FCA publishes consultation paper on SDR and investment labelling

Sustainable investment classification and labelling

Perhaps the most eagerly anticipated part of the consultation paper is the FCA’s approach to the classification and labelling of investment products. The labelling regime aims to help consumers distinguish between products on the basis of their sustainability characteristics, themes and outcomes, and help them distinguish between different types of sustainable investment product. The labelling regime will be applicable to investment products marketed in the UK, provisionally from 30 June 2024.

The FCA has proposed three sustainable investment labels, comprised of ‘Sustainable Focus’, ‘Sustainable Improvers’ and ‘Sustainable Impact’. These three categories broadly correspond to the labels included under the sustainable banner in the discussion paper, although the ‘Transitioning’ category has been changed to ‘Improvers’ (to remove any implication that this category relates to climate transition only) and the ‘Aligned’ category has been changed to ‘Focus’ (to improve the clarity and reduce potential confusion). In addition, the ‘Responsible’ and ‘Not Promoted as Sustainable’ categories have been removed in order to simplify the regime. The FCA clarifies that products without a sustainability objective that use ESG integration strategies (i.e. to consider the risks, opportunities and impacts that may be material to the financial performance) would not qualify for a sustainable investment label. This is aligned to the approach taken by the European Supervisory Authorities in relation to the EU Sustainable Finance Disclosure Regulation (SFDR) regime.

In terms of criteria and implementing guidance, products qualifying for a sustainable investment label must meet the following:

• five overarching principles, covering (1) sustainability objective; (2) investment policy and strategy; (3) KPIs; (4) resources and governance; and (5) investor stewardship;
• a number of key (‘cross‑cutting’) considerations associated with each of the overarching principles, which include what firms must do to meet each principle and the sustainability-related features of their investment products;
• certain category‑specific key considerations relevant to their particular label.

The criteria for each label must be met in full and continue to be met on an ongoing basis in order to use the relevant label.

Sustainable Focus

Products in the ‘Sustainable Focus’ category will be those which invest in assets that a reasonable investor would regard as being environmentally and/or socially sustainable. Such products will likely pursue thematic ESG strategies which focus on particular aspects of the sustainability agenda, or those which focus on addressing ESG issues more generally.

The key features of this category of product are:

• Sustainability objective. Alongside its financial risk/return objective, the product will have an objective to invest in assets that meet a credible standard of environmental and/or social sustainability, or that align with a specified environmental and/or social sustainability theme.
• Primary channel for sustainability outcomes. The product would pursue its sustainability goals primarily via the market-led channel of influencing asset prices, and thereby reducing the relative cost of capital of sustainable economic activities/projects.
• Secondary channel for sustainability outcomes. The product will also typically pursue continuous improvements in the sustainability performance of assets through investor stewardship activities.

The criteria for this category include that at least 70% of the product’s assets meet a credible standard of environmental and/or social sustainability, or align with a specified environmental and/or social sustainability theme. Although the FCA recognises that this may be demonstrated through alignment with the upcoming UK Green Taxonomy, it has decided against being prescriptive at this stage.

Sustainable Improvers

Products in the ‘Sustainable Improvers’ category will be those which invest in assets that, while not objectively environmentally or socially sustainable at present, have the potential to deliver measurable improvements in their environmental and/or social sustainability over time. Such products may be invested broadly across sectors, with the firm aiming to embed and accelerate improvements in the sustainability profile of assets.

Products in this category will be those which focus on active ownership strategies with robust approaches to investor stewardship. The product will have clear and measurable ESG targets with Key Performance Indicators (KPIs) to assess performance over a period of time.

The key features of this category of product are:

• Sustainability objective. Alongside its financial risk/return objective, the product will have an objective to deliver measurable improvements in the sustainability profile of its assets over time, including through investor stewardship.
• Primary channel for sustainability outcomes. The product would pursue its sustainability goals primarily via the channel of investor stewardship. The stewardship approach would be directed towards encouraging and accelerating improvements in the environmental or social sustainability profile of its assets, including through participation in system-wide initiatives, with flow-on positive implications for environmental and/or social sustainability.
• Secondary channel for sustainability outcomes. The product’s portfolio construction and asset selection would be geared towards identifying those assets that are best-placed to improve their sustainability profile over time. A secondary channel would therefore be the market-led channel of influencing asset prices and the relative cost of capital of more sustainable economic activities/ projects.

