FCA consultation on new UK sustainability disclosure regime and investment labels

Following some significant concerns with aspects of the proposals set out in the November 2021 discussion paper, many of the proposals in the consultation paper are welcome. The labelling regime is simpler and part of a clear architecture. The disclosure rules "clamp on" to existing requirements, building on those contained in the TCFD-aligned rules in ESG – so while firms will undoubtedly need the additional time to prepare, this will not be a "ground up" exercise. Overall, the FCA has recognised the benefits of developing its proposals on an incremental basis, starting with UK regulated asset managers in respect of UK funds, and then looking to expand to asset owners and other areas later.

While the FCA says that it has considered other initiatives such as the EU's own sustainability regime in EU SFDR and the SEC proposals, there will be some considerable differences.  Annex 1 of the consultation paper addresses the question of mapping the FCA's requirements to EU SFDR requirements and the SEC's proposals on disclosure requirements. However, things may not be as simple as the FCA's mapping flow diagrams suggest. Even if they are, the FCA's diagrams indicate that many products may not map across to a sustainable label (for instance, as we explain in Section 4, an Article 8 EU SFDR product may not qualify for any label under the UK SDR regime).

Annex 1 also includes a table looking at the things that firms making EU SFDR product-level disclosures have to consider and then mapping across to indicate whether each of these are requirements under the UK SDR proposals. It is clear that, in terms of detailed product-level disclosure obligations, UK SDR will not go as far as EU SFDR, at least not on current proposals. By way of example, the UK SDR proposals do not have any requirements which correlate to the EU SFDR product-level disclosure requirements in relation to do no significant harm (DNSH), principal adverse impacts, Taxonomy-alignment or the proportion of investments.

What the FCA does appear to have achieved, in the light of the criticisms around the EU's sustainability measures – particularly regarding the complexity of the rules and the large amounts of data required – is the development of a more consumer-friendly regime for the UK which, it is to be hoped, provides meaningful information to investors. 

That said, the draft rules are highly detailed. Over the coming days and weeks we will be working through them in further detail. In the meantime, we set out a high-level overview of the proposals including how they interact with other non-UK initiatives.

The headlines are set out below. Further details are set out in the rest of this briefing.

• Scope, application and implementation dates: very broadly, for the purposes of this consultation, the detailed rules (on labelling, disclosure, naming and marketing and distribution) are directed at investment funds and the firms that manage or distribute those products, and while some specific, granular requirements apply to funds that are marketed or distributed to retail investors there are significant aspects of the regime that are applicable to, or otherwise relevant to, funds with institutional investors. The earliest that some of these new requirements will come into effect will, on current expectations, be 30 June 2024. However, there will be one general "anti-greenwashing" rule which will apply to all regulated firms and this will come into effect immediately upon publication of the policy statement with the final rules, expected to be 30 June 2023. See Section 3 which sets out further details on the scope and application of the rules for different components of the new regime, together with proposed timings for their implementation.
  
  
• Sustainable investment labels: there will be three, mutually exclusive, labels describing three different types of sustainable product ('sustainable focus', 'sustainable improvers' and 'sustainable impact')(see Section 4). These will be designed for consumers but can be adopted by firms targeting professional investors if they wish. Firms will have to meet certain qualifying criteria to use them, but it will not be mandatory for a firm to have a label. Any products that are not labelled – out of choice or because they do not meet the qualifying criteria – will be subject to new "naming and marketing rules" where they are marketed to retail investors.
  
  
• Consumer-facing product-level disclosures: these will be required regardless of whether a firm's product is labelled, and even if it has no sustainability-related features. See Section 5.
  
  
• Detailed disclosures: broadly, these will be required for institutional investors and any consumers seeking more information and will consist of:
  
  
  • Pre-contractual disclosures: relating to the sustainability-related features of products.
  • Sustainability product report: ongoing sustainability performance information, including sustainability KPIs and metrics.
  • Sustainability entity report: relating to the measures that in-scope firms are using to manage sustainability-related risks and opportunities.

