Below is an article I wrote for Investment Life and Pensions Moneyfacts which was published this week (December 2022).

You can download a pdf of the printed version here: p 10-11 SDR What and Why Dec 2022

Please see our other recent blogs for links and our video.

SDR: what and why?

Last month, the World Meteorological Office announced ‘the last eight years have been the warmest on record’, the UN published its emissions gap report ‘The Closing Window’- saying our ability to hold global temperatures to +1.5– 2 C degrees (as agreed in 2015), is slipping away – and their secretary general Antonio Guterres told world leaders, at COP27, that humanity is on a “highway to climate hell”.

This increased urgency chimes with public opinion. Edelman’s trust barometer recently indicated 77% of people were ‘worried about climate change’.  And in spite of many fine words, the financial services community has not covered itself in glory. The 2021 FCA Financial Lives survey (see DP21/4) indicated that 80% of respondents ‘wanted their money to ‘do some good’, while also providing a financial return’ while UKSIF’s 2022 Good Money Week research indicated that only around 20% of people are aware of sustainable investment options.

Increasingly extreme (read as scared) anti fossil-fuel campaigns are calling for government action – bring the mismatch between public opinion and the rate of change to our screens – and roads. Yet emissions continue to rise, the financing of fossil fuel exploration continues, and investors are all too often confused.

Welcome SDR

And so it is that I am happy to welcome the FCAs Sustainability Disclosure Requirements and Labelling consultation paper – SDR.  The SDR is no magic wand, but it is an important cog in the sustainability wheel.

SDR’s focus is to ensure people who care about environmental and social issues are not misled by exuberant marketing claims, or shocked by where funds invest.   Greenwash such as this is damaging for many reasons.  It angers clients, destroys trust and risks capital being misallocated – and so hinders our ability to address global warming.

Importantly SDR positions sustainability within existing rules like ‘clear, fair and not misleading’.  It will create quite a lot of work, but it proposes ‘guardrails’ – that both industry and clients have been calling for, without being prescriptive and risking stifling necessary innovation.

And importantly for the acceptance of SDR, as, let’s be clear – not everyone is going to be on the same page – it is effectively optional. Only those who choose to make sustainability claims are significantly impacted.  Detractors can stop making sustainability claims.

The 179-page consultation, that I will attempt to summarise below, explains broadly how fund managers should describe what they do – and prove it.

There are six core areas that the FCA says they ‘want to change’ (see section 3.2): 

1. Sustainable investment labels. There will be three client friendly, plain English fund labels that managers can chose to use – providing they comply with the relevant requirements.
2. Consumer facing disclosures. Labelled and unlabelled funds will need to be accompanied with client friendly literature setting out what the fund does from a sustainability perspective – enabling interested clients to make better informed choices.
3. Detailed disclosures at product and entity levels. Relevant funds will be required to produce additional detailed information about sustainability objectives, sustainable investment policies and strategies, KPIs, governance and resourcing and (entity level) Stewardship, and about how the firm is managing sustainability risks and opportunities.  The three core strands (see 3.6) are: ‘pre-contractual disclosures’ (ie fund prospectus), ‘ongoing sustainability  performance information’ (ie fund report),  a ‘sustainable entity’ report (asset manager wide report).
4. Naming and marketing rules. Certain words will become protected, and no longer able to be used by ‘unlabelled’ funds in product names and marketing.
5. Requirements for distributors. All parts of the investment chain need to be involved if the right information is to be received by clients. This brings distributers such as platforms and advisers in scope.
6. A general ‘anti-greenwash’ rule will apply to reinforce concepts such as ‘clear, fair and not misleading’. This is likely to be implemented when the policy statement is published.

Exploring the labels

SDR proposes three client facing ‘sustainable fund labels’.  They reflect key elements of retail fund strategies, and are intentionally easy to understand. (They map to – but are different from the EU’s SFDR – as SDR is designed for individual investors).

Each fund can only use one label, set by the manager.  Funds that focus on ESG integration (risk management) and /or stewardship (engagement) activity will not qualify – as this is increasingly ‘business as usual’.

In precis (and alongside standard risk / return objectives) the ‘distinguishing features’ of the labels are:

1. Sustainable focus (4.28)
   • Sustainability Objective of this group include having a sustainable 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.’
   • Additional ‘outcomes’ text describes ‘pursuing sustainability goals via the market led channel of influencing asset prices and thereby reducing the relative cost of capital of sustainable economic activities /projects’ – plus pursuing ‘ongoing improvement’.
2. Sustainable improvers (4.32)
   • Sustainability Objective – must have an objective ‘to deliver measurable improvements in the sustainability profile of its assets overtime, including through investor stewardship’.
   • Additional ‘outcomes’ text describes sustainability goals being primarily pursued ‘via the channel of investor stewardship’ which will be directed towards ‘encouraging and accelerating improvements’. Also references ‘focusing on assets best placed to improve their sustainability profile over time’ and ‘collaborative initiatives’.
3. Sustainable impact (4.38)
   • Sustainability Objective – having an objective ‘to achieve a predefined, positive and measurable environmental and / or social impact’.
   • Additional ‘outcomes’ text describes pursuing sustainability goals by ‘directing typically new capital to projects and activities that offer solutions in underserved markets or to address observed market failures. Products will be expected to have a stated theory of change and to pursue highly selective asset selection.’ Also references stewardship.

