Final Rules on UK Sustainability Disclosure Requirements and Investment Labels - Key Takeaways for Asset Managers

On 28 November 2023, the Financial Conduct Authority (FCA) published its Policy Statement (PS23/16) (the Policy Statement) setting out its final rules on UK Sustainability Disclosure Requirements (SDR) and investment labels.

This follows the publication of the FCA Consultation Paper (CP22/20) on 25 October 2022 (the Consultation Paper). For a discussion of the Consultation Paper, please see our previous Update Financial Conduct Authority Consultation on UK Sustainability Disclosure Requirements -- Five Key Takeaways for Asset Managers (14 November 2022).

As a reminder, in the Consultation Paper, the FCA proposed a framework for the SDR, encompassing the following elements:

• a new opt-in labelling regime for sustainable investment products;
• a requirement to prepare consumer-facing product-level disclosures;
• additional requirements on pre-contractual disclosures for products using an investment label or where sustainability features are otherwise integral;
• ongoing sustainability reporting for firms using investment labels;
• entity-level disclosures;
• new naming and marketing rules, restricting the use of sustainability-related terminology;
• an anti-greenwashing rule applicable to all authorised firms to reinforce that sustainability-related claims must be fair, clear, and not misleading; and
• requirements for distributors to ensure that product-level information (including the labels) is made available to consumers.

Each of these elements remains in the final rules set out in the Policy Statement, although the FCA has made a number of substantial changes to its initial proposals in response to stakeholder feedback. The more substantial changes are as follows:

1. Portfolio management — the removal of portfolio management products and services from scope of the SDR (for now);
2. Non-UK AIFs — clarification that non-UK alternative investment funds (AIFs) are not in scope of the SDR;
3. A fourth label — the addition to the labelling regime of a fourth “Sustainability Mixed Goals” label for funds that invest across a mix of different sustainability objectives and strategies;
4. Clarification of labels — amendments and clarifications to the requirements of the investment labels proposed in the Consultation Paper;
5. Anti-greenwashing guidance — the launch of a consultation on guidance to supplement the new anti-greenwashing rule (which otherwise remains substantially the same); and
6. Naming and marketing rules — relaxations to the naming and marketing rules to allow for the use of most sustainability-related terms in relation to funds that do not use a label, provided certain conditions are met.

We set out further detail on each of these changes below, followed by the next steps for firms that will be in scope, and key dates in the implementation timeline.

SIX KEY CHANGES FROM THE ORIGINAL PROPOSALS

1. Removal of portfolio management products and services from scope of the SDR

The FCA had proposed in the Consultation Paper that the SDR would apply to FCA-authorised fund managers (including UK Undertakings for Collective Investment in Transferable Securities management companies, full-scope Alternative Investment Fund Managers (AIFMs), and small authorised AIFMs) and UK firms undertaking “portfolio management” (which, as noted in our previous Sidley Update, would have included the activities of private equity firms that advise offshore general partners).

The FCA received feedback that its proposed approach for portfolio management would not be suitable, particularly as most portfolios are diversified and unlikely to invest only in UK funds with labels. In the Policy Statement, the FCA has removed portfolio management firms from the scope of the SDR — for the moment. Accordingly, FCA authorised investment firms carrying out portfolio management activities (such as in the context of a separately managed accounts or as a sub manager to the primary manager of a fund) will not be in scope of the SDR. Note that the exception to this is the anti-greenwashing rule, which applies to all UK FCA authorised firms.

The FCA will consult in early 2024 on whether and how to apply the SDRs to portfolio management firms, with a focus on portfolio management undertaken for UK retail clients, including managed portfolios and discretionary wealth management services.

The FCA will continue working with HM Treasury to understand the options for extending the regime to overseas recognised funds, including those marketing under the Overseas Funds Regime (a new UK regime under which investment funds domiciled overseas may be offered to UK retail investors).

2. Clarification that non-UK AIFs are not in scope of the SDR

The FCA had proposed in the Consultation Paper that overseas funds and firms would not be in scope of the SDR to begin with, and this remains the case in the final rules set out in the Policy Statement. The SDR will apply only to UK firms and their UK-domiciled products marketed in the UK. Accordingly, funds marketed in the UK on a cross-border basis, for example, AIFs marketed by a non-UK AIFM under the UK National Private Placement Regime, or European Union–domiciled funds marketed in the UK under the temporary marketing permissions regime, are not in scope of the SDR.