The criteria for this category include that the sustainability objective must align with requirements in the ‘investment policy and strategy’ section – i.e. to invest in assets that have the potential to become more environmentally and/or socially sustainable over time, including in response to active investor stewardship.

Sustainable Impact

Products in the ‘Sustainable Impact’ category will be those which aim to achieve a positive, measurable contribution to real world sustainability outcomes. A firm seeking to use this label would commit to deliver and report on its (the investor’s) contribution to a positive environmental and/or social sustainability outcome through financial as well as other types of investor additionality.

To evidence environmental or social outcomes in line with the product’s stated objective, the manager would be expected to apply industry standard approaches to performance measurement, reporting against rigorous, evidence-based KPIs that capture the investor contribution to positive sustainability outcomes.

The key features of this category of product are:

• Sustainability objective. Alongside its financial risk/return objective, the product will have an objective to achieve a pre‑defined, positive and measurable environmental and/or social impact.
• Primary channel for sustainability outcomes. The product would pursue its sustainability goals by directing typically new capital to projects and activities that offer solutions to environmental or social problems, often in underserved markets or to address observed market failures. The product would be expected to have a stated theory of change, and to pursue a highly selective asset selection strategy aligned with that theory of change.
• Secondary channel for sustainability outcomes. Driving continuous improvements in the sustainability performance of assets through investor stewardship activities would be a secondary channel.

The criteria for this category include that the sustainability objective must be to achieve a predefined, positive, measurable real-world environmental and/or social outcome.

Comparison with EU SFDR regime

The FCA’s proposed framework is designed as a labelling regime, with detailed criteria to determine eligibility, while the SFDR introduced three categories of products with respective disclosure requirements which have become a de facto classification and labelling system. The starting point to determining eligibility is therefore different between the two systems. 

Given that many UK firms are already subject to the EU SFDR in respect of their cross border EU business, the FCA has mapped the UK product categories to those in the EU SFDR to help firms leverage the systems investments they have already made:

• Products falling under Article 6 (those that do not integrate sustainability into the investment process) will not have a sustainable label attributed to them under the FCA’s proposed regime.
• Products falling under Article 8 (those that promote environmental and/or social characteristics) are most closely aligned to the Sustainable Focus or Sustainable Improvers labels. However, it is arguable these labels set a higher bar than Article 8, which is considered to be a catch all category comprising a broad range of ESG investment strategies.
• Products falling under Article 9 (those that have sustainable investment as their objective) are most closely aligned to the Sustainable Impact label. However, it is considered that the Sustainable Impact label sets a higher bar than Article 9, in that such products must demonstrate additionality and not only alignment to sustainable investment criteria.
  Article 8 and 9 products would have to meet the cross-cutting and category-specific criteria under the FCA’s proposed regime in order to use a sustainable label, which will place an additional compliance burden on firms offering sustainable investment products in the UK market. 

Disclosures

The consultation paper proposes disclosure requirements for asset managers with a view to extending them to certain FCA regulated asset owners. The FCA’s proposals aim to increase access to information on the sustainability related features of investment products to retail investors. The proposals build on the existing TCFD-aligned disclosure requirements in the ESG Sourcebook by focusing on three distinct areas: the introduction of consumer facing disclosures; more detailed product level disclosures in pre contractual materials and a ‘sustainability product report’, and entity-level disclosures in a ‘sustainability entity report’.

The FCA stressed that these proposals are a starting point and that the rules relating to both the disclosure requirements and the scope of such requirements will be developed over time –  for example, to include more specificity to both product and entity level disclosure requirements.

Consumer-facing disclosures

The consumer-facing disclosures are intended to provide a summary of the products’ key sustainability related features, helping consumers to better understand those features and hold the provider to account for its sustainability claims. The FCA proposes that all in scope firms must produce a consumer facing disclosure for all in scope products. This means that even products that are not engaged in any sustainability strategies will require disclosures, though inherently more limited e.g. the label field must be marked with ‘no sustainable label’ and other fields marked ‘not applicable.’ Firms providing portfolio management services will not be required to produce their own consumer facing disclosures, but instead provide an index of the underlying funds in which it invests, including the label and hyperlinking to the individual funds’ consumer facing disclosure, as applicable.

The FCA proposes that these disclosures be made available in a prominent place on the relevant digital medium for the firm (e.g. on the main product webpage or page on a mobile application) and no more than ‘one mouse click away’ from the label of any sustainable products.

