ESG Hot Topics: New ESG Rules from the FCA by adopting the SDR, uncovering its impact and how it compares to the SFDR

Greetings, fellow ESG and sustainability enthusiasts! ??

Welcome to ESG Hot Topics, the seventh blog post; in the ever-evolving landscape of sustainable finance, staying abreast of regulatory developments is crucial. Today, we embark on a journey through the latest insights from the Financial Conduct Authority (FCA) in the UK, unveiling their groundbreaking measures to enhance transparency and trust in sustainable investment products. The FCA has officially introduced its response to the Sustainable Finance Disclosure Regulation (SFDR), aptly named PS23/16: Sustainability Disclosure Requirements (SDR) and Investment Labels. On November 28, 2023, the FCA confirmed long-awaited final rules and guidance for UK asset managers aimed at bolstering trust and transparency in sustainable investment products.

The FCA's unveiling of PS23/16 introduces a comprehensive set of measures, including an anti-greenwashing rule, sustainability investment labels, and guidelines for firms marketing investment funds based on their sustainability characteristics. These initiatives, born out of consultations like CP22/20, are geared towards informing and safeguarding consumers, fostering competition, and building trust in the market for sustainable investment products.

The FCA has responded to industry and stakeholder concerns by making significant changes to its initial proposals. Here's a breakdown of the key updates:

1. Exclusion of Portfolio Management Products: ?? Portfolio management products and services have been temporarily excluded from the scope of the investment labels and disclosure regime. Originally, the proposals included discretionary portfolios, but industry feedback deemed these criteria unworkable. The FCA now plans to consult on labeling proposals for this product type in Q1 2024.
2. Flexibility in Naming and Marketing: ??? Responding to criticism about restrictive naming and marketing rules, the FCA has amended regulations to allow asset managers to promote non-labeled funds with ESG characteristics. This permits terms like "green," "net-zero," and "responsible" in marketing. However, rules and consumer-facing disclosures will govern how these funds are marketed, emphasizing transparency in investment strategies.
3. Introduction of "Sustainability Mixed Goals" Label: ?? A new addition to the labeling regime is the "Sustainability Mixed Goals" label. This caters to sustainable funds with diverse investment strategies that don't neatly fit into the existing "focus," "improvers," or "impact" labels. Funds meeting the qualifying criteria can now apply this new label.
4. Updates to Anti-Greenwashing Rule: ?? The anti-greenwashing rule applying to all authorized firms remains largely unchanged but will be complemented by new guidance. The FCA has extended the implementation date to 31 May 2024, allowing a consultation period on the additional guidance (published as GC23/3). Stakeholders have until 26 January 2024 to provide input. In this pivotal moment for UK sustainable finance regulation, the FCA's measures extend to consumer-facing information, detailed disclosures for institutional investors and consumers, and requirements for distributors.

The FCA is proposing the introduction of sustainable investment product labels, empowering consumers to confidently choose products aligned with their values. This initiative aims to enhance trust and facilitate navigation through the complex investment landscape.

The product labels will comprise of four categories:

1. Sustainable Focus: Non-financial objective; Must invest at least 70% in assets with a "robust, evidence-based standard that is an absolute measure of sustainability."
2. Sustainability Improvers: Non-financial objective; Must invest at least 70% in assets poised to become more sustainable over time, including in response to stewardship. Must obtain robust evidence for selecting assets.
3. Sustainability Impact: Non-financial objective to achieve a pre-defined, positive, measurable impact; Must invest at least 70% in assets providing solutions to environmental or social problems. Supported by a theory of change emphasizing the contribution to the problem at hand, with a robust method to measure and demonstrate impact.
4. Sustainability Mixed Goals: Non-financial objective to invest in products with any combination of the other labels; Must invest at least 70% in accordance with a combination of the sustainability objectives for the other labels. Disclose details of the proportion of assets invested in accordance with each relevant label. Must comply with the requirements for each of the relevant labels.

Notably, there are limited exceptions to meeting the 70% thresholds. While firms are not obligated to adopt a label under SFDR, the policy statement outlines marketing restrictions for retail funds that opt not to adopt a label. Consequently, a list of prohibited terms, including 'Sustainable,' 'Sustainability,' and 'Impact,' cannot be used within a product’s naming or marketing if no label is adopted.

