Almost a year after the second consultation period closed and two years since the original discussion paper, the Financial Conduct Authority (FCA) has finally published its ‘Sustainability Disclosure Requirements (SDR) and investment labels’ policy statement1. It had been rumoured that the FCA was toying with the idea of playing Santa Claus by launching the policy on Christmas Eve. In the end, however, and perhaps in anticipation of the COP28 negotiations in Dubai (or even to coincide with the morning of WHEB’s own annual investor conference) the policy ‘dropped’ on the 28th November.
After skimming the 200 odd pages of the policy statement, our overwhelming reaction at WHEB was one of relief. As avowed impact investors, the FCA’s original framing of the ‘Sustainability Impact’ label was deeply problematic. The final policy statement however has taken account of our and others’ feedback on this and other contentious points. Our intention will be to adopt the Sustainability Impact label at the first opportunity for all our in scope funds.
It is not an overstatement to say that the SDR will fundamentally change the sustainability investment market in the UK. Several organisations have already produced very useful summaries of the detailed policies in the statement2. But beyond the detail, we believe the SDR will have three strategic impacts. These will affect not just the UK market but many other jurisdictions as they establish their own frameworks for regulating sustainability investments.
Maturing of the market
The most visible change that SDR will bring is a clear differentiation in the market. Over the decades that sustainability investing has developed, distinct approaches have emerged. The SDR formally recognises these different approaches by providing specific labels for the three main variants: ‘Sustainability Improvers’, ‘Sustainability Focus’ and ‘Sustainability Impact’. A fourth ‘Sustainability Mixed Goals’ has also been included in the final policy covering hybrid funds that offer a mix of the other three.
This differentiation will have a profound impact on the market. Conflating these distinct approaches under generic terms like ESG has for many years confused consumers and created space for greenwashing. The formal endorsement by the regulator of these distinct approaches now gives each a legitimate place in the market and will, we believe, enable each to develop further in meeting specific client needs.
Additionality and causality out, intentionality in
We remain convinced that the narrow concept of additionality as applied to the investors’ contribution in impact is deeply problematic and misses the systemic nature of markets. WHEB have been strong advocates for limiting the importance of additionality in the Sustainability Impact label3.
The final policy statement has moved significantly in this direction. For example, while the importance of ‘new’ capital in impact investment is still recognised, critically the policy statement no longer makes it the defining feature of the Sustainability Impact label. Instead, the policy replaces ‘additionality’ as the defining characteristic with requirements to demonstrate investment ‘intentionality’ and provide a corresponding ‘theory of change’ along with measurable indicators of impact.
The requirement to demonstrate ‘causality’ between engagement activities and outcomes has also been removed. It is extremely rare – and probably not even desirable – that companies adapt policies and performance on issues at the behest of a single investor. Instead, the policy now requires detailed reporting on the intentionality of engagement alongside any associated outcomes.
Balancing principles and prescription
We believe that one of the key weaknesses of the European Union’s Sustainable Finance Disclosures Regulation (SFDR) is that it is overly prescriptive in mandating the reporting of specific KPIs. These are often irrelevant for the assets that are held and result in meaningless and sometimes even misleading reporting.
The FCA does a much better job of avoiding this debilitating level of prescription. The principles underpinning the SDR statement are directly linked to the FCA’s obligations to the consumer. Labelled products are required to meet ‘general criteria’ that include setting out the sustainability objective of the product and establishing key performance indicators (KPIs) that the fund needs to report against. Each label then has additional ‘specific criteria’ that products need to comply with such as reporting a theory of change for Sustainability Impact products.
Critically though, and in stark contrast to the SFDR, the detail of the strategy, and the KPIs that are selected, are left to the fund manager to define. This avoids the top-down prescription that has been so painful for the industry and so unhelpful to consumers.
The future of sustainability investment regulation
The SDR is not finished, and it is also not perfect. Discretionary wealth managers still must wait until 2024 to receive proposals governing their activities. We were disappointed to see a 70% threshold applied as the qualifying hurdle for each of the three original labels (we think it should be higher). We have also called publicly for asset managers to disclose all their holdings. We hope that the FCA might make this a requirement as the regulation evolves.
Nonetheless, we see the policy statement and the principles on which it is based as a hugely positive step forward. This is the first major piece of FCA regulation on sustainability investment and in our view will help underpin trust and support authenticity in sustainability fund management.
Several other regulators, including the EU and the US, are reviewing their own approaches to the regulation of sustainability investing. We very much hope that they take note of the approach used by the UK and replicate it in their own policy making.
It has taken a long time to get here. It has been worth the wait.
1 https://www.fca.org.uk/publication/policy/ps23-16.pdf
2 https://esgclarity.com/fca-releases-sustainability-disclosure-requirements/
3 For example see our blog ‘WHEB’s view on the FCA’s proposals for Sustainable Disclosure Requirements (SDR)’ (https://www.whebgroup.com/our-thoughts/whebs-view-on-the-fcas-proposals-for-sustainable-disclosure-requirements-sdr) and our White Paper on Impact Investing in Listed Equities (https://www.whebgroup.com/news/whebs-new-white-paper-impact-investing-in-listed-equities).
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