See Section 5 and the application table for more details. 

• "Anti-greenwashing rule": while the detailed requirements referred to above will apply to asset managers and their distributors, as noted above a new general "anti-greenwashing" rule (technically included within the naming and marketing rules) will apply to all regulated firms to the effect that all sustainability-related claims must be clear, fair and not misleading. See Section 6. 
  
  
• Naming and marketing rules: as above, any product that is not labelled (whether through choice or because the qualifying criteria are not met) must meet new naming and marketing rules. Broadly, these will serve to restrict the use of certain prescribed sustainability-related terms in names of products and marketing materials when dealing with retail investors. See Section 6. 
  
  
• Requirements for distributors: broadly, these are to ensure that product-level information (including, where relevant, the investment label) is made available to consumers. See Section 7.

In-scope firms and products

Aside from the anti-greenwashing rule, which will apply to all regulated firms, the new rules on labelling, disclosure, naming and marketing and distribution will generally apply, or otherwise be relevant, to:

• asset managers for the purposes of the ESG rules – i.e. full-scope UK AIFMs, small authorised UK AIFMs, UK UCITS management companies and ICVCs that are UCITS schemes without a separate management company and portfolio managers (together referred to in the consultation paper and this briefing, for convenience, as "in-scope firms"),
  
  
• in relation to "sustainability in-scope business" – i.e. managing an AIF, managing a UK UCITS and (subject to some conditions) portfolio management,
  
  
  • and so, in terms of products, this means unauthorised AIFs (including investment trusts), authorised funds (excluding feeder funds and funds in the process of winding up or termination) and portfolio management services (subject to conditions) which are collectively referred to in the consultation paper and this briefing, for convenience, as "in-scope products",
    
    
• where that business is carried out from an establishment maintained by the firm in the UK.

By way of reminder, "portfolio management" has an extended meaning under the TCFD-aligned rules in the ESG sourcebook: in addition to the regulated activity of discretionary portfolio management, it captures private equity and other private market activities consisting of either advising on investments or managing investments on a recurring or ongoing basis in connection with an arrangement the predominant purpose of which is investment in unlisted securities. That said, only some of new sustainability rules apply when the sustainability product is an agreement or arrangement under which a firm provides a client with such portfolio management.

Potentially out of scope asset management firms?

Firms with assets under administration or management which amount to less than £5bn (calculated as a 3-year rolling average on an annual assessment) are currently exempt from the climate related disclosures under ESG 2. Under the new regime they will also be exempt from the requirements relating to the sustainability entity report, but not – on the face of the rules as currently drafted – from the other new consumer-facing and detailed product-level disclosure requirements, at least not by virtue of their size alone. It is not clear whether this was the FCA's intention.

It may be fair to say, however, that – with the exception of the anti-greenwashing rule – for a manager of a fund that has no retail clients, which does not use any label, which has no sustainability objectives, and which has assets under management of less than £5bn there should not be any new requirements under the proposals. That said, before reaching such a conclusion, it may be safer to drill down further into the granular requirements – particularly, for instance, as regards the obligations of a UK AIFM, that manages an unauthorised AIF not listed on a recognised investment exchange, to meet client requests under the 'on demand' regime.

Overseas funds/products

It is important to note that, for the purposes of this consultation, the FCA clearly states that overseas products are excluded from the in-scope products described above (although it is not entirely clear as to whether the technical definition of "sustainability product", which is essentially the same as the definition of "TCFD product" with some exemptions, quite achieves that carve out, for instance as regards unauthorised AIFs managed by UK AIFMs). The FCA intends to consult separately on extending the regime to overseas products.

Therefore, until such extension, it may be that aspects of the proposals will not have immediate significance for some firms in terms of their technical application (though of course investors may have their own priorities). For instance, the provisions that attach to portfolio managers (including the rules requiring them to link to information on underlying products) may not attach to a UK segregated portfolio manager acting under a delegation from an AIFM in respect of a Luxembourg or Irish fund. There will be other examples where "in scope" firms manage products that are currently out of scope. However, since an extension of the regime would seem to be inevitable, all firms should have regard to the proposals in the consultation since, once settled, they will form the foundations on which the extension will be built.

