the information needs for institutional investors.

The Discussion Paper is open for comment until 7 January 2022 with a consultation paper expected in Q2 of 2022.

Sustainability Disclosure Requirements

The DP builds out the high level summary that was provided in the Roadmap in relation to the SDR.  At its heart, the SDR is aimed at providing consumers and institutional investors with sustainability related information.  That information will explain how the firm is managing sustainability risks, opportunities and impacts, as well as the sustainability characteristics of investment products.

SDR builds on the UK’s implementation of the Task Force on Climate-related Financial Disclosure (TCFD).  The FCA are looking to make TCFD mandatory for asset managers and asset owners from 2022 (for the first phase), following their consultation earlier in the year.  However the SDR goes further as it is focussed not just on climate change issues but looks to sustainability more broadly.

SDR has been described informally as the UK’s ‘answer’ to the EU’s Sustainable Finance Disclosure Regulation (SFDR) but in reality it is much wider.  The UK SDR aims to address in one framework what the EU has sought to achieve with many pieces of sectoral legislation.  You could therefore think of the SDR as the UK’s rolled-up answer to:

  • the Non-Financial Reporting Directive (NFRD)/Corporate Sustainability Reporting Directive (CSRD)
  • SFDR
  • changes to MiFID/IDD/UCITS/AIFMD

It therefore addresses multiple points in the investment ecosystem and captures all corporates, not just financial institutions.

The challenge for the FCA, and on which it is seeking views, is to how the SDR:

  • can sit together with TCFD in a streamlined way
  • will interact with SFDR
  • will incorporate global initiatives, such as the work being carried out by the International Sustainability Standards Board (ISSB)

What disclosures will be required under SDR?

The current proposal is that the disclosures will be set at two levels – consumer facing and detailed underlying disclosures meant for sophisticated and institutional investors.

Consumer facing disclosures

The consumer facing disclosures will be aimed at retail investors and will deal with the most important sustainability information which will allow investors to make informed choices when they invest

The FCA suggests that the disclosures will include the following:

  • the product label (discussed in more detail below)
  • the objective of the product, including any specific sustainability objectives
  • the investment strategy
  • the proportion of assets allocated to sustainable investment (as defined by the UK Taxonomy)
  • a firm’s approach to investor stewardship
  • wider sustainability performance metrics

The FCA highlight that some of the above were included in their Guiding Principles sent to Chairs of authorised fund managers earlier in the year and that all firms in the scope of the SDR will need to incorporate the Guiding Principles into their products. Products such as investment trusts and unauthorised AIFs may find themselves looking to incorporate the FCA’s Guiding Principles into the design and delivery.   

See our client briefing “A Roadmap to Sustainable Investing in the UK: A view from Financial Services”.

The FCA are suggesting that they will require firms to provide some baseline sustainability metrics in the disclosure – for example carbon reduction metrics.  These may be the TCFD based metrics supplemented by other metrics to address social and governance issues.  There is a recognition from the FCA that these disclosures may not, despite the focus on simplicity, be immediately accessible to retail investors, so they are considering what investor education may need to be provided and how terms and metrics can be explained and contextualised.  Consumer testing will be carried out in the coming months to establish how investors interpret and understand the disclosures.

Finally, the FCA is suggesting that they may be prescriptive as to how the disclosures are made, including potentially prescribing a template or using an ESG factsheet.  The disclosures will need to sit alongside the KIID to give extra information on the ESG aspects of a product.  The FCA is seeking views on the content and location of the disclosures.

Detailed underlying disclosures

The FCA is asking for views on a second layer of disclosure that could be provided to sophisticated and institutional investors.  Like the SFDR, these disclosures would be made at entity and product level.

Product level disclosures

The product level disclosures will be in addition to the consumer facing disclosures highlighted above.  The FCA envisages the following disclosures :

  • information on how metrics have been calculated
  • information on data sources, limitations and quality
  • supporting narrative and contextual and historical information
  • information about UK Taxonomy alignment
  • information about benchmarking and performance

It is likely that there will be overlap with work that firms will have to do for TCFD disclosure and for SFDR to the extent that is relevant.

Entity level disclosures

The likelihood is that firms will be asked to build on the TCFD disclosure requirements which will  start to take effect for the largest asset managers and asset owners from 1 January 2022.  The FCA is likely allow disclosure at a consolidated level in light of the fact that many firms operate globally.