Portfolios will be able to use the labels if 90% of their assets fall within a given label. Distributors will be expected to display labels.

All Sustainability labelled funds must meet both the requirements of their label (above) and threshold ‘cross cutting’ (company/firm wide) requirements.

Five overarching principles set out firm level requirements (see boxed text from 4.55), listing key considerations.  In brief, these are:

• Principle 1 – Sustainability Objectives – ‘a sustainable investment product must have an explicit environmental or social objective’.
• Principle 2 – Investment Policy and Strategy – ‘a firm’s investment policy and strategy for the SI product must be aligned with its sustainability objective’. Considerations include identifying any areas that a reasonable investor might consider to be in conflict with the fund’s objective.  
• Principle 3 – key performance indicators – there must be credible, relevant, evidence based KPIs that measure ongoing ‘performance’ against sustainability objective(s).
• Principle 4 – resources and governance – firms must ‘apply and maintain appropriate resources, governance and organisational arrangements’ – ie need to demonstrate they can do what they claim to do.
• Principle 5 – Stewardship – ‘a firm must maintain its active investor stewardship strategy and resources in a manner consistent with… product objectives.’ Additional text references FRC Stewardship Code and COBS 2.2.3.

This is just a brief summary of a complex paper.

My impression is that it has been well received by those who know the area well.

However, this is a consultation.  It is not set in stone.  The following are some areas I think may be subject to further debate, focusing on the labels (4.28) because of their profile.

Discussion points for labels

The Improvers label describes a fund style that did not exist a few years ago – where engagement is central to the sustainability strategy.  This approach has polarised people (in ‘retail’) and turbo charged greenwash allegations – as stock selection is often only minimally changed.  Some managers (often those newer to the area) see this as the only sensible strategy.  Its detractors say it is greenwash. Misleading. Both are right and wrong. The paper sets out the case for higher standards in this area, ensuring there is a genuine focus on encouraging far higher standards and making sure clients know what they are getting. In brief, SDR legitimises it but raises the bar, which I believe is very helpful.

The sustainable focus label is for funds that invest in assets that are regarded as sustainable today.  These funds are typically for people want to invest in positive, forward-looking companies whilst staying away from laggards and major polluters. This is, in my experience, what clients generally expect when they invest ‘sustainably’.  In other words – their focus is positive stock selection. The paper appears a little light on this, putting emphasis ‘the cost of capital’ – which I do not believe clients ever mention.

The paper proposes that only 70% of assets in this label need to be ‘sustainable’.  That means 30% could be doing significant harm.  I believe many clients specifically looking for a ‘sustainability focus’ would find that shocking. Today most well-established sustainable funds allow a 3, 5 or 10% (de minimis) ‘tolerance’ – as a reflection of the realities of investing. Indeed, 30% implies some funds could be ‘browner’ than the old economy weighted FTSE100.  I’d recommend funds of that kind use the ‘improvers’ label and focus on engagement to avoid greenwash criticisms.

By contrast the sustainable impact label sets the bar very high.  This may be a good thing.  It could increase innovation and opportunities in what the paper refers to as ‘under-served markets’.  However, as well as being challenging for investors in secondary markets it opens up a big gap between ‘impact’ and ‘sustainable focus’ funds.  This could leave the many clients who simply want to invest in good companies adrift, particularly in the lower and mid risk ranges.

Leading the way

There isn’t room here to describe everything I believe is valuable or demonstrates leadership in this paper, which as you will have gathered, I support, but here are examples…

The focus on getting the right information to real people, end clients, is most welcome.  The potential trickle-down benefits could be huge.  De-emphasising governance is part of this.  It is important – but most clients don’t understand it.  Likewise, the belt and braces explaining ‘surprise holdings’ (5.38) and ‘general anti-greenwash’ rule are important – as is the combination of ‘entity’ and fund information.

I appreciate some managers, including portfolio managers, may worry about the workload – and be scratching their heads. But I don’t think most of this needs to be too onerous, providing managers understand its purpose. The ‘guardrail’ approach has the potential to be flexible and no client, or fund picker, will want to see 200 pages of reports!

And most importantly, I am confident these measures will stand managers in good stead as scrutiny increases – which is what is needed.  Trust has a key part to play if we are to jam the climate window open.

The FCA is inviting responses by 25 January 2023.

– End –

Julia Dreblow

Founder SRI Services and Fund EcoMarket fund tool

Julia is a member of the FCA DLAG.  The opinions expressed here are her own.

Consultation paper and questions: https://www.fca.org.uk/news/press-releases/fca-proposes-new-rules-tackle-greenwashing

links to reports mentioned are available via our blog https://fundecomarket.co.uk/help/blog