A note on the use of the terms "retail investors" and "institutional investors"

Throughout the narrative provisions of consultation paper, the FCA uses the terms "retail investor" and "institutional investor" when describing the application of certain parts of the regime, which makes sense given the focus on asset managers and funds. However, it should be noted that, in the draft rules, the terms "retail client" and "institutional client" are used instead. The Glossary definition of "retail client" means a client who is neither a professional client or an eligible counterparty; but the draft rules extend the existing COBS meaning of "client" to capture unitholders or potential unitholders in collective investment schemes and investors or potential investors in AIFs.

Like the consultation, we use the terms "retail investor" and "institutional investors" for convenience in light of the extended meaning of "client".

Scope and implementation of elements of the new SDR and labelling regime

In light of the above, and although the detailed rules should be referred to in all cases, the scope and application of the various components of the new regime can be summarised as below:

Simplification

The FCA's proposals have developed since the discussion paper. In recognition of industry responses, the labelling regime has been simplified. In place of the potentially over-complex five categories, the consultation now proposes three simpler, more consumer-friendly labels. The additional categories or labels set out in the discussion paper – "responsible investments" and "not promoted as sustainable" have been dropped.

Intentionality and no hierarchy

The labelling of products is based on "intentionality" (particularly as regards the sustainability objective the firm is seeking to achieve) and is intended to describe one of three primary channels and investor contribution mechanisms by which an investor may plausibly contribute to positive outcomes. The FCA is at pains to stress that there is no hierarchy; they are different labels designed to describe different profiles of assets. This is to be contrasted with EU SFDR, where, despite the fact there is avowedly no labelling system, an Article 9 product is, in colloquial terms, "greener" than an Article 8 product.

However, underneath the consumer-friendly labelling and descriptions, there are some detailed qualifying criteria. Importantly, if a product does not have a sustainability objective and does not satisfy any of the other prescribed overarching and specific qualifying criteria, a label cannot be used.

The three labels

The table below summarises the three labels and the objectives, investment channels and qualifying criteria that underpin them.

Qualifying criteria

In order to qualify for one of the above sustainable investment labels, a product must satisfy certain criteria, some of which are overarching and apply across the board, others of which are specific to the relevant label:

• Five general, overarching principles:
• • Sustainability objective – a firm must ensure that a sustainability product has an explicit sustainability objective.
  • Investment policy and strategy – a firm must ensure that a sustainability product's investment policy and strategy are aligned with its sustainability objectives.
  • KPIs – a firm must have in place credible, rigorous and evidence based key performance indicators for the purposes of measuring a sustainability product's ongoing performance towards achieving its sustainability objective.
  • Resources and governance – a firm must apply and maintain appropriate resources, governance and organisational arrangements commensurate with the delivery of the product's sustainability objective.
  • Investor stewardship – a firm must maintain an active investor stewardship strategy and resources at both firm and product level, consistent with the product's sustainability objective.

• A number of cross-cutting considerations associated with each of the five general principles above.
  
  
• Specific criteria relevant to the product label (see above table).

As a reminder, if a product does not have a sustainability objective (the first, fundamental principle) and does not satisfy any of the other general and specific criteria, a label cannot be used.  Additionally, any products which, for instance, promote themselves as "ESG-integrated" and which employ exclusion/negative screening strategies, will not qualify for a label on those grounds alone.

There is no longer a "negative" requirement to apply a "non-sustainable" label where the sustainability criteria are not met. However, even if a product does satisfy the criteria for one of the labels, the firm now remains free to choose whether to apply the label.

No label means naming and marketing rules apply

Any products which are not labelled, for whatever reason, must instead comply with the FCA's new "naming and marketing" rules where there are retail investors (see below).

How does the labelling system correlate with international requirements?