In this regard, the FCA has clarified in the Policy Statement that the SDRs will not apply to non-UK AIFs, including those managed by an in-scope management entity, such as a UK AIFM. For example, a Cayman AIF managed by a UK AIFM would not be in scope of the SDR, whereas a UK AIF managed by that same entity would be. One exception to this is that the entity-level disclosure rules apply to UK firms, in respect of UK and overseas funds managed from the UK. For further details on the entity-level disclosures, please see our previous Sidley Update.

The FCA states that HM Treasury will separately consult as part of its work on the Overseas Funds Regime on whether and how non-UK funds should be made subject to the SDR.

3. New “Sustainability Mixed Goals” investment label

In response to feedback from industry raising concern as to whether funds invested with a combination of the attributes of the labels proposed in the Consultation Paper would qualify for a label, the FCA has added an additional, fourth label: Sustainability Mixed Goals.

This label addresses the previous mutual exclusivity of the labels and is intended to be suitable for funds that invest across different sustainability objectives and strategies aligned with the other categories.

As the FCA states in the Policy Statement, the Sustainability Mixed Goals category will create a place within the labelling regime for “products invested in a mix of assets that are already sustainable, have the potential to improve their sustainability over time, and/or aim to achieve a positive impact” (consistent with the Sustainability Focus, Sustainability Improvers, and Sustainability Impact labels, respectively).

Accordingly, the expanded labelling regime will now feature the following four labels:

• Sustainability Focus: invests mainly in assets that focus on sustainability for people or the planet.
• Sustainability Improvers: invests mainly in assets that may not be sustainable now but have the potential to improve their sustainability in time.
• Sustainability Impact: invests mainly in solutions to sustainability problems with an aim to achieve a positive impact for people or the planet.
• Sustainability Mixed Goals: invests mainly in a mix of assets that either focus on sustainability, aim to improve their sustainability over time, or aim to achieve a positive impact for people or the planet.

4. Amendments and clarifications in relation to the investment labels proposed in the Consultation Paper

In the Policy Statement, the FCA has made a number of changes or clarifications to the labels it had proposed in the Consultation Paper. Some of the more notable changes the FCA has made are as follows:

• Names of the labels
  • The names of the labels that the FCA had proposed in the Consultation Paper were “Sustainable focus,” “Sustainable improvers,” and “Sustainable impact.” Respondents to the Consultation Paper did not consider the term “Sustainable” to be appropriate for the “Sustainable improvers” label, given this label is designed for a product that is “improving” its sustainability rather than investing in sustainable assets from the outset.
  • In response to this feedback, the FCA has amended the names of all labels from “sustainable” to “sustainability” to better reflect that the labels represent an investment approach.
• 70% minimum threshold for all labels
  • Respondents to the Consultation Paper had sought clarification on whether the proposed 70% threshold for investing in assets under the Sustainability Focus label applies to other labels as well as on how assets held in the product for liquidity and risk management purposes (e.g., cash, government bonds, derivatives) would be treated.
  • In response, the FCA has applied the 70% minimum threshold to all labels.
  • As a result, for all the investment labels, the product may invest in other assets for liquidity and risk management purposes so long as 70% of the gross value of the product’s assets is invested in line with the sustainability objective.
• Sustainability Impact — investing in public markets
  • Respondents to the Consultation Paper had raised a concern that the requirement for “financial additionality” under the “Sustainability Impact” label allowed only for impact to be achieved through directing new capital into assets, thereby limiting the label to investments in private markets (at the expense of public market investing). Suggestions included giving recognition to the contribution made by assets within a product to a real-world outcome and not only the investor’s contribution.
  • In response, the FCA has clarified that as long as other criteria are met, investments in public markets can qualify for use of the label. In particular, the amended criteria for use of the label acknowledge the role that the product’s assets may have in contributing to positive impact alongside the investor’s contribution, in line with industry practice and frameworks.
• Sustainability Improvers — stewardship expectations
  • Respondents to the Consultation Paper had (i) highlighted challenges in demonstrating a causal link between stewardship and improvements, (ii) noted that stewardship takes place in different forms, and (iii) noted that investor stewardship strategies are usually developed at firm rather than product level.
  • In response, the FCA has made amendments and clarifications such that the rules are not prescriptive as to the form in which stewardship would take place or whether the strategy is at firm or product level. For example, references to terms that may imply a certain approach (e.g., “active” stewardship, engagement, voting) have been removed.
  • The FCA has also clarified that firms are not required to demonstrate a causal link between stewardship and assets’ improvements.
• Sustainability Focus — use of internal frameworks
  • In response to calls for clarification from respondents to the Consultation Paper, the FCA has confirmed that internal frameworks can be used to meet the “credible standard” that the product’s assets must meet.
  • The FCA has clarified further that an independent assessment of the same can be carried out either by a third party or via a firm’s internal processes.
• Hierarchy between the labels
  • Respondents to the Consultation noted, while the labels are not designed as a hierarchy, consumers may perceive one (potentially from Sustainability Improvers, through Sustainability Focus, to Sustainability Impact as the perceived “worst to best”).
  • The FCA reiterates in the Policy Statement that the labels are not designed as a hierarchy but represent different types of investment objectives and approaches. The FCA does, however, acknowledge that consumers are likely to place the labels into their own hierarchies according to their needs and preferences, and that this is supported by the FCA’s consumer research on this topic.