Additional Notes:

• The term "credible standard" has been replaced with "robust, evidence-based standard."
• The FCA clarified that internal frameworks can be used, and independent assessments can be carried out either by a third party or via a firm’s internal processes.
• The option to qualify for the Focus label by aligning with a sustainability theme has been removed.
• References to real-world impact have been removed, but it's noted that all labels lead to some form of impact. ????

The FCA is introducing the following requirements:

• An anti-greenwashing rule for all FCA-authorised firms to reinforce that sustainability-related claims must be fair, clear, and not misleading. We are also consulting on supporting guidance.
• Naming and marketing rules for investment products to ensure the use of sustainability-related terms is accurate.
• Four labels to help consumers navigate the investment product landscape and enhance consumer trust.
• Consumer-facing information to provide consumers with better, more accessible information to help them understand the key sustainability features of a product.
• Detailed information targeted at institutional investors and consumers seeking more information in?pre-contractual, ongoing product-level, and entity-level disclosures.
• Requirements for distributors to ensure that product-level information (including the labels) is made available to consumers.

Background to why the SDR is needed:

In the extensive FCA Policy Statement (PS23/16), the final rules and guidance for Sustainability Disclosure Requirements (SDR) and a consumer-focused investment labeling regime have been confirmed. This follows a robust consultation process (CP22/20) initiated in October 2022 and a discussion paper (DP21/4) released in November 2021, incorporating feedback from stakeholders ranging from the asset management industry to consumer groups. The much-anticipated PS23/16, originally slated for Q2 2023 and subsequently delayed, was eventually published on November 28, 2023.

With the management of approximately $18.4 trillion in ESG-oriented assets globally, which is projected to rise to $34 trillion by 2026, the introduction of SDR aligns with the demand for investments with positive environmental or social impact. The SDR strives to position the UK as a leading global hub for asset management and sustainable investment, fostering a virtuous circle of improved industry standards, enhanced market integrity, and the consolidation of the UK's reputation in sustainable finance. ????

What does the SDR introduce?

The final SDR package encompasses a range of measures, including an anti-greenwashing rule for all authorized firms, four distinct sustainability investment labels, new rules and guidance for marketing investment funds based on sustainability characteristics, and consumer-facing information. These initiatives aim to empower consumers with better understanding, provide transparency, and ensure accountability in the sustainable investment market. Let's explore the key features and implications of the SDR, unpacking the multifaceted approach adopted by the FCA. ????

Labeling regime - what are the new labels?

Chapter 5 of PS23/16 sets out the principles of the labeling regime and general criteria. The FCA received significant feedback on the detailed criteria to qualify for a label, and part of the response to that feedback has been to add a fourth label, ‘Sustainability Mixed Goals’. This label is suitable for funds that have a mix of assets meeting the attributes of the Focus, Improvers, and/or Impact labels, with the potential to improve their sustainability over time.

Starting from July 31, 2024, consumers will encounter labels on investment funds that specifically target environmental or social goals. The four labels — Sustainability Focus, Sustainability Improvers, Sustainability Impact, and Sustainability Mixed Goals — aim to provide clarity on the sustainability objectives and investment approaches of different funds. These labels require annual updates on progress toward their respective goals, emphasizing transparency and accountability in sustainable investing. ????

What is the anti-greenwashing rule, and is there any guidance on it?

The anti-greenwashing rule, summarized in Chapter 4 of PS23/16, is a pivotal element of the SDR measures. It reinforces the principle that sustainability-related claims made by authorized firms must be fair, clear, and not misleading (FCNM). Applicable to all communications about financial products or services referencing environmental and/or social characteristics, the rule covers a broad spectrum, including statements, assertions, strategies, targets, policies, information, and images.

To provide additional clarity, the FCA is consulting on guidance (GC23/3) for the anti-greenwashing rule. The consultation is open for comments until January 26, 2024, with the effective date for the rule set at May 31, 2024. The FCA's proactive approach in implementing this rule underscores its commitment to ensuring the integrity of sustainability-related claims in the market. ??????

Labeling regime - what are the general qualifying criteria?