The FCA recognises that many firms are already subject to EU SFDR, with its categorisation of products into Article 6, Article 8 ("light" and "mid green") and Article 9 products which (despite EU statements to the contrary) has become something of a de facto labelling system.

In Annex 1 of the consultation paper, the FCA suggests that a product categorised under EU SFDR can be mapped across to the proposed UK labelling system as follows:

Financial Conduct Authority Consultation paper 22/10

The FCA says that an Article 8 product would have to "level up" because of the need to meet the new overarching requirement under the UK labelling regime to specify an explicit sustainability objective.

Whether the above "mapping" is as straightforward as the above suggests remains to be seen. Furthermore, as can be seen, it is entirely possible that a product marketed into the EU under EU SFDR and categorised under that regime will fail to qualify for a label under the proposed UK regime. Article 6 funds will never be able to obtain a label.

There is a similar flowchart in Annex 1 looking at how a product categorised under the SEC's proposals should be mapped across to the sustainable labels (if at all).

Broadly, the FCA intends to proceed with the structural approach to disclosures outlined in its November 2021 discussion paper, with a set of consumer-facing disclosures (containing a subset of more detailed product-level information) and a second layer of more detailed disclosures aimed at institutional investors and other stakeholders (including retail investors seeking more information than is provided in the label and the consumer-facing disclosures).

As outlined in the discussion paper, the disclosures would form a three-tiered system as follows: 

Financial Conduct Authority Discussion Paper 21/4

Consumer-facing disclosures

The consumer-facing disclosures would complement, where relevant, the labels outlined above and provide key, standardised sustainability information for consumers to make investment decisions.

The requirements in relation to these consumer-facing disclosures include the following:

• They should be made available in a prominent place in a digital medium, for instance, the firm's main product webpage.
• They will need to be in a standalone document, alongside other documents that present other key investor information (such as the PRIIPs KID).
• They will have to be no more than "one mouse click away" from the relevant label (if relevant) – for example, by way of a hyperlink.
• They will be required for all in-scope products (regardless of whether they have a label).
• There will be some prescription governing the format and content of the disclosures - the FCA is not introducing a template but encourages the industry to develop a market-led one.
• In terms of frequency, the first consumer-facing disclosures will need to be available at the same time as the label(s) – likely to be from 30 June 2024, depending on finalisation of the rules according to the current timetable.
• Firms will be required to review and update their disclosures annually.

Firms will have to have regard to how their consumer-facing disclosure rules comply with the FCA's new Consumer Duty, particularly the consumer understanding outcome (see our briefing on the Consumer Duty).  This is likely to require firms to test, monitor and, if necessary, adapt their consumer facing disclosures.

Detailed disclosures at product and entity level

Product-level disclosures

Broadly, in terms of detailed product-level disclosures these will consist of:

• Pre-contractual disclosures: setting out the sustainability-related features of an investment product, and to be included in a dedicated section of the fund prospectus or other prior information document (as required under FUND 3.2 for full scope UK AIFMs):
  • The requirement to make these disclosures will apply to all in-scope firms using a sustainable investment label.
  • If the product does not use a label, but nonetheless has sustainability-related features central to the firm's investment policy and strategy, then the expectation is that they will also be included in pre-contractual disclosures.
  • While firms that provide portfolio management services will not be required to produce their own pre-contractual disclosures, they will still have to provide retail investors with a way of linking to the underlying disclosures.
  • Where a product neither qualifies for a label nor adopts any sustainability-related policies and strategies, the firm will not have to make any pre-contractual disclosures.
  • The first pre-contractual disclosures will be required to be made available at the same time as the label and consumer-facing disclosures above – i.e., depending on when the rules are finalised and effective, from 30 June 2024.