Firms will be required to produce the consumer facing disclosure as a new, standalone document, which should be presented alongside other key investor documents to ensure that consumers do not consider sustainability related information in isolation. The rules do not require sustainability related disclosures to be set out in the key information document (KID) and any relevant sustainability disclosures should be incorporated in line with existing UK PRIIPs Regulation disclosure obligations. However, the supplementary consumer facing disclosure should allow for more targeted information.

The FCA has developed its proposals so as to avoid being overly prescriptive in terms of format, and, as such, the disclosures will only have to be clear, concise, and suitable for consumers, and to not exceed 2 pages of A4. However, in the interests of consistency, the FCA has encouraged the industry to consider developing a market led template. In terms of content, the FCA proposes that firms must disclose certain types of information, including on the product’s basic details, label, sustainability goal, sustainability approach, unexpected investments, sustainability metrics, and signposting / hyperlinking to other firm disclosures.

The disclosures will become applicable provisionally from 30 June 2024 and will have to be updated at least annually with further reviews to be conducted prior to any proposed change to the product. 

Detailed disclosures

The detailed disclosures are aimed at a wider audience including institutional investors and other stakeholders – or retail investors that may be interested in receiving more information. Such information will involve transparency on the product’s sustainability objective, strategy, and progress towards meeting the objective, as well as ongoing performance metrics and contextual information. Firms will provide this more granular information in the form of pre contractual disclosures and a sustainability product report, which will apply provisionally from 30 June 2024. Two of these are documents already in existence, which should reduce the burden on firms while ensuring sustainability related information reaches the intended audience. There are also rules relating to the ongoing reporting of sustainability-related performance information, which will apply provisionally from 30 June 2025.

Pre-contractual disclosures

Pre contractual disclosures made before issuing an investment product (e.g. in the fund prospectus) must be made in relation to products using a sustainable investment label, as well as those which do not but nevertheless adopt sustainability related features integral to their investment policy. 

The disclosure should set out key information on sustainability related features of investment products, in accordance with Principle 1 – Sustainability objective; Principle 2 – investment policy and strategy; and Principle 5 – stewardship. Where there is no prior disclosure document for an in‑scope product (e.g. AIFs managed by small AIFMs), the firm must make the pre‑contractual disclosures in the sustainability product report. 

Sustainability product reports

The FCA will also require that firms produce disclosures on the sustainability related performance of their products on an ongoing basis in a dedicated sustainability product report which builds from the TCFD product report. For now, this will only apply to products that qualify for a sustainable label, which must be displayed in the report alongside the product’s sustainability objective as well as progress towards meeting that objective. 

The firm will be required to make the following disclosures in accordance with Principle 2 – investment policy; Principle 3 – KPIs; and Principle 5 – stewardship, in addition to any other metrics useful to a client in understanding the firm’s approach to meeting the sustainability objective or deciding whether to invest. 

Entity-level disclosures

All in-scope asset managers will be required to produce a sustainability entity report covering how they are managing sustainability related risks and opportunities. The FCA has proposed a phased implementation, similar to the approach it took in introducing TCFD-aligned disclosures. Larger firms (asset managers with above £50 billion in AUM) will be required to make their first disclosures by 30 June 2025, with smaller firms, excluding those with under £5 billion in AUM, required to make their first disclosures one year later.

As a starting point, the FCA has only proposed core entity level disclosure requirements based on the TCFD’s four recommendations, covering governance, strategy, risk management and metrics and targets. The FCA has proposed to add Handbook guidance which includes references to the International Sustainability Standards Board’s (ISSB) general sustainability‑related disclosure requirements and Sustainability Accounting Standards Board (SASB) standards, which are considered relevant to helping firms to determine the content of disclosures that may be useful for clients. Where a firm uses a sustainable investment label, it must make the disclosures in relation to the qualifying criteria in its sustainability entity report in accordance with Principle 4 – governance and resources. 

Product names and marketing materials

The FCA has proposed to prohibit firms providing in-scope products that do not qualify to use one of the sustainable product labels from using sustainability-related terms in their product names and marketing, such as ‘ESG’, ‘climate’, ‘green’ or ‘sustainable’. The FCA also proposes that products that qualify as ‘Sustainable Focus’ or ‘Sustainable Improvers’ be prohibited from using the term ‘impact’ in the naming and marketing of these products. This aims to avoid any potential confusion that such products meet the standard set for ‘Sustainable Impact’ products. These rules will apply provisionally from 30 June 2024.

