The FCA's discussion paper on sustainability

A regular briefing for the alternative asset management industry.

Private markets firms have faced a barrage of complex and confusing sustainability regulation in recent years. Most of that has emanated from the EU – most notoriously, the SFDR, but also the Taxonomy Regulation and changes to the AIFMD rulebook. The UK has also been ramping up its regulatory interventions. As well as preparing for a new (slightly delayed) UK disclosure and labelling regime – which will be quite different to the EU's SFDR – firms also need to gather the data required for demanding new climate-related reporting requirements. That will be resource-intensive for firms this year.

So when the UK regulator tentatively floated further rule changes in a discussion paper issued in February, the market did not exactly welcome the idea. While there may be a place for additional rules on sustainability in the future, firms need time to absorb the existing and forthcoming changes before new ones are promulgated.

That was very much the BVCA's message in its response to the FCA's discussion paper. The industry association urged the regulator to allow the landscape to evolve further before introducing specific new rules on governance, remuneration and competency. There may a role for further guidance, and perhaps even high-level requirements, but not (yet) for prescriptive new rules. (In the meantime, the BVCA, Invest Europe and other industry associations are playing a vital role in helping firms prepare: see, for example, this excellent guide to TCFD reporting prepared by the BVCA in conjunction with iCI and KPMG.)

Other responses – including from UKSIF, the UK's leading membership organisation for sustainable finance – made similar points: there is a role for the regulator in promoting industry wide and sector specific guidance, but firms will have a variety of approaches to sustainability, driven by their business model and investor preferences, and a single set of detailed rules would not be appropriate.

Many respondents also pointed out that existing sustainability-related rules already cover several of the areas highlighted by the FCA. For example, the UK's TCFD-aligned reporting rules require firms to disclose how they are considering climate-related factors in their governance, strategy and risk management processes.

The FCA is already, rightly, focused on greenwashing. A separate proposal, currently in the final stages of development, is expected to lead to a general "anti-greenwashing" rule later this year. Consistently with that focus, some responses noted that there is clearly a role for rulebooks to ensure that firms have the resources and expertise to deliver on the commitments that they have made to investors and other stakeholders, and that their approach to remuneration is consistent. But it is not for the FCA to dictate what those commitments should be.

In fact, that has been the approach of the European Commission in its changes to the AIFMD (and other sectoral) rules: a requirement to take account of financially material ESG risks in due diligence and to maintain the resources and expertise to do so; a requirement to take account of other material impacts only if the firm has committed to do that; and a requirement to consider sustainability issues in conflicts and risk management policies, and organisational and governance arrangements.

"… behaviour is already changing in response to growing investor demands and economic incentives, so it is not clear that there is a market failure that justifies further regulatory intervention."

Adding some similar judicious references to sustainability may be a way to signal to firms that the FCA expects them to focus on ESG as part of their normal business processes – and would be a proportionate response to a new requirement that the regulator should "have regard to the Government's ambitions for the provision of sustainable finance". Whether such rule changes would make a meaningful difference to behaviour may be doubtful – but behaviour is already changing in response to growing investor demands and economic incentives, so it is not clear that there is a market failure that justifies further regulatory intervention.

Indeed, some of the mooted regulatory interventions could do more harm than good. In a compelling article published as part of the discussion paper, Tom Gosling, Executive Fellow at the London Business School, reminds us that, while linking ESG to pay "sounds like a no-brainer", it is far from straightforward. Although there may be circumstances when stretching ESG targets, measured by transparent and reliable key performance indicators, are helpful, Gosling argues that "regulators … should not assume that ESG targets are always appropriate or that all ESG issues should be included in pay". Indeed, UKSIF's response echoes Gosling's concern that the wrong targets and metrics will only result in higher pay, without moving the needle on real-world outcomes. And the BVCA points out that, although some impact funds are linking carried interest pay outs to impact objectives, the market is still innovating. Prescriptive regulatory requirements would be premature.

The FCA has some pretty big operational objectives: to protect consumers from "bad conduct"; to promote competition; and to maintain the integrity of the UK financial system. No doubt the FCA can also help to address the climate crisis – and the UK government is about to give it a mandate to do just that. Its rulebook can certainly promote a more sustainable approach to investment and finance, and many believe that it should.

But it is equally clear that the regulator needs to tread carefully. A rush to more regulation – on top of what is already in the works – would be counterproductive at a time when market-led solutions are still emerging. It would also further divert firm resources that could be better focused on delivering tangible ESG improvements to portfolio investments.

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