The general qualifying criteria for products with any of the sustainability labels align under five key themes:

1. Sustainability Objective: All labeled products must have a sustainability objective to improve or pursue positive environmental and/or social outcomes. Firms must disclose whether pursuing these positive outcomes may result in material negative outcomes.
2. Investment Policy and Strategy: Typically, at least 70% of a labeled product's assets must align with its sustainability objective, referencing a robust, evidence-based standard measuring environmental and/or social sustainability. The FCA has removed the previous proposal for an independent party to assess an investment strategy as 'credible.'
3. Key Performance Indicators (KPIs): Firms must identify KPIs to measure progress against the sustainability objective, whether for the entire product or individual assets.
4. Resources and Governance: Firms must ensure appropriate resources, governance, and organizational arrangements are in place to support the delivery of the sustainability objective.
5. Stewardship: Firms must disclose their stewardship strategy, detailing actions and expected outcomes to support the sustainability objective. An escalation plan for assets not making sufficient progress is also required.

The FCA emphasizes that the labels are not hierarchical, marking a departure from approaches taken in the disclosure requirements of the EU SFDR. The nuanced criteria aim to provide a comprehensive framework for evaluating and communicating the sustainability attributes of investment products. ????

What are the key features of the naming and marketing rules within the SDR?

The naming and marketing rules, consistent with the Consumer Duty's 'consumer understanding' outcome, impose stringent criteria on the use of sustainability-related terms in product names and marketing. These rules apply to all FCA-authorised firms and outline the following:

1. Label Use: Sustainability-related terms can only be used in product names and marketing if the product carries a label. However, when using the 'Sustainability Focus,' 'Sustainability Improvers,' or 'Sustainability Mixed Goals' labels, the term 'impact' cannot be used in the product's name.
2. Non-labeled Products: For products without a label, firms must adhere to specific criteria, including accurately reflecting sustainability characteristics in the product's name. However, terms such as 'sustainable,' 'sustainability,' 'impact,' and variations thereof must not be used.
3. Accurate Descriptions: Firms are encouraged to accurately describe their products to facilitate consumer navigation based on their needs and preferences.
4. Retail Investors: The naming and marketing rules apply specifically when targeting retail investors and referencing sustainability characteristics.
5. Exemptions: The rules do not apply to short, factual, non-promotional statements about a product, such as information about service providers or periodic reporting practices.

The rules aim to ensure that sustainability-related terms are used transparently and consistently, fostering consumer understanding and trust in the market. ???????

What are the key features of the consumer-facing, detailed product-level, and entity-level disclosures?

Consumer-facing Disclosures:

Detailed in Chapter 8 of PS23/16, consumer-facing disclosures aim to provide clear, concise information for products with or without a label. Key points include:

• Location: Disclosures must be prominently placed on relevant digital mediums, such as webpages or mobile apps, and be available in hard copy upon request. The document should not exceed two pages.
• Content: Disclosures must include the product's sustainability objective and label (or a statement clarifying the lack of a label), investment policy and strategy, relevant metrics, information access points, and, for the 'Sustainability Mixed Goals' label, the proportion of assets aligned with each relevant label.
• Review and Update: The disclosure must be reviewed and updated annually as needed. Products with labels require updates reflecting progress towards the sustainability objective.

Product-level Disclosures:

For products with a label or using sustainability-related terms in naming and/or marketing, sustainability information must be included in pre-contractual disclosures and annual ongoing product-level disclosures. These disclosures align with the qualifying criteria for the labels.

Entity-level Disclosures:

Consistent with the TCFD's four pillars, firms must disclose their governance, strategy, risk management, and metrics and targets regarding managing sustainability-related risks and opportunities. Firms with over ￡5 billion AUM must make these disclosures annually in a sustainability entity report aligned with the TCFD's structure.

Firms can cross-reference disclosures made in group or parent-level reports, provided clear signposting and cross-referencing requirements are met.

These comprehensive disclosure requirements aim to provide consumers and stakeholders with a holistic understanding of a firm's sustainability practices, promoting transparency and accountability. ??????

How will the FCA supervise and enforce the SDR?