The FCA advises that the rules will apply to in-scope products that are made available to retail investors, but not those offered to institutional investors at this stage.

Where firms adopt sustainability‑related investment policies and strategies that are integral to their investment policy and strategy, firms should describe these factually and in a proportionate way in their pre‑contractual disclosures. As such, the prohibition on including sustainability‑related terminology does not apply for the purposes of disclosing factual information in the pre‑contractual disclosures, the summary of information in consumer-facing disclosures, and any other disclosure requirements a firm may be subject to. This will be a welcome clarification for firms offering products across which they integrate ESG risks and opportunities into their investment processes, but do not have specific ESG objectives or otherwise meet the FCA’s criteria for a sustainable label. It should be noted that most asset managers have now adopted ESG integration as standard across their fund ranges, irrespective of whether they are marketed as sustainable finance products. 

In addition, and as highlighted by the FCA, firms providing a tracker fund that does not qualify for a label but follows an ESG-tilted benchmark should disclose the use of this benchmark.

‘Anti-greenwashing’ rule

The FCA has proposed a new ‘anti-greenwashing’ rule which would require all regulated firms to ensure that the naming and marketing of financial products and services in the UK is clear, fair and not misleading and consistent with the sustainability profile of the product or service – i.e. proportionate and not exaggerated. The FCA proposes that this rule provisionally comes into effect on 30 June 2023.

While firms are already required to ensure that the information they communicate to clients is clear, fair and not misleading under PRIN 2.1, Principle 7 and COBS 4.2.1, the FCA considers it necessary to add a specific rule to link this directly to sustainability claims to clarify the expectations on firms. This does not mean, however, that firms should not already be ensuring that any sustainability claims they make in relation to their products and services are clear, fair and not misleading, in order to comply with existing rules and guidance as well as broader FCA expectations. For example, it should be noted that, in its Dear AFM Chair Letter of July 2021, the FCA provided guidance for authorised funds that ESG claims should be considered in light of the ‘clear, fair and not misleading’ rule.

Although the FCA’s new rule is a welcome clarification, it should not radically change how many firms are currently approaching their marketing and product approval processes. That said, the presence of such a rule will certainly augment the level of regulatory risk that firms bear when they make available sustainable financial products and services. The FCA warns that it will use this new rule to challenge firms that it considers to be potentially greenwashing their products or services, and take enforcement action against them as appropriate.

Requirements for distributors

The FCA recognises the important role played by distributors in communicating sustainability‑related information, in particular to retail investors. The FCA has proposed requirements for distributors of products to retail investors, which aim to ensure that product‑level information is made available to such investors, which will apply provisionally from 30 June 2024.

The FCA proposes that distributors of in-scope products must not use a sustainable investment label for a product other than the label that has been assigned by the firm under the FCA’s regime, and display it prominently on the relevant digital medium (e.g. product page on a mobile application). Distributors of products, regardless of whether a label is applied, will be required to provide retail investors with access to the consumer‑facing disclosures. Distributors must keep the relevant digital media and marketing communications updated with any changes a firm makes to the label and disclosures.

The FCA notes that these proposals are consistent with its current expectations on information access and that distributors must comply with existing requirements for the distribution of financial products in the PROD Sourcebook and under the new Consumer Duty.

The FCA is yet to consult on how its proposals will apply to overseas products, and has therefore provided for a temporary approach in the event that rules for UK funds come into effect before those for overseas products. The FCA proposes that distributors of overseas products that are recognised schemes, including exchange-traded funds, must give notice to retail investors that the product is not subject to the labelling and disclosure requirements. The FCA will require the notice to be placed in a prominent place on the relevant digital medium, and be accompanied by a hyperlink to the FCA webpage setting out the labelling and disclosure requirements in further detail.

Persons that offer, sell, recommend, advise on, arrange, deal, propose or provide a product or service will be considered a ‘distributor’. As such, financial advisers and investment platforms through which investors can compare and invest in multiple investment products will be in scope of the rules.

Next steps

The FCA requests that responses to the consultation paper are submitted by 25 January 2023. Following this, the FCA will review feedback received and intends to set out its final rules in a policy statement by the end of the first half of 2023. 

The FCA also intends to follow with further consultations in due course. These consultations include expanding the scope of the SDR regime to overseas and pension products, new rules for financial advisers on taking sustainability preferences into account, disclosure of transition plans, and taxonomy-related disclosure requirements.