• Sustainability product report: this will contain ongoing sustainability-related performance information. The intention is that this will build on the existing requirement for a TCFD public product-level sustainability report as required by the FCA's Environmental, Social and Governance sourcebook (ESG):
  • Where the product does not have a fund prospectus or other pre-contractual disclosure requirements, firms will be required to publish "Part A" of their sustainability product report in a prominent place on a relevant digital medium where the product is offered, such as on product webpage.
  • "Part B" of the sustainability product report will only be required in relation to products using a sustainable investment label (except for firms providing portfolio management services and UK AIFMs managing unauthorised AIFs not listed on a recognised exchange – see below).
    • At this stage it will not be necessary to include a baseline of sustainability-related metrics in the sustainability product report – however, Part B of the report must contain other metrics that a client or consumer might find useful, together with contextual information alongside KPIs/metrics disclosures and historical annual calculations on KPIs/metrics after the first year of reporting.
  • The sustainability product report must be published in a prominent place of the firm's website and must include the information required in ESG.
  • While firms that provide portfolio management services will not be required to produce their own sustainability product reports, they will still have to provide retail investors with a way of linking to the relevant underlying disclosures.
  • As with the "on demand reporting" provisions of the ESG/TCFD rules, there will be recognition that public disclosures are not appropriate in some situations, significantly in the context of (i) UK AIFMs managing unauthorised (and unlisted) AIFs and (ii) firms that provide discretionary portfolio management services to individuals or institutional investors. Where such firms choose to use a label for these products, and their clients need the information to satisfy their own sustainability disclosure obligations, the firm will be required to make non-public disclosures to the client on request on an annual basis. The client will not be able to make such a request before 1 July 2025, in respect of a calculation date no earlier than 30 June 2024 (assuming the new rules enter into force on 30 June 2023).

Entity-level disclosures

This requirement for a sustainability entity report will be phased-in in similar fashion to the introduction of the TCFD-aligned disclosure requirements under ESG – in other words, large asset managers with assets under management of more than £50 billion will be required to make their first entity-level disclosures by 30 June 2025. Other asset managers (except for those with less than £5 billion AUM) will be required to make their first disclosures by 30 June 2026.

There are two elements to the FCA's proposals in relation to naming and marketing.

"Anti-greenwashing" rule – all regulated firms

First, a new, general "anti-greenwashing" rule is being introduced which will apply to all regulated firms. This will require all regulated firms – whether they are undertaking sustainability in-scope business or not, and including firms that approve financial promotions for unauthorised persons – to ensure that any reference to the sustainability characteristics of a product or service is consistent with the sustainability profile of the product or service and that it is clear, fair and not misleading. While other aspects of the consultation are subject to implementation transition, this rule will not be: it will come into force immediately upon the final rules being published – which, as currently proposed, is 30 June 2023.

Ban on use of ESG terminology – non-labelled products and retail investors

Second, firms that provide in-scope products to retail investors where those products do not use a sustainability label (through choice or because the product does not qualify) will be banned from using certain terms in the naming or marketing of that product. These include terms such as "ESG", "climate", "sustainable" or "sustainability", "green", "net zero", "impact", "Paris-aligned" or, for good measure, any other term which implies that a sustainability product has sustainability characteristic.

Broadly, where the product has a label, the distributor must display the label prominently on a relevant digital medium and provide access to the relevant customer-facing disclosures. Where the product does not use a label, the distributor will nonetheless be required to provide retail investors with access to the consumer-facing disclosure.

Consultation closes on 25 January 2023. Industry associations, many of whose comments on the discussion paper were taken into account by the FCA, will no doubt engage. The FCA currently proposes to finalise its rules and publish the policy statement by 30 June 2023.

As mentioned above, the new anti-greenwashing rule will come into force immediately – that is, on current reckoning, from 30 June 2023. Other aspects of the new rules will come into effect on various dates as outlined above in the briefing.

In the meantime, the FCA is continuing to consider whether and how to extend the requirements to pension products and certain other investment products. It is also looking into expanding the regime further to cover overseas funds and products, investment advisers and disclosure of transition plans. It is also considering how to update its existing product-level disclosure requirements to include relevant disclosures once the UK Green Taxonomy is developed.

If you would like further information or assistance in understanding the proposals, please speak to your usual Travers Smith contact or any of the individuals below.