A week of developments for European ESG regulation: FCA publishes its final rules on SDR and ESAs publish final report on SFDR 1.5

Over the past week, both the European Supervisory Authorities (ESAs) and the UK’s Financial Conduct Authority (FCA) have published their latest regulatory proposals in the world of sustainable finance. 

On 4 December, the ESAs released their final report on the review of the SFDR’s regulatory technical standards (also known as SFDR 1.5).  This follows the publication by the FCA on 28 November of its final rules on the Sustainability Disclosure Requirements (SDR). 

ESA final report

The report is the ESAs response to the European Commission’s mandate, directed at reevaluating certain aspects of the operation of the SFDR’s regulatory technical standards (the RTS).  At a high level, the impact of the report for asset managers is not as significant as it could have been (it being acknowledged that some changes were not made because of the broader SFDR review). However, the key changes include: 

Extension of social PAI indicators: The draft RTS brings new indicators spotlighting socially adverse impacts.  Examples include factors such as “exposure to companies involved in tobacco production”, “employees earning below a fair wage” and “accumulated earnings in non-cooperative tax jurisdictions”.

Modifications to existing PAI indicators, for example:

• Gender pay gap between male and female workers has been modified to revert to the original definition of “unadjusted gender pay gap”, aligning with the European Sustainability Reporting Standards (“ESRS”).
• “Rate of recordable work-related injuries” has been modified to change “injuries” to “accidents” in alignment with ESRS terminology.
• The definition of “deforestation” has been modified to align with the recent Regulation relating to the conversion of forest to agricultural use, whether human-induced or not.

Amendments to the PAI framework including:

• New formulae reflecting alterations to the indicators.
• Requirements for financial market participants to disclose what part of the adverse impact stems from data provided by investee companies and what part is based on estimations or reasonable assumptions.
• Clarification on including value chains of investee companies in PAI calculations only if the investee company reports on that specific value chain.

The introduction of disclosure requirements for Article 9 funds with greenhouse gas emissions reduction targets as their investment objective: This will involve setting out the financed GHG emissions for a baseline year with percentage figures showing the amount of the reduction by the final year, and for any intermediate targets.

Updates to the pre-contractual and periodic disclosure templates: The report proposes simplified pre-contractual and periodic disclosure templates for Article 8 and 9 products.  Importantly, there will be a new “dashboard” summarizing key information in a digestible format, The dashboard highlights whether a product has a sustainable investment objective or promotes environmental/social characteristics.  The dashboard includes a statement about the product’s nature.  Four essential elements are included in the dashboard: Sustainable investments, Taxonomy-aligned investments, Principal Adverse Impacts consideration, and GHG emissions reduction targets.

Calculation of “sustainable investments”: The draft RTS now also contains two ways to calculate the proportion of sustainable investments in a fund – it is possible to calculate this at the economic activity or investment level but the way in which it is calculated needs to be disclosed. 

The “Do no Significant Harm” (“DNSH”) Principle: The ESAs are also proposing minor technical amendments to the website disclosure requirements.  Most notably, website disclosures will now need to include information on the thresholds or criteria used to determine that a sustainable investment do not significantly harm any environmental or social objectives and how this is determined.  While there have been no changes to how DNSH is assessed, the extension in the number of PAI indicators to be considered could have a material impact for funds that make sustainable investments.  The Final Report also notes that the DNSH framework is subject to the wider European Commission review on the SFDR, so there may yet be changes in.

Timings 

In terms of timing, the draft RTS will undergo a three-month assessment by the Commission for potential endorsement before these changes are implemented.  Notably, these amendments will be applied independently of the comprehensive SFDR review this area announced by the Commission in September 2023 (see our post).  SFDR 2.0 will contain more substantive changes to the regime and so this draft RTS is far from the end of the SFDR journey.

In the interim, the key changes for most fund managers subject to SFDR include considering the extended PAIs as part of the DNSH assessment, disclosing how DNSH is assessed in website disclosure and working on the updated templates. 

FCA final rules on the SDR

Following a consultation process initiated in October 2022, the FCA engaged with stakeholders on a package of measures aimed at addressing the issue of greenwashing. As an overview of the new provisions:

A new anti-greenwashing rule mandating that all claims about the sustainability aspects of a product or service must be transparent, equitable, and not misleading.  In parallel, the FCA has published draft guidance on the anti-greenwashing rule to help better explain the FCA’s expectations.  The consultation window for the guidance runs until 26 January 2024.  The draft guidance sets out four key principles in relation to sustainability-related claims.  Such claims should be: (1) correct and capable of being substantiated; (2) clear and presented in a way that can be understood; (3) complete – they should not omit or hide important information; (4) fair and meaningful in relation to any comparison to other products or services.

Four sustainable investment product labels which aim to categorize products according to whether their strategy involves investing:

1. In assets that are environmentally and / or socially sustainable (“sustainable focus”).  A minimum of 70% of the product’s assets must be consistent with an aim to invest in assets that are environmentally and / or socially sustainable.
2. To improve the environmental and/or social sustainability of assets over time, including in response to the stewardship influence of the firm (“sustainable improvers”).  Firms will need to identify the period of time by which the product and/or its assets are expected to meet the standard, including short and medium-term targets. They must also obtain robust evidence to satisfy themselves that the assets have the potential to meet the standard.
3. In solutions to environmental or social problems, to achieve positive, real-world impact (“sustainable impact”). Firms must specify a theory of change setting out how they expect their investment activities and the product’s assets to achieve a positive impact.
4. In a mix of assets that either focus on sustainability, aim to improve sustainability over time, or aim to achieve a positive impact for people or the planet more generally (“sustainable mixed goals”).

Importantly, the labels remain an opt in regime, so aren’t compulsory like the SFDR.

Naming and marketing rules for investment products which prohibit non-labelled products marketed to retail clients from using sustainability-related terms including (but not limited to): “ESG”, “climate”, “sustainable”, “sustainability”, “responsible”, “green”, “SDG”, “Paris-aligned” or “net zero” in their product names unless they meet certain other naming and marketing criteria.  Even where the product is labelled, if it is the “sustainable focus”, “sustainable improver” or “sustainable mixed goal” label, firms are prohibited from using the word “impact” in the product name.

Consumer-facing, product-facing and entity-level disclosures.  Certain consumer-facing disclosures, such as the “investment strategy” and “ongoing reporting on sustainability metrics” are required of all firms.  Pre-contractual and sustainability product report disclosures are only required in respect of products with a sustainable investment label.

Requirements for distributors such as investment platforms to ensure that any sustainable investment labels and consumer-facing disclosures for in-scope products are displayed prominently on a relevant digital medium and should be accessible to consumers.  The FCA intends to launch a separate consultation on this issue for overseas products.

Timings and scope

In terms of timing, the FCA is taking a phased approach to the implementation of this new regime with the anti-greenwashing rule applying from the end of May next year and most of the other rules being implemented from July and December next year.  

In terms of scope, the anti-greenwashing rule will apply to all FCA authorized firms.  The labelling rules, product-level disclosure requirements and name restrictions will apply to UK asset managers in relation to UK funds and the entity level reporting will apply to asset managers with more than £5bn AUM. As such, at this stage the rules will not apply to non UK managers marketing their funds into the UK or to UK investment managers. However, this is likely to change over time. 

For UK asset managers targeting institutional investors, the key element of the regime will be the anti-greenwashing rule and managers should ensure their fund materials meet the relevant standard in advance of the 31 May deadline next year.