The Sustainability Disclosure Requirements and Investment Labels Rules: Tougher ESG Standards for UK Private Fund Managers

In our previous client alert, FCA ESG Rules: The Next Deadline for UK Private Fund Managers, we noted the likely expansion of the Environmental, Social, and Governance Sourcebook (ESG Rules) of the UK Financial Conduct Authority (FCA) following consultation on Sustainability Disclosure Requirements (SDR) and investment labels, noted in DP21/4: Sustainability Disclosure Requirements and investment labels | FCA. The FCA has now published its consultation paper CP22/20 (CP 22), which covers sustainable investment labels, disclosures, naming and marketing, and distributor-specific rules.

CP22 is open until 25 January 2023. The FCA intends to publish final rules by 30 June 2023, expanding the ESG Rules. An ‘anti-greenwashing rule’ is expected to come into force on 30 June 2023 with a phased-in implementation of the remaining rules, with milestones on 30 June 2024, 30 June 2025, and 30 June 2026.

The FCA’s overall aim in CP22 is to increase transparency on the sustainability profile of products and firms and reduce the risk of harm from greenwashing which, for the FCA, means making exaggerated, misleading, or unsubstantiated sustainability-related claims about products that don’t stand up to closer scrutiny. CP22 also proposes rules with the aim of protecting consumers, providing better comparables among products and ultimately increasing capital flows into sustainable activities.

For a manager to use one of the three sustainable labels proposed in CP22, its fund will have to have a sustainable objective aligned with its investment objective that meets the specific high-level entry criteria of a label.

We expect that many existing funds will not currently qualify, but that the proposed FCA approach gives managers time to consider how their strategies may be shaped in the future if they choose to seek to use a sustainable label.

Although materially different from the EU Sustainable Finance Disclosure (SFDR) regime, the FCA sets out how it foresees the relationship with these rules and the US Securities and Exchange Commission (SEC) ESG proposals. The FCA indicates that it intends to try to dovetail its requirements with the EU and US requirements, seeking efficiencies between initiatives where possible.

We have set out our initial thoughts on how CP22 aligns with the EU and US regimes, as private fund managers will need to consider all of the significant ESG disclosure standards when raising funds and in the ongoing management of those funds. We also provide a broad overview of and our general thoughts on the CP22 proposals.

Comparing CP22 with the EU and US Regimes

There are some fundamental differences between the FCA proposals and the other regimes. The obvious differences are that the rules proposed in CP22 do not currently include the equivalent of the SFDR’s ‘do no significant harm’ disclosures, taxonomy-alignment, principle adverse impacts, or SEC or EU templates. We would flag a few pros and cons of the contrasts we have drawn, set out below.

• Helpfully, SDR recognises that transitional strategies can be categorised as sustainable (which is not the case under SFDR and would not fall under an Article 9 product or be separately acknowledged)

• There is an expectation that product disclosures in other regimes will map across to SDR (for example, the SFDR obligation to report on monitoring a sustainability objective is aligned with the SDR Key Performance Indicators (KPIs)-related product disclosures). Consumer-facing disclosures in SDR will have to be considered separately

• The FCA also intends that products can be mapped across regimes. In our view, the reality is that there will be a limited amount of overlap, at least to start, as many Article 8 funds may not achieve an FCA label (Sustainable Focus or Sustainable Improvers is suggested) given the high hurdles in the criteria to be met

• SDR entity-level disclosures can cross-refer to group or affiliate reports containing other sustainability disclosures, including under SFDR, Task Force on Climate-related Financial Disclosures (TCFD) for asset managers and listed issuers, providing the disclosures are SDR-compliant (and comply with the cross-referencing rules). Again, the ability for firms to achieve these efficiencies may not be seamless

For UK managers in scope of the FCA proposals as well as any of the EU, US, Asian, or other regimes, we expect compliance to be an involved and delicate exercise of assessing and disclosing in parallel on a case-by-case basis.

The 'Anti-Greenwashing Rule'

The FCA proposes an express rule that reiterates requirements for all regulated firms (therefore capturing firms that approve financial promotions for unauthorised persons) that sustainability claims must be fair, clear, and not misleading.

Whilst not strictly necessary (many firms already ensure this for client communications), it gives the FCA more range to challenge and enforce against firms falling short on sustainability issues in particular.

Sustainable Investment Labels: High Bar to Meet the Qualifying Criteria

In-scope firms can only use one of the three proposed product labels where they meet the criteria for the relevant label (set out in the table below) as well as five general criteria in respect of their products/funds, set out below.

