The FCA introduces fund labels in the UK, departing from the EU’s disclosure regime (SFDR)
On 28 November 2023, the UK’s Financial Conduct Authority (FCA) published the Sustainability Disclosure Requirements (SDR) and investment labels policy statement (PS23/16). The policy statement introduces rules that could impact all regulated financial entities in the UK. Asset managers wanting to use a “sustainability label” or sustainability-related language in product names or marketing materials have until July 2024 to prepare.
SDR Regulatory Overview
The policy statement is part of the UK’s broader sustainable finance program and introduces a number of measures including:
- An anti-greenwashing rule for all FCA-authorised firms;
- Four investment labels for sustainable funds;
- Naming and marketing rules restricting the use of certain sustainability terms in fund names and marketing materials;
- Consumer-facing disclosures related to the labels and other detailed disclosures;
- Requirements for distributors who pass the information to the end investors; and
- Reporting obligations related to product and entity-level TCFD reporting.
The rules begin coming into force from May 2024 with the labels ready for asset managers to use from July.
Four Investment Labels: A Departure from SFDR
Many commentators have observed the confusion emerging from the EU’s decision to make SFDR a disclosure-based regime. With the benefit of hindsight, it can now be seen that the three fund designations under SFDR – Article 6, 8 and 9 – have become de facto labels leading to some confusion amongst fund managers, distributors and end investors.
The FCA, in building its SDR proposal, had the benefit of a second mover advantage and seems to have made a conscious effort to improve on some areas of perceived weakness within the SFDR. This includes the introduction of explicit labels for sustainable funds. Interestingly, as part of its ongoing Level 1 review of SFDR, the European Commission appears to be considering options that mirror closely the proposal from the FCA.
Key general qualifying criteria for all labels:
Amongst other things, all products using a label should ensure the following:
- Sustainability objective: those products using a sustainability label must disclose their objective that should facilitate a positive environment or social outcome. Firms must disclose if positive sustainability outcomes may result in material negative outcomes.
- Investment policy and strategy: A minimum of 70% of a product’s assets must be invested in alignment with its sustainability objective(s), referencing a robust, evidence-based standard that is an absolute measure of environmental and/or social sustainability. Firms must disclose any other assets held in the product for other reasons (eg, cash, derivatives), including why they are held.
- KPIs: Firms must identify KPIs to measure the progress of their sustainability objectives and regularly report on these to their investors.
- Stewardship and escalation: while some of the ideas around “active” stewardship have been watered down from the initial proposal, firms must still disclose the stewardship strategy needed to achieve their sustainability objectives. Firms must also set an escalation plan for when assets do not demonstrate sufficient progress towards the sustainability objective or KPIs.
To begin with, the regime will only apply to UK funds: overseas funds, pensions and portfolio management are all out to begin with.
The four labels are:
- Sustainability Focus:
- Funds that maintain an evidence-based and robust standard of sustainability in the profile of the assets
- E.g. through revenue aligned to a sustainability outcome or reference to an authoritative taxonomy such as the EU Taxonomy
- Sustainability Impact:
- These are products with a specific sustainable outcome as an objective consistent with an aim to achieve a predefined positive measurable impact in relation to an environmental and/or social outcome, including a “theory of change”
- E.g. through demonstrating an alignment to specific impact focused metrics
- Sustainability Improvers:
- Funds that invest in assets that may not be sustainable at present but that have potential to improve over time. Funds must select KPIs to measure over time and include short and medium term targets for improvement
- E.g. by showing improvement on certain KPIs towards a credible standard of sustainability at asset or company level over time, or investing in assets on a pathway to net zero by 2050
- Sustainability Mixed Goals:
- This label is addressed towards mixed assets and other funds that invest in products that use a mixture of the above three labeling categories. Funds must disclose the proportion of assets invested in each labeling category.
How Can Clarity AI Support UK Asset Managers to Align with SDR
At Clarity AI, we monitor sustainable regulatory developments that could impact our clients. Wherever relevant, we engage in the development of such regulations. In this case, we responded to the FCA’s consultation on SDR in January 2023.
At a high level, we see similarities between the philosophy of the regulation and Clarity AI’s own approach to sustainability. Different stakeholders will have different priorities and objectives when it comes to sustainability and will view the issues through different lenses. We see a need for some hard guidance on what is meant by “sustainability” and related terms to avoid greenwashing, increase accountability and protect consumers. Checks and balances are also important. But we also see value in allowing some degree of flexibility and customization to allow the emergence of different strategies and objectives. This only works where the market embraces transparency and facilitates full traceability and visibility on how sustainability is being defined and the data and KPIs that sit behind that. We believe the FCA’s rules lay the groundwork for this approach and Clarity AI supports such transparency and customization.
That is why we have always offered sustainability solutions covering a breadth of different strategies. The tools are always customizable by the end user, including the data used, the methodology underlying the analytics (including materiality, for example), and the tools to visualize and manage the information. And always in a fully transparent and traceable manner. Such an approach can support fund manufacturers to define, describe and communicate their sustainability objectives – and use of any SDR label – by mapping the fund’s objective and strategy to specific data points and KPIs to monitor and evidence its performance.
As a result of this cross-over, Clarity AI is amongst the first providers in the market to develop a bespoke solution for fund labeling under SDR. The solution allows financial institutions to label their products as Sustainable Focus, Improvers, Impact and Mixed, in line with the SDR rules.
The dataset includes coverage of 70,000+ companies (including subsidiaries), 430,000+ funds, and 400 national and local governments, depending on the selected KPI. We offer a wide range of sustainability metrics, including Climate Temperature Alignment, SFDR PAIs, EU Taxonomy Alignment, and SDGs Revenue Alignment.
This allows users to:
- Create funds that align with specific labels
- Evaluate existing funds for UK SDR eligibility
- Regularly monitor fund’s performance
- Benchmark portfolio against industry peers and report against KPIs
The UK SDR is a major development for sustainable finance regulation globally. The labeling regime marks a departure from the EU’s SFDR and it is an approach that we expect will be mimicked by jurisdictions across the globe in the coming years. By allowing its users to visualize and monitor their investments against KPIs, Clarity AI is supporting UK financial institutions to prepare for the July 2024 deadline.