The FCA's approach to supervising and enforcing the SDR reflects a commitment to ensuring compliance and addressing potential issues effectively:

1. Label Classification: While the FCA's Fund Authorisation team will review and may challenge the application of any new fund submitted for authorization, this doesn't constitute approval of the label. Firms remain responsible for the classification and appropriateness of the label.
2. Supervisory and Enforcement Approaches: The FCA will apply its usual supervisory and enforcement approaches to the SDR, responding to compliance issues as they arise. Enforcement action may be taken if evidence suggests serious misconduct.
3. Support to Industry: The FCA commits to providing ongoing support to the industry through stakeholder engagement, including webinars and events. This collaborative approach aims to facilitate a smooth implementation of the SDR.

The FCA's vigilance in supervising and enforcing the SDR underscores the importance of maintaining market integrity and consumer trust in sustainable finance. ????????

Has the FCA considered alignment across jurisdictions, for example, contrasting SDR and SFDR approaches?

The FCA acknowledges the importance of international interoperability, particularly with the EU's SFDR. Annex 3 to PS23/16 includes a mapping of the SDR to the SFDR, showcasing the FCA's efforts to encourage alignment. As the UK pioneers investment labels, the FCA expresses its readiness to collaborate with EU authorities and other jurisdictions, aiming for a level playing field for all firms operating in the market.

The ongoing review of the SFDR and the FCA's proactive engagement with global counterparts reflects a commitment to establishing rules that protect consumers while fostering market growth. The FCA's willingness to collaborate and align with other jurisdictions highlights a broader effort to maximize the benefits of the SDR for consumers on a global scale. ??????

What should firms do to prepare for the SDR?

For all authorized firms:

1. Anti-greenwashing Rule: Prepare for the new anti-greenwashing rule by ensuring claims about sustainability characteristics are fair, clear, and not misleading.
2. Guidance Consultation: Review the FCA's accompanying consultation on further guidance to the anti-greenwashing rule and decide whether to respond by January 26, 2024.

For UK asset managers:

1. Labeling Decision: Decide whether to label products aiming for positive sustainability outcomes, ensuring they meet the qualifying criteria.
2. FCA Requirements: Familiarize yourself with the FCA requirements outlined in PS23/16, covering label usage, qualifying criteria, naming and marketing, disclosures, and ongoing obligations.

For all distributors:

1. Consumer-facing Disclosures: Prepare to make labels and consumer-facing disclosures available to retail investors, ensuring updates following any changes by the firm.
2. Notice on Overseas Funds: If relevant, be prepared to add a notice on overseas funds, informing consumers that they are not subject to the SDR regime.

These proactive steps will position firms to navigate the evolving landscape of sustainable finance and ensure compliance with the SDR's multifaceted requirements. ??????

SDR: Next Steps and Key Timelines

The rules and guidance outlined in PS23/16 mark the beginning of the SDR journey, with the FCA intending to expand and evolve the regime in the future:

1. Portfolio Management: In early 2024, the FCA will consult on a similar approach for portfolio management, focusing on UK retail clients.
2. Overseas Funds: Although not currently in scope, the FCA will collaborate with HM Treasury to explore options for extending the SDR to overseas recognized funds.
3. Pension Products: The FCA plans to explore whether and how to extend the SDR to pension products, recognizing the importance of this area in promoting sustainability objectives.

Firms are advised to stay engaged with the FCA, monitor developments, and proactively adapt their practices to align with future iterations of the SDR. ??????

Understanding the UK SDR and EU SFDR Regulations

The UK Sustainable Disclosure Regulation (SDR) and the EU Sustainable Finance Disclosure Regulation (SFDR) represent key sustainability disclosure frameworks for financial market participants. Let's delve into the objectives, key differences, and challenges associated with these regulations.

Objectives of the Regulations:

Both the UK SDR and EU SFDR share common objectives, aiming to:

• Build trust and integrity in sustainable instruments to combat greenwashing.
• Increase transparency and disclosure surrounding sustainable finance products and investments.
• Provide investors with more information to make informed investment decisions.

