As the requirements of the Sustainable Finance Disclosure Regulation (SFDR) did not come into force until March 2021 – i.e. after the end of the Brexit transition period, the UK government was not under an obligation to implement that legislation in the UK. However, the government has stated on more than one occasion its commitment to “matching the ambition of objectives” of the EU’s Sustainable Finance Action Plan. At the heart of that plan is the need to avoid greenwash and ensure more capital is redirected towards investments that are aligned with the transition to a net zero, more sustainable economy.
The Financial Conduct Authority (FCA) is planning to consult on a set of “anti-greenwash” principles for the UK investment industry to clarify the regulator’s expectations when assessing applications to authorise sustainable investment products. The principles will build on the existing requirement to be “clear, fair and not misleading.”
The FCA has made it clear that its role is not to dictate where firms invest. What it wants to ensure is that consumers are given the right information so that they can make informed decisions. This is one of the priorities in FS 19/6 on climate change and green finance.
In a speech in October 2020, Richard Monks, director of strategy at the FCA, set out the regulator’s initial thinking on a set of guiding principles to help firms with ESG product design and disclosure. In such a fast-moving pace, the FCA thinks it is important to strike the right balance between principles and prescription.
The FCA has five areas for potential principles in mind:
- Consistency in messaging and approach. A product’s ESG focus should be clearly stated in its name. And then reflected consistently in its objectives, its investment strategy, and its holdings. This is all about ensuring that a product really does do what it says on the tin and matches consumers’ expectations.
- A product’s ESG focus should be clearly and fairly reflected in its objectives. Where a product claims to target certain sustainability characteristics, or a real-world sustainability impact, its objectives should set these out in a clear and measurable way.
- A product’s documented investment strategy should set out clearly how its sustainability objectives will be met. This should include describing clearly any constraints on the investible universe. This includes any screening criteria and anticipated portfolio holdings. This should also include the fund’s stewardship approach and actions the fund manager will take if investee companies are failing to make the desired progress.
- The firm should report on an ongoing basis its performance against its sustainability objectives. This is about giving consumers the information they need to understand whether the stated objectives have been achieved in a quantifiable and measurable way.
- The firm should assure ESG data quality, understand their source and derivation, and articulate clearly and accessibly how it is used. This includes the use of ESG ratings in the investment process.
As sustainability factors are increasingly influencing consumers’ decisions, consumers should be able to trust the products they are offered and rely on them to perform as they expect. The FCA is therefore keen to ensure that innovation in the sustainable finance market does not come at the expense of trust, particularly if the UK is to position itself as a global centre for green and sustainable finance: “Trust is hard won but easily lost”.
The FCA is reflecting on feedback received following a roundtable held on 4 February 2021 and is due to publish its draft principles for consultation shortly. The FCA has also not ruled out as yet the possibility of a UK SFDR, but any thinking on this appears to still be preliminary.
Regulation of ESG ratings providers
Mark Manning, FCA technical specialist on sustainable finance and stewardship, is reported to have said, at an Ownership Day event organised by the UK Sustainable Investment and Finance Association (UKSIF) in March 2021, that the FCA is planning to scrutinise the role and transparency of ESG ratings providers in the UK.
The FCA’s focus on the development and the integrity of the ESG market is likely to include ratings as well as qualifications and that: “this could consider things such as training and certification, to guard against competence washing, whether we can put in place arrangements for effective assurance and validation services to support corporate reporting on sustainability and security specific disclosures…Also, whether there’s more that we can do to look at the role played by ESG rating providers, and the governance and transparency of the rating judgements that they reach, which are increasingly relied upon across the marketplace.”
The FCA has previously indicated that it expects fund selectors to avoid using ratings mechanistically without understanding the methodology used by the ratings providers.
There are similar plans afoot in the EU. In December 2020, the Dutch and French financial regulators called on the European Commission to draft legislation regulating ESG data and ratings providers. The regulators’ proposals include requirements on transparency on methodologies, management of conflicts of interest, internal control processes, and enhanced dialogue with companies subject to sustainability ratings.
In January 2021, the European Securities and Markets Authority (ESMA) published a letter to the Commission sharing its views on the main challenges in the area of ESG ratings and assessment tools and outlining a potential future legal framework. According to the ESMA, as the market for ESG ratings and other assessment tools is currently unregulated and unsupervised, this gives rise to increased risks of greenwashing, capital misallocation and products mis-selling when combined with increasing regulatory demands for ESG information (for example, under the EU Disclosure Regulation). ESMA suggests that the larger more systemic entities should be subject to a full suite of organisational and conflict of interest requirements that reflect their growing importance in sustainable finance. ESMA suggests that the Credit Rating Agencies Regulation could provide a starting point for any framework given the parallels between the processes of ESG and credit rating agencies.
Our understanding is that the European Commission is expected to address this in the Renewed Sustainable Finance Strategy, which is expected to be published in May 2021.