1. The fund’s sustainability objective is expressed in clear, specific, and measurable terms as part of its investment objective with a credible link to an environmental (E) and/or social (S) outcome. A firm has to have adequate processes to monitor performance against its sustainability objective and provide ongoing reports to clients
   
   
2. The fund’s investment policy and strategy are aligned with its sustainability objective
   
   
3. A firm has in place KPIs in order to measure a sustainability product’s ongoing performance towards achieving its sustainability objective
   
   
4. A firm must apply and maintain resources, governance, and organisational requirements that are commensurate with the delivery of the sustainability product’s sustainability objective
   
   
5. A firm must maintain and apply an active investor stewardship strategy and resources (at firm or product level) for achieving the fund’s sustainability objective

Firms select their labels and whilst independent verification is encouraged where considered helpful to investors, it is not a requirement. When using a label, a firm is subject to various obligations, including: to notify the FCA within one month and adopt its graphic, to publish the label on a prominent place on its website, and to signpost consumer-facing disclosures. A firm cannot use the label in a misleading way. It must also prepare and maintain records on the use of the label. Firms must review their product labels at least annually and give investors at least 60 days written notice in advance of any changes.

	Sustainable Focus	Sustainable Improvers	Sustainable Impact	No Sustainable Label
Consumer-Facing Description	‘Invests mainly in assets that are sustainable for people or the planet’	‘Invests in assets that may not be sustainable now, with an aim to improve the sustainability of those assets for people or the planet over time’	‘Invests in solutions to problems affecting people or the planet to achieve a real-world impact’	Products that do not meet the criteria for a sustainable investment label
Specific Criteria for Each Label	At least 70% of the sustainability product’s assets either: (i) meet a credible standard (i.e. that is robust, independently-assessed, evidence-based, and transparent) of E and/or S sustainability, or (ii) align with a specified E and/or S theme	The sustainability product is invested in assets that have potential to become more sustainable over time (either E and/or S), including in response to investor stewardship	The sustainability product’s objective aims to achieve a pre-defined, positive, measurable real-world outcome in respect of an E and/or S outcome
Other Criteria of Note	Firm must take measures to restore compliance (where it ceases to meet the above requirements for reasons beyond its control) as soon as reasonably practicable, having regard to investors’ interests KPIs that are credible, rigorous, evidence-based, and relevant Cannot use ‘impact’ in naming and marketing	Product may be broadly invested across sectors KPIs to enable a firm to be held to account for performance over time Cannot use ‘impact’ in naming and marketing	A firm must develop a theory of change to show how its investment process aims to contribute to E and/or S issues, a robust method to measure and demonstrate the impact of its activities and an escalation plan to cater for potential changes Manager to seek to avoid unintended negative E or S impacts KPIs that apply enhanced impact measurement and reporting based on industry best practices

Fund Managers in Scope (And Impact on Those Who Are Not Caught)

Those within scope include UK full-scope alternative investment fund managers (AIFMs), small authorised UK AIFMs, and firms carrying out portfolio management in respect of both authorised funds and unauthorised AIFs (listed and unlisted). Portfolio management services are only within scope if 90% or more of the value of all its investment products qualify for the same label (in which case it must make disclosures for each of the underlying products available to consumers).

Products that do not qualify to use a label may still have to produce SDR disclosures, where sustainability characteristics are an integral part of a product’s investment policy or strategy (i.e. a firm has specific policies and strategies in place regarding ESG characteristics of a product). In these cases, a firm must provide details of its sustainability products in its pre-contractual materials (for small AIFMs, its sustainability product report) as set out below.

Disclosures: Tiered and Standardised for Consistency and Comparabiliy

Disclosures can be grouped into three (and with two sub-categories for product level disclosures). All of them must be published on a prominent place on a firm’s website/product webpage and with clear signposting from other key investor information (e.g. a PRIIPs KID) — although note there is a carve out for those (including certain UK AIFMs and portfolio managers) who can provide product reports on request instead.

1. Consumer-Facing Disclosures for Retail Investors Only

These are to help consumers understand the key sustainability-related features of an investment product (including its sustainability objective, investment approach, and performance) and identify the sustainability label (or know none apply, if this is the case). A maximum length of two sides of A4 paper when printed, it is to be accessible in digital format and tailored to the retail customer.

These disclosures are relevant for those in-scope of sustainable investment labels (set out above) and that are marketing to retail (i.e. non-professional) investors. There is a carve-out for firms providing portfolio management services, that instead have to provide an index of the underlying in-scope products linking to their label and consumer-facing disclosure.

