Overview

As COP26 winds down in Glasgow, ESG is high on the agenda in financial services.

For the past two weeks, COP26 has held the sector’s focus as the UK Chancellor, Rishi Sunak, promised to make Britain “the world’s first net zero-aligned financial centre.” Financial services firms are pivotal to delivering the objectives of COP26 and achieving the UK’s 2050 net-zero target.

Most major asset managers now offer various ESG funds and products, and financial advisors are dealing with more and more clients who wish to invest with ESG in mind. But ESG can mean different things to different people, with the potential risk that a fund or product may not always meet an investor’s objectives.

The FCA, with its latest Discussion Paper on Sustainability Disclosure Requirements and investment labels (published on day four of COP26), is now tackling how to ensure investors (particularly consumers) are adequately informed about the funds and products they invest in. The FCA already has expectations on firms in terms of fund applications and financial advisors’ assessments of suitability (see paragraph 5.5 of the paper). The Discussion Paper is the next step in terms of requirements on firms to combat greenwashing and ensure transparency for consumers.

There are several existing international disclosure regimes, including the EU’s Sustainable Finance Disclosure Regulation (SFDR). The International Platform on Sustainable Finance is working on harmonisation in taxonomies, disclosures, standards and labels, and has developed a Common Ground Taxonomy. So a challenge for the FCA is ensuring its work builds on that already done and avoids material inconsistencies.

This article considers what the proposed requirements could mean for firms and provides a summary of the key aspects of the Discussion Paper.

What are the key proposals in the Discussion Paper?

The Discussion Paper looks at two key elements: product labels and disclosures (described in as Sustainable Disclosure Requirements (SDR)). The FCA envisages introducing three measures that target three different levels.

Product labels

Certain investment products will be required to display a label reflecting their sustainability characteristics. This regime will complement the UK’s SDR with the intention that a standardised labelling system will help with consumer understanding of product characteristics, allowing comparisons to be made.

The Discussion Paper suggests that the FCA’s preferred approach would be to develop a labelling system which incorporates five categories. These categories would be mapped against the EU’s SFDR to ensure consistency with the EU regime. The five suggested categories are:

Categories would apply at product level, but the FCA is seeking views on whether it would also be appropriate to apply entity-level criteria applicable to the firm responsible for delivering the product and managing the investments. Entity-level criteria would mean that firms would be required to show that their processes, resources and decisions are consistent with the product’s aims.

Sustainability disclosure requirements

The UK’s SDR is intended to widen the scope of the climate-related disclosures already consulted on by the FCA to include other ESG factors.

The Discussion Paper proposes two levels of disclosure: (1) consumer-facing disclosures; and (2) detailed underlying disclosures.

  1. Consumer-facing disclosures - should be accessible to retail consumers and designed in a way that’s easy to read alongside the Key Investor Information Document. This could include the objective of the product, investment strategy, proportion of assets allocated to sustainable investments, wider sustainability performance metrics and approach to investor stewardship. The FCA acknowledges that investor education will be essential to ensure these disclosures can be understood by investors and help them to make properly informed decisions.
  2. Detailed disclosures - expected at two levels: (a) product level; and (b) entity level. The disclosures would supplement the consumer-facing disclosures and be aimed at more sophisticated or institutional investors.

a. Product level – providing stakeholders with additional information that supports the consumer-facing disclosures. The FCA has suggested this could include information on data sources, UK Taxonomy alignment and benchmarking and performance.

b. Entity level – building on the FCA’s proposed TCFD disclosure requirements, entity-level disclosures would allow investors to understand how ESG risks and opportunities are incorporated into investment processes. To inform its proposals in this area, the FCA is keen to understand the challenges faced by firms in producing sustainability-related disclosures in line with the TCFD’s framework.

A key difficulty here will be delivering on the UK Chancellor’s ambition to “set a new global standard for sustainability” while still achieving an acceptable level of harmonisation. One example of the FCA’s approach to this problem is the proposal to create a five-tier labelling system. This goes beyond the EU’s three-tier system and so provides greater scope for comparison than the EU system. This disparity creates a harmonisation issue that the FCA proposes to address by mapping the UK’s five tiers to the EU’s three tiers.

Who would the new rules apply to?

The new requirements would apply to certain asset managers and FCA-regulated asset owners, and the investment products they offer.

The FCA will also, however, look to introduce rules for financial advisors. Not only that, but there also appears to be confirmation from the FCA that advisors should already “consider sustainability matters in their investment advice and ensure their advice is suitable and reflects consumer sustainability-related needs and preferences.”

The suggested requirements applicable at entity level would likely involve scrutiny of ESG factors throughout the investment chain. So, firms that do not fall within the scope of the regime may, in any event, experience pressure to comply voluntarily.

What do firms need to think about now?

This Discussion Paper is the latest signpost of vast and impending regulatory change regarding ESG. But it’s not clear how firms will be expected to measure ESG factors, report on ESG factors, access meaningful data and what green taxonomy that will be used.

For now, there are significant risks for firms launching new products without certainty of how the ESG disclosure landscape will change during the lifetime of those products. The actions of firms today may be judged by the standards of tomorrow – at least in the court of public opinion. The Discussion Paper is an opportunity for regulated firms, industry groups, stakeholder groups and others to influence the upcoming regulatory change.

What’s next?

The FCA is seeking feedback on a potential approach now and it aims to consult in Q2 2022 on proposed rules to implement these regimes. Firms should consider the proposals in the Discussion Paper and use this opportunity to provide feedback on their experiences of compliance with the SFDR and TCFD requirements.