5. Guidance Consultation on the anti-greenwashing rule

The FCA has confirmed that it will introduce the anti-greenwashing rule proposed in the Consultation Paper.

In response to widespread calls from respondents for guidance on the rule, and its interaction with the naming and marketing rules, the FCA is consulting on Guidance on the anti-greenwashing rule (GC23/3). In its proposed guidance on the anti-greenwashing rule, the FCA clarifies that the rule applies to references to environmental and/or social characteristics of financial products or services. The FCA does not provide a specific list of terms for the rule.

The guidance consultation is open for comments until 26 January 2024.

The FCA has also extended the effective date for the anti-greenwashing rule in response to feedback. The anti-greenwashing rule will come into effect on 31 May 2024 (in contrast with the initial proposal in the Consultation Paper that it would come into effect immediately on publication of the FCA’s policy statement).

6. Relaxation of the naming and marketing rules for funds not using labels

In the Consultation Paper, the FCA had proposed to restrict the use of certain sustainability related terms (such as “ESG,” “climate,” “impact,” and “sustainable”) in product names and marketing materials, unless the product used a sustainable investment label (the so-called “naming and marketing rules”). The naming and marketing rules were not proposed to apply to institutional products, only to products marketed to retail investors.

The FCA has relaxed the naming and marketing rules in response to criticisms that they were overly restrictive (and could, among other things, lead to so called “greenhushing” (where organisations hide their ESG credentials to avoid scrutiny and regulatory requirements).

As a result of the changes, firms will be able to continue to use sustainability-related terms in product names and marketing for products that either (i) use a label or (ii) do not use a label but comply with certain product name and marketing conditions.

The product name and marketing conditions include that the product has sustainability characteristics that are accurately reflected in the name, the specific terms “sustainable,” “sustainability,” “impact,” and any variation of those terms are not used, and that a prominent statement is published in the product-level disclosures to clarify that it does not have a label and the reasons why.

Next steps for firms

The FCA recommends the following as next steps for firms in anticipation of the incoming rules.

All FCA-authorised firms should:

• prepare for the new anti-greenwashing rule if they make claims about the sustainability characteristics of their products or services, to ensure sustainability-related claims are fair, clear, and not misleading; and
• read the FCA’s GC23/3 consultation on further guidance to the anti-greenwashing rule.

In addition, UK asset managers should:

• decide whether to label products that aim to achieve positive sustainability outcomes, if they meet the qualifying criteria; and
• familiarise themselves with the FCA’s requirements (summarised in Annex 2 and set out in full in Appendix 1 of the Policy Statement) and prepare to meet the relevant regulatory requirements within the implementation timeframes set out below.

The FCA also notes that it runs a series of webinars and events to help firms implement the rules, which firms should consider attending as part of their implementation work.

Implementation timeline

The rules and guidance relating to the various aspects of the SDR come into force on the following dates:

• 31 May 2024 – anti-greenwashing rule and guidance will come into force;
• 31 July 2024 – firms can begin to use labels, with accompanying disclosures;
• 2 December 2024 – naming and marketing rules will come into force, with accompanying disclosures;
• 2 December 2025 – ongoing product-level and entity-level disclosures for firms with AUM greater than £50 billion will come into force; and
• 2 December 2026 – entity-level disclosures will be extended to firms with AUM greater than £5 billion.