2. Detailed Product Level Disclosures for Labelled (And Some Other) Products

Firstly, pre-contractual disclosures about the key sustainability-related features of products (specifically relating to sustainability objective, investment policy, and strategy and stewardship) should be provided in a firm’s prospectus or pre-contractual materials (for small AIFMs, they should sit in the sustainability product report — see below). There are extensive provisions setting out the detail to be disclosed, including the extent to which the sustainability objective has (or may have) impacted on financial return, a description of the product’s investible universe and its asset-level selection criteria, any ‘unexpected investments’, and any investment that might be considered in conflict with the sustainability objective, investment policy, and strategy of the product. Firms using ‘sustainable improvers’ or ‘sustainable impact’ labels have to provide additional information.

These disclosures apply to all in-scope firms (except those providing portfolio management services as set out above) that either use a sustainable investment label or where sustainability-related features are integral to the investment policy and strategy. 

As is consistent with product labels, firms must review the consumer-facing and pre-contractual disclosures at least annually (and before any product changes), provide updates on the progress of the product in meeting its objective, and give investors at least 60 days written notice in advance of any revisions to its disclosures.

In addition, those in scope must prepare a dedicated sustainability product report containing ongoing sustainability-related performance information. This report includes the content from the ‘TCFD product report’ and, as for TCFD reports, can cross-reference to other TCFD-aligned reports (subject to certain provisos). The FCA plans to expand the content of this report in due course, to include metrics for all products, regardless of whether or not a label is used, as well as against the UK Green Taxonomy (once developed). 

UK AIFMs of unauthorised and unlisted AIFs and firms providing portfolio management services are subject to an ‘on demand’ regime (rather than to publish annually), to be provided where a client requires that information to meet its own legal obligations. Firms are encouraged, where practicable, to extend this client reporting to others. Firms are to ensure the disclosures are consistent with the sustainable investment label and update them annually.

3. Sustainability Entity Report

The sustainability entity report introduces new core entity-level disclosure requirements based on the TCFD recommendations (around governance, strategy, risk management, and metrics and targets). The FCA points firms towards the International Sustainability Standards Board (ISSB) requirements and SASB standards as helpful references. This report must have a statement, signed by a member of senior management, confirming that the disclosures (including any third party or group disclosures cross-referenced in it) comply with the ESG Rules.

Restrictions on Use of Sustainability-Related Terms in Product Names and Marketing to Retail Investors

These proposed restrictions are to ensure that those marketing products to retail investors in which those products do not use a sustainable label cannot promote them as sustainable through names or in marketing materials (although firms may use such terms in their disclosures). A non-exclusive list of prohibited terms for product names and marketing is set out — for example, ‘ESG,’ ‘climate,’ ‘impact,’ ‘sustainable,’ ‘transition,’ and ‘green’. 

Timing

Item	Expected Date
The anti-greenwashing rule	30 June 2023
Distributors offering in-scope products that have a sustainable investment label to retail investors (including platforms and financial advisers) must display the label applied by the firm prominently on the product webpage and provide access to the accompanying consumer-facing disclosures	30 June 2024
Labelling, naming, and marketing consumer-facing and pre-contractual disclosures	30 June 2024
The labelling regime for portfolio management services	30 December 2024
Sustainability product reports (those subject to the ‘on demand’ regime, from 1 July 2025)	30 June 2025
Sustainability entity reports for in-scope firms with £50bn or more AuM	30 June 2025
Sustainability entity reports for the remaining in-scope firms with £5bn or more AuM	30 June 2026

Data Gaps

The FCA acknowledges the issue of data gaps and methodological challenges causing some disclosures around metrics to be misleading. It states that such metrics should only be disclosed (along with an explanation) if a firm can address these by using proxy data or assumptions. Otherwise, where a metric may still mislead, a firm must explain the gaps, why it has been unable to address them, and steps it will take to address the gaps or challenges in the future. Data relied on for labels must be accurate and complete (including through use of proxies and assumptions where appropriate) and are not subject to this proviso.

Work in Progress

The FCA intends to expand the SDR and labelling regime in several areas, namely: to overseas products, to pensions and other investment products, to financial advisers, asset owners, and listed issuers. Also it intends to develop the ESG Rules to include reference to TCFD-aligned transition plans and UK Green Taxonomy disclosures, to add a baseline of core metrics, and to add more specificity and granularity in line with the development of future ISSB standards. Finally, the FCA plans a post-implementation review three years after the rules come into force.