Explaining the FCA’s Consultation Paper on the UK’s Sustainable Disclosure Requirements (SDR)
What’s new from the FCA’s consultation paper, and how does SDR compare to the EU’s SFDR?
The FCA published its delayed Sustainable Disclosure Requirements (SDR) consultation paper (CP). SDR will mandate the disclosures that different sustainable funds need to make in the UK, and outlines three labels to represent different types of sustainability: ESG Focus, ESG Improvers, and ESG Impact. This will be of great interest to our clients – particularly asset managers – who operate in the UK. The three labels are a change from earlier expectation that the regulation would stipulate five categories, with the FCA opting for a more simplified approach. The FCA has stressed that the labels are not hierarchical and instead indicate the objective of the fund:
- “Focus” – this label suggests that the fund maintains a high standard of sustainability in the profile of the assets (fund should invest at least 70% in sustainable assets suggested in the CP).
- “Improvers” – this label is the most novel and indicates that the product invests in assets that may not be sustainable at present but that have committed to improvements. Key to this category is the idea of “stewardship” on the part of the asset manager to make a “measurable” improvement in underlying ESG performance.
- “Impact” – these are products with a specific sustainable outcome as an objective (to “achieve a pre-defined, positive and measurable environmental and/or social impact”, with no minimum sustainable investment required)
- Other – funds that do not meet the criteria for a sustainable label. It is worth noting here that the FCA intends for all firms to consider ESG risk as part of their fiduciary duty.
That the labels are mutually exclusive and not hierarchical presents one potential problem: what if a fund both performs well on sustainability metrics (either through focus and impact) but also commits to improve the underlying performance of the assets it invests in (through stewardship)? In this case, it is not clear which label the fund should select, and it makes it more likely that financial market participants will have to trade-off different objectives. The treatment of funds of funds that encompass multiple strategies is also a question mark.
Disclosures will be split between pre-contractual, and then ongoing product and entity level sustainability reports. The pre contractual materials will include information on the sustainability objective and investment strategy. The product report will include TCFD information and sustainability performance metrics. Both of those will be summarized in an “easy to digest” consumer facing report. Then finally, the entity report will include TCFD data and other entity level sustainability disclosures.
Key Differences: UK SDR vs. EU SFDR
In short, the main differences are that the UK is defining its labels and where a fund is focusing on sustainable investments, it will require a minimum percent of sustainable investments. This offers more clarity to funds in determining their appropriate label and potentially will offer investors more certainty in selecting funds that reflect their preferences. The UK is also not including, for now, any “do no significant harm” requirements or using “principal adverse indicators”.
Below is a table (See Table 1) that summarizes the key differences between SDR and SFDR from the above mentioned consultation.
Table 1 (Source: FCA.org.uk)
Some key differences to highlight:
– The overall level of convergence between SFDR and SDR may be lower than the market would have hoped. In terms of leveraging compliance efforts from SFDR and SDR (in its current form), there is only limited crossover. This will engender costs for the industry.
– The three labels proposed in SDR (focus, impact, improver) do not correspond to the three categories in SFDR (Article 6, 8 and 9).
- The SFDR categories are not labels and instead represent levels of disclosures that the fund will make.
- The FCA labels cover different objectives, whereas the three SFDR categories do suggest a hierarchy of sustainability. There is a minimum set of criteria for each SDR label (unlike SFDR).
- e.g. for a “focus” fund, they must commit to invest in 70% sustainable investments.
– The FCA approach potentially offers more clarity to both asset managers in determining their appropriate label and related disclosures and also to investors in choosing funds that reflect their preferences.
– For determining whether investments are sustainable or not, the UK proposal offers some divergences from SFDR.
- The SDR does not contain a “do no significant harm” test. This may be introduced at a later stage but for now the FCA views it as too restrictive.
- The SDR also does not include any reference to Taxonomy alignment. We expect this to change when the UK Taxonomy is developed.
- Finally, the SDR does not have any reference to the reporting of Principal Adverse Impact indicators (PAIs).
– The SDR introduces an interesting concept of “unexpected investments”. This is where a financial market participant would need to explain the presence of any holdings within a product that an investor may not reasonably expect to be there. The market is not clear what this means and it is very subjective. One view is that it is analogous to the requirement in Article 9 of SFDR that funds make only sustainable investments except for instruments intended for hedging or cash management. Perhaps the unexpected investments gives a fund manager the ability to invest in instruments not directly related to the fund’s strategy?
– There is no “ESG integration” label in SDR. It is instead expected that all funds consider ESG risks in their investment decisions (in accordance with their fiduciary duty). For SFDR, Article 6 (the default category) also expects as a minimum that funds explain how ESG risks were taken into account for investment decision making (though it is possible for firms to explain that they did not take them into account).
– SDR – employing insights from behavioral economics trials – has suggested differing disclosures for retail investors that summarize the key information (with longer disclosures also available). This will help retail investors understand the most material information for making their investment decisions.
– FCA will look to develop quantitative KPI disclosures based on, amongst other things, TCFD and ISSB standards.
Clarity AI intends to respond to the consultation, leveraging our extensive technology-driven data set to ensure the final rules achieve their goal of enabling investors to confidently choose sustainable investments that can deliver investors’ intended outcomes.