Key Differences Between SDR and SFDR:

While the SDR is often considered the UK's response to the SFDR, significant differences exist. A major distinction lies in the approach to sustainable investment classification and labels:

1. Sustainable Investment Classification and Labels: SDR (UK): As mentioned above, the SDR comprises of four product labels (Sustainable Focus, Sustainable Improvers, Sustainable Impact, Sustainability Mixed Goals) based on intentionality and the level of sustainable investments. These labels offer clarity and cater to different consumer preferences.
2. SFDR (EU): The SFDR mandates that products be classified as either Article 6, 8, or 9 based on characteristics and sustainability levels. Unlike labels, these categories represent levels of disclosures. Articles 6, 8, and 9 funds align differently with the SDR labels. The SDR labels cover distinct investment objectives, while the SFDR categories suggest a hierarchy of sustainability. A challenge arises when a product is deemed sustainable under one regime but not under the other.

Key Actions for Firms:

To navigate these complexities, firms are advised to:

• Conduct a scoping and product classification exercise to identify in-scope products and entities.
• Undertake a post-implementation review of SFDR to learn from experiences and enhance SDR implementation.
• Review resources, governance structures, and organizational arrangements to support disclosed characteristics and sustainability objectives.
• Assess stewardship approaches and employ technology for monitoring and reporting engagements.
• Scrutinize marketing materials for prohibited sustainability-related terms, utilizing technology-enabled solutions for identification and monitoring.

SDR Policy Challenges:

The FCA's SDR proposals have generated significant industry feedback, highlighting challenges such as:

• A significant gap between existing market structures and stringent labeling criteria.
• Potential regulatory divergence with other regimes like SFDR, creating operational complexity.
• Stringent marketing restriction approaches require careful review and potential adjustments.

The FCA acknowledges industry feedback and commits to considering adjustments, emphasizing clarity on primary and secondary channels for achieving sustainability outcomes.

Preparing for SDR Implementation:

As the final rules are awaited, firms can take proactive steps to prepare for SDR implementation:

• Conduct scoping exercises and product classifications.
• Perform impact and gap analyses to identify necessary changes and disclosure requirements.
• Establish a labeling operating model for ongoing compliance and enhancements.
• Prepare for disclosure production, leveraging lessons from SFDR implementation.

ESG Governance Considerations:

Firms need robust governance and oversight arrangements to meet SDR requirements, including:

• Adequate resources, expertise, and clear roles for greenwashing risk management.
• Governance structures and oversight forums to monitor sustainability approaches.
• Enhancement of existing sustainable investment frameworks and necessary policy revisions.

Tailored Legal Assistance for SDR Implementation

Wondering how to navigate the intricacies of the SDR and how to optimize your organization toward these new compliance and legal requirements? A Triple C Consulting is here to help you navigate and tackle these issues. With our extensive experience and expertise in Legal and ESG compliance matters, we offer tailored legal assistance to guide you through the evolving regulatory landscape.

Comprehensive Support:

• Regulatory Insight: we are closely monitoring the development and implementation of SDR. We understand the nuances and complexities, ensuring you stay ahead in compliance.
• Toolbox for Success: Access a suite of tools and resources designed to facilitate your journey through the changing ESG landscape. From training presentations and checklists to templates and guides, we provide practical solutions.

SDR Implementation Challenges:

• Internal Resource Demands: We recognize that SDR will necessitate significant internal resources. Our approach acknowledges the unique nature of each case, emphasizing a customized strategy rather than a one-size-fits-all solution.
• Business-As-Usual Complexity: SDR implementation shouldn't disrupt your business-as-usual. Our experience in applying draft rules to funds reveals the need for a meticulous, case-specific approach to maintaining operational efficiency.

Why Choose Us:

• High-Quality Assistance: We are confident in our ability to provide high-quality, tailored, and timely legal assistance. Our goal is to support you in meeting SDR requirements efficiently and cost-effectively.

Feel free to reach out to us if you need an ESG advisor or help with ESG data collection to support your existing ESG workflows and compliance efforts. At A Triple C Consulting, we have ESG legal expertise (Magic Circle Law firm based in Luxembourg), ESG data platform (Seneca ESG), and ESG climate and carbon accounting capabilities. A true end-to-end service offering at your disposal. ?? ?? ??

Best regards,

Albin Axelsson

Founder & CEO of A Triple C Consulting

[email protected]

www.atriplecconsulting.com

Note: The content provided in this newsletter is for informational purposes only and should not be construed as financial or legal advice.