Overall, the FCA is cognisant of the potential overlap with other initiatives such as SFDR and is considering how any SFDR disclosures might be relevant to the UK and captured under SDR.  The FCA has also confirmed that it will adopt and endorse the standards which are being developed by the International Sustainability Standards Board (ISSB), which in time will replace the TCFD as the reference regime for disclosure.

Sustainable investment labelling scheme

The FCA is proposing a labelling regime that will provide better disclosure and help consumers and institutional investors make more informed decisions.

It will apply to the ‘full range of investment products available to retail consumers’.  Without further explanation, we envisage that this will cover open-ended and closed-ended funds sold to retail investors and packaged pension and insurance products.  It is not clear at this stage whether investment services (wealth mandates, model portfolios etc) will be in scope since traditionally these would be considered ‘services’ in the UK (but are captured as ‘products’ by recent EU regimes like SFDR).

In scope investment products will be required to display a label that meaningfully reflects their sustainability attributes.  That label will reflect the product’s position on a product classification scale.  This is intended to be complimentary to the entity-level and product-level disclosures under SDR. 

The proposals will be consulted upon in the second quarter of 2022 informed by feedback from this Discussion Paper.

To support its work on the labelling scheme, the FCA is setting up an advisory forum, the Disclosures and Labels Advisory Group (DLAG).  One of our Partners, Phil Spyropoulos, will attend DLAG meetings as a representative of a trade association.

Design principles

The DP sets out key design principles for the labelling scheme and invites feedback on these:

Objective

The classification that determines the label should be objectively derived.  The classification will therefore be based on objective criteria (e.g. percentage of sustainable investments) and descriptive labels.  The FCA wants the classification to be verifiable for obvious reasons.

Combination of intention and practice

The classification may take account both of the objective and strategies of the products themselves as well as the proportion of the portfolio that is categorised as being sustainable (potentially by reference to the UK Green Taxonomy).

Compatibility with other initiatives

The FCA is seeking to build consistency but ideally without upending existing terminology and practices; but with flexibility for future changes and innovations.

A potential approach

The FCA consultation sets out one potential approach to a product classification and labelling system.  It envisages five categories on a spectrum from, at one end, traditional products (labelled as ‘not promoted as sustainable’) to impact products at the other.  In between would be ‘responsible products’, ‘transitioning’ products and ‘aligned’ products.  The FCA’s commentary gives some indicative mapping against the ‘de facto’ SFDR categories (Articles 6, 8 and 9) showing awareness that many firms will have already categorised their products in this way.  We have combined this information in the diagram below.

However, we observe that, due to the differences between the labelling regime and SFDR, this mapping only works ‘one way’ (from UK regime to SFDR) and not in reverse.  For example:

 

  • a traditional financial product that is categorised as ‘not promoted as sustainable’ under the proposed FCA system would be an SFDR Article 6 product (as the FCA suggests).  However, Article 6 is broader than the FCA’s categorisation and can include products with ESG risk integration (which seemingly do not fit into the FCA ‘not promoted as sustainable’ category);
  • a ‘responsible’ product under the proposed FCA system would be an SFDR Article 8 product.  However, if you start with an Article 8 categorisation, you will not know if the product is ‘responsible’ or ‘transitioning’ under the FCA system; and
  • likewise Article 9 products can translate to either ‘aligned’ or ‘impact’.

 

Click on the image to zoom in.

This potential approach is supported by a set of classification criteria.

Category

Description

Minimum criteria

 

Not promoted as sustainable (traditional)

  • No sustainability risk integration
  • No specific sustainability goals

N/A

Responsible

 

  • Considers impact of material sustainability factors on financial risk and return
  • No specific sustainability goals
  • ESG integration
  • Evidence of ESG analytical organisational capabilities and resources
  • Demonstrable stewardship
  • ESG integration
  • Evidence of ESG analytical organisational capabilities and resources
  • Demonstrable stewardship

Sustainable

Transitioning

 

  • Has sustainability characteristics, themes or objectives but does not yet have a high proportion of underlying sustainable assets*
  • Pursues a strategy that aims to influence underlying assets towards meeting sustainability criteria over time, for instance through active and targeted investor stewardship
  • Expectation that the proportion of sustainable assets will rise over time

Evidence of sustainability characteristics, themes or objectives may include some combination of:

  • restrictions to investible universe, including investment limits and thresholds
  • screening criteria (positive or negative)
  • the application of benchmarks or indices and expected or typical tracking error relative to the benchmark
  • the entity’s stewardship approach as applied to the product

Aligned

 

  • Has sustainability characteristics, themes or objectives and a high proportion of underlying sustainable assets*

 

Evidence of sustainability characteristics, themes or objectives may include some combination of:

  • restrictions to investible universe, including investment limits and thresholds
  • screening criteria (positive or negative)
  • the application of benchmarks or indices and expected or typical tracking error relative to the benchmark
  • the entity’s stewardship approach as applied to the product

 

In addition the product will need to meet minimum thresholds for asset allocation.

