Travers Smith's Sustainability Insights: Sustainability labels for the UK

A regular briefing for the alternative asset management industry.

When the UK left the EU, it could have chosen to copy out the EU's Sustainable Finance Disclosure Regulation (SFDR). Many observers assumed it would do just that. Having a single set of sustainability rules would have made sense for many firms, for whom Europe is still a single market, and British policymakers were keen to emphasise their green credentials.

But, of course, the UK government of the time had little appetite for copying out EU rules – and the mood has only hardened since. Prime Minister Sunak's rhetoric contemplates a bonfire of EU law. The UK thinks it can do better, especially in relation to financial services.

Time will tell whether the government is right about that, but doing better than the SFDR will not be hard. The EU can take credit for being first out of the blocks, but the costs of implementing rules that even the regulators do not understand has been immense. Lack of a coherent policy objective and over-hasty implementation led to muddled regulation that has created confusion in the market.

The UK has been working on its own version of SFDR for some time, and when the regulator, the FCA, published draft rules for consultation at the end of last month it became clear that it is following quite a different path. While the benefits of inter-operability with the SFDR were acknowledged, the proposed UK rules will look very different. (See our detailed note.)

The FCA proposes to introduce a general "anti-greenwashing" rule, which makes clear that ESG disclosures must be "clear, fair and not misleading". This doesn't add much to the existing law, but is a reminder that the regulator is planning to step up enforcement action against firms that fail to deliver on ESG pledges.

All UK firms with more than £5 billion under management or advice will soon need to produce TCFD-aligned disclosures. The FCA now proposes to expand these to cover sustainability-related risks and opportunities more generally, using international accounting standards. At the moment, these are proposed to be fairly high level, adopting the TCFD's four themes.

But the centrepiece of the proposals is a labelling regime. The UK has learned from the EU's misstep here, and intends that the labels have clear and easy-to-understand definitions. They will be entirely optional – products, even those with sustainability features, will not be labelled unless a firm wants them to be. The labels are designed primarily with retail investors in mind, although any UK fund could use them if it wished.

Three mutually exclusive labels are proposed: Sustainable Focus, Sustainable Improvers and Sustainable Impact. Any firm using a label will have to comply with some overarching principles as well the category-specific criteria, and the bar is set quite high.

The FCA offers a suggested mapping to the SFDR categories and those more recently proposed by the SEC, and asserts that many SFDR Article 8 products would not qualify for any of its labels. For example, exclusion policies would not be enough to qualify for a label, and any labelled product must have a clear, measurable, and specific sustainability objective. (While this FCA mapping is helpful, it will not be definitive; firms will have to work out how to navigate these differences for themselves.)

Product-level disclosures, both pre-contractual and periodic, will be significant for those firms that choose to use a label, but fairly light for those that do not. If the product has retail investors, it will need to have consumer-facing disclosures, whether it is labelled or not. More detailed disclosures are required for retail or institutional products that have "sustainability-related features that are integral to their investment strategy", and these will need to be kept up to date. But only labelled products will have to prepare a "sustainability product-level report", again drawing on developing international standards.

...the centrepiece of the proposals is a labelling regime. The UK has learned from the EU's misstep here, and intends that the labels have clear and easy-to-understand definitions.

As with the TCFD-aligned rules, firms managing private, unauthorised funds are not subject to public product-level disclosure requirements. Instead, their "client" (usually, on a strict reading of the rules, the fund) can request equivalent information "on demand"; firms might also want to consider making these disclosures available to any fund investor that asks for them.

Firms targeting retail investors will also be subject to a naming rule, to ensure that – unless they use a label – the name of the product and its marketing material does not use certain sustainability-related terms. As currently proposed, that rule would not apply to funds with only institutional investors.

That means that a UK-regulated private capital firm with no retail investors and which does not choose to use a UK label will only have additional product-level disclosure obligations to the extent that a UK product has core sustainability features, and these disclosures will be limited. The FCA is also not currently planning to apply the rules (and therefore the option to use a label) to non-UK funds that are marketed to UK investors, although it says that it may do so in future. (The current rules do not clearly exclude non-UK products managed by a UK firm from scope.)

The draft UK rules are subject to consultation until January, and it is expected that they will be finalised by the end of June 2023. Apart from the general anti-greenwashing provision, which will apply immediately, the rules will come into force in stages from June 2024 onwards.

It is noteworthy that the FCA rejects the EU's "principal adverse impacts" regime, preferring to use international standards, and has no equivalent of the SFDR's "do no significant harm" test, which it says is too restrictive. Currently, there are also no requirements to report Taxonomy-alignment, although that may change when the UK Taxonomy has been developed.

There is a lot of detail to work through in the FCA's proposals and the private capital industry is already preparing its response. But so far, the signs are good. The FCA has clearly listened to the market's feedback on its 2021 discussion paper and simplified and modified its proposals accordingly.

Private markets firms that are still grappling with SFDR (and the EU Taxonomy, and forthcoming US rules) will not welcome having to get to grips with a new set of sustainability disclosures – and the market has legitimate concerns about regulatory fragmentation, and the resulting complexity and lack of comparability. But the UK was never going to copy out the SFDR, and it is welcome that its proposals are, on the whole, proportionate and well-calibrated.

Of course, the EU and US regulators both oversee much larger markets than the FCA, and the impact of UK sustainable investment regulation will be significantly more limited. Nevertheless, the regime will be important for asset managers with a UK footprint – and the British government no doubt hopes that it might also influence the development of rulebooks in those jurisdictions.

We will be hosting a webinar towards the end of January to discuss the FCA's proposed new UK sustainability rules. As well as explaining what the rules will mean for private capital firms, we will discuss the industry's reaction to them. If you would like to register your interest in joining this webinar, please email us.

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