At Square Mile, we recently responded to the FCA’s paper on the Sustainable Disclosure Requirements (SDR). As our business is grounded on fund research, investment management and consultancy services, and as an active participant in the industry, we deal with responsible investing and many subsequent ESG-related issues. Responding to the FCA’s paper is our way of ensuring the right framework is in place to help consumers and their clients.

To that end, our response to the FCA covered our opinions on the proposed SDR and investment labels.

Products in scope

The paper’s proposed scope of products under the regime in the UK is limited to funds and does not include other widely used savings vehicles, such as pension funds and offshore funds, which we believe could introduce potential confusion for end consumers.

Additionally, the lack of clarity on how offshore funds will be classified could significantly affect umbrella structures (e.g., MPS, pension products and fund of funds) as many sustainable funds are currently offshore domiciled. Losing access to these will reduce the investment universe of high-quality funds available for selection which, in turn, may impact diversification potential.

Given these issues, we would hope that offshore funds are brought into scope, within a well-aligned framework to the UK fund regime, as soon as possible. We would make a similar comment about pension funds, suggesting they be brought into scope using the same framework. That would affect how these products are marketed too and should help prevent greenwashing of offshore and pension products.

Approach to labelling

Central to Square Mile’s research process is understanding a fund’s objectives and the delivery of expected outcomes. As a result, the same focus on labelling within the proposed regulation should be beneficial as a key attribute of any sustainable product must be an environmental and/or social objective to complement the financial return aim. Plus, with the requirements’ emphasis on intentionality, the framework mandates a necessary and important differentiator between sustainable and non-sustainable investment approaches.

There are, though, several areas that may be an issue with the proposed requirements. Namely:

• When the new regulations go live, advisers and consumers will favour funds that choose to adopt these labels, seeing them as more attractive and safe options, and so a hierarchy will inevitably form in the market.

• Funds which do not meet the suggested criteria but still have worthwhile social/and/or environmental outcomes, such as ethically screened/exclusion funds may be disadvantaged. As an unintended consequence, their presence in the market may diminish. Explicit positive acceptance in regulations may prevent this.

Other areas for consideration:

• Independent verification, whilst desirable, should not disadvantage smaller funds on cost grounds, so keeping it optional (at this stage) would be sensible.

• The differentiation between SDR and SDFR could also potentially disadvantage UK based consumers and advisers, as the variations in disclosures and reporting could cause confusion and is also likely to lead to higher costs.

Currently, the likely product profiles and strategies are Sustainable Focus, Sustainable Improvers and Sustainable Impact. Our thoughts on the proposed requirements for these labels are:

Sustainable Focus:

This category could be a successful label as the threshold of 70% will result in investors having high integrity in it. However, given the large scope for variability in interpretation, further guidance as to what constitutes a credible standard for environmental and/or social sustainability would be helpful.

As it currently stands, some groups may see the use of third party ESG ratings as a credible standard to support their sustainability credentials. We, however, do not feel that these are always a true indicator of sustainability or intentionality-based investing, especially when one considers the fact that the assumptions can differ by ratings provider and therefore it is hard to reconcile the information and deliver a consistent approach.

Sustainable Improvers:

We liked the proposed features for this label. However, there is potentially great scope for greenwashing here so KPIs with very clear metrics for assessing performance must be in place. In terms of these KPIs, there should be at least some requirement at an individual security level to show whether change is being achieved. Portfolio-level metrics could potentially allow for the masking of underlying issues.

It could, therefore, be worth clearly stating that the KPIs must be relevant and material to the company or sector and that the firm evidences and documents why these are relevant. For how sustainability, and indeed an improvement in the sustainability profile of a company, is defined is open to interpretation, with some focusing on metrics or factors that are not the most material to a company and/or sector.

Furthermore, given the short-termism of the industry, it would need to be clearly communicated to consumers that the changes expected to be driven within these companies cannot be achieved in a quarter or in some cases even within a year. Instead, they should be considered on a multi-year time frame.

Sustainable Impact:

This label is currently very narrow and, we believe, favours private market investment. Therefore, we do not think it would be readily applicable to many funds currently available in the market. Arguably, public markets can be impactful if sustainability or ESG research/ratings results in changes in the cost of capital assumptions for a security and consequent material shifts in capital allocation to that company. Furthermore, fixed-income markets can also be impactful through the specific use of proceeds and covenant protections, such as Green Bonds or Sustainability Linked Bonds.

A narrow scope for the ‘Sustainable Impact’ label comes with the potential risk of making impact investment exclusive rather than making it an option available to all. It could also mean that some impact/higher solution funds would fall into the ’Sustainable Focus’ label which may cause that to be highly variable in scope too.

The proposed distinguishing features could be softened, or sub-categories within the ‘Sustainable Impact’ label could be introduced, including one which focuses on public market funds and one which favours private market investment. In addition, we believe that there needs to be some accounting for ethical or exclusions-based products, which are currently an integral part of the market and one that meets the needs of a large consumer segment.

Approach to disclosure:

We broadly agreed with the FCA’s proposed approach to disclosures, including a tiered structure and the division of information in the consumer-facing and detailed disclosures. Most notably, simplicity should underpin the disclosures regime as our concern is that too much information may prove counterproductive to consumers. Using, and building from, TCFD-aligned disclosure rules in the first instance will be a good circular reference to SDR, with disclosure requirements evolving over time in line with the development of future ISSB standards.

With regards to the proposals for consumer-facing disclosures, including location, scope, content, and frequency, they should be appropriate. We agree that firms providing umbrella structures (MPS/fund of funds) should not have to produce their own consumer-facing disclosures and that providing links to the individual funds’ disclosure is suitable. In the absence of any standard templating for consumer-facing disclosures, the respective label of any underlying fund should be a stipulated requirement and should be prominently displayed.

Areas for concern:

• The requirement to “signpost to other disclosures” may lead to confusion for consumers. We would recommend that non-sustainability disclosures, such as product costs, be as prominent as sustainability disclosures and even incorporated into the same linked document.

• Consistency is paramount to successfully implementing SDR. Despite the fund factsheet being the principal source of information for investors, there is no standard format, and they are usually not comparable between fund groups. We believe that the fund factsheet needs to incorporate both sustainable and non-sustainable information and, in the absence of a standard template, key fields required in the factsheet should be stipulated by the FCA and collected by data providers.

For more information on Square Mile’s response to the FCA’s Consultation Paper (CP22/20) Sustainability Disclosure Requirements (SDR) and investment labels, please contact us.