Impact

 

  • Objective of delivering net positive social and/or environmental impact alongside a financial return.
  • Intentionality
  • Theoretical ability to deliver and measure additionality (whether the product will produce ‘extra good’ e.g. versus not investing - see below) through investment decision-making and investor stewardship
  • Impact measurement and verification
  • Intentionality
  • Theoretical ability to deliver and measure additionality (whether the product will produce ‘extra good’ e.g. versus not investing - see below) through investment decision-making and investor stewardship
  • Impact measurement and verification

* ‘Sustainable assets’ being assets meeting the sustainability criteria set out in the UK Green Taxonomy (or which can otherwise be verifiably established to be sustainable, where a taxonomy is not yet available).

Meaning of various terms

The FCA is seeking feedback on the proposed lines drawn between categories and the consequences of including or excluding particular products in particular categories.  For example, discussion includes calibrating the definitions and criteria for ‘impact’ and in particular whether this should require ‘additionality’.  Additionally represents the ‘extra good’ that comes from the investment versus a baseline (commonly, the extra good compared with not having made an investment).  Including this requirement makes the definition of ‘impact’ more rigorous and means that fewer products would qualify.  Given that retail-focussed products typically invest in liquid investments (and liquidity is typically a function of listing) there are fewer opportunities to demonstrate that the underlying investments produce this additionality as the investee company has ready access to finance and investment.  There is therefore an additional onus on stewardship. 

Additional techniques

The FCA is seeking views on the role that derivatives, short-selling and securities lending will play in this context.

What does this mean for you?

The proposals are ambitious and far reaching.  They will require impact assessments, self-categorisation exercises and lots of updates to disclosures.  In due course, the FCA will be monitoring the success of the regime and, acknowledging the potential cost, has also raised the possibility of independent verification of product disclosures as a market-led control mechanism.  It may be that, over time, recognition of the labels and disclosures, and their integration with investment advice, may prompt (or accelerate) changes to market appetites and may make traditional financial products less attractive.

Firms should consider the proposals carefully and consider responding with feedback either directly or through aggregators like trade associations or ourselves.

Distribution: notably absent?

The FCA acknowledges that the proposals centre on product manufacturers rather than distributors (although the FCA is considering the role that investment advisers will play).  It does seem to us that the success of retail disclosures will depend on how the disclosures and labels are ultimately presented to investors.  Asset management firms may feel more comfortable if there were to be a corresponding obligation on distributors.  There is an opportunity in the DP to feed back on this point.

Mandatory Transition Plans

In addition to the FCA’s statement on SDR and the labelling regime, the UK Government also published its plans for making asset managers, regulated asset owners and listed companies produce transition plans on a mandatory basis.  The plans will look for in scope firms to set out details of their plans for attaining next zero or to explain if they have not done so.  The plans will set out the high level targets a firm is working to, for example greenhouse gas reduction targets, interim milestones and actionable steps they are taking to reach the targets.

It is recognised that there is not currently a template for firms to use when developing their plan.  The proposal is that the Government will set up a Transition Plan Taskforce to work with academics and regulators to develop a standard transitions plan.  They hope to have this in place by the end of 2022.

How can Eversheds Sutherland help?

Eversheds Sutherland has an excellent relationship with the FCA and a proven track record assisting businesses with their regulatory and compliance requirements including extensive experience with product disclosure and categorisation exercises. Our practice works with key industry bodies in the ESG space to ensure we stay at the forefront of regulatory developments and understand the impacts such regulation is likely to have on the sector.

For corporate-level disclosures, Konexo (our provider of alternative legal and compliance services) can consider any necessary adjustments to your compliance reporting with you.  For more information on how Konexo can support your business, please contact Simon Collins.

For more information, please get in touch