Recent Developments for Fund Managers in the UK and the EU and What the Future May Hold #UKFinance

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By Romin DabirPartner, and Bogomil KukovskiAssociate, Reed Smith

This year has been eventful for fund managers in ESG (environmental, social and governance) regulatory developments. Two of the most significant are the introduction of new requirements in the United Kingdom (UK) and potential reforms to the European Union’s (EU’s) existing regime. Although the UK’s Financial Conduct Authority (FCA) has emphasised that the regimes are compatible and that fund managers can leverage information used to satisfy the qualifying criteria under the EU’s regime for product categorisation and disclosures, there are still notable divergences that fund managers within the scope of both sets of rules will need to navigate. These developments are summarised in more detail below, together with the practical implications that they may have for fund managers and a look into the possible evolution of the constantly changing ESG regulatory landscape.

The introduction of the UK’s Sustainability Disclosure Requirements regime

Perhaps most significantly, as far as UK-based firms are concerned, we saw the introduction of the UK’s (highly anticipated by some and much dreaded by others) Sustainability Disclosure Requirements (SDR) and investment labels, which began to take effect as of the 31^st of May 2024 with the FCA’s anti-greenwashing rule coming into force.

The SDR introduces a number of new requirements, including (i) a specific rule designed to combat greenwashing that is universally applicable, (ii) a new voluntary labelling regime, (iii) naming and marketing rules and (iv) product- and entity-level disclosures. New obligations were also introduced for distributors. These new requirements will have significant implications for UK fund managers’ investment strategies, governance, data management, reporting and marketing practices, as well as for those distributing their products.

To help consumers navigate the investment-product landscape and enhance consumer trust, from the 31^st of July of this year, UK fund managers have been able to use one of the four sustainability labels under the SDR—if their products meet a label’s qualifying criteria. The four labels are Sustainability Focus, Sustainability Improvers, Sustainability Impact and Sustainability Mixed Goals. The FCA has emphasised that the labelling regime is voluntary, with no hierarchy between the four labels.

To use a sustainability label for a product, fund managers must ensure that any labelled product possesses the following qualifying criteria:

1. Sustainability objective: The product’s sustainability objective aligns with one of the labels and is clear, specific and measurable.
2. Investment policy and strategy: The product must have at least 70 percent of its assets invested in accordance with the sustainability objective. The assets must be selected with reference to a robust, evidence-based standard that is an absolute measure of environmental and/or social sustainability, and any other assets must not conflict with the sustainability objective.
3. Key performance indicators (KPIs): Firms must identify KPIs to measure either the performance of the product or its individual assets towards achieving its sustainability objective.
4. Resources and governance: Firms must implement the appropriate resources, governance and organisational arrangements needed to deliver the sustainability objective.
5. Stewardship: Firms must identify the stewardship strategy needed to fulfil the sustainability objective, including the expected activities and outcomes, and ensure the strategy and appropriate resources are applied.

UK fund managers need to notify the FCA regarding their use of a sustainability label, which must be in the form of the relevant graphic prescribed by the FCA. The label must be visible in a “prominent place” on the specific page of a website, mobile application or other digital medium through which the sustainability product is offered. Fund managers are required to conduct reviews of their use of a sustainability label at least every 12 months and prior to any proposed changes to the sustainability product. Consequently, fund managers must prepare and retain a record of the basis on which the label has been used and keep the record up to date according to changes made to the product.

Recommendations for reforming the EU’s Sustainable Finance Disclosure Regulation

From the EU perspective, the European Supervisory Authorities (ESAs) issued a joint opinion (the Opinion) on the 18^th of June 2024 — “on the assessment of the Sustainable Finance Disclosure Regulation (SFDR)” addressed to the European Commission (the Commission)—providing recommendations and suggestions to improve the SFDR framework.

The impetus behind the ESAs’ recommendations stems from their acknowledgement that the SFDR’s disclosure regime has led to lengthy and complex disclosures that consumer testing has shown are difficult to understand, particularly for retail investors.

Further, although the SFDR framework was designed as a disclosure regime, investors have been using Article 8 (for products that promote environmental or social characteristics) and Article 9 (for products with sustainable investment as their objective) as in fact sustainability labels. There has been considerable uncertainty as to what is required before a product can be disclosed under Article 9, whereas the criteria to disclose under Article 8 are very broadly drawn. This has led to a concentration of products disclosed under Article 8 that have a wide range of ESG characteristics. Rather than preventing greenwashing and misselling as originally intended, the way that the SFDR has evolved in this respect has arguably increased such risks.

To address these issues, the recommendations include doing away with the current Article 8 and Article 9 disclosure requirements and replacing them with sustainability indicators or product categories (or both) underpinned by clear and objective criteria.

The proposed introduction of the sustainability indicator is intended to clearly demonstrate to investors the sustainability features of a product through the use of a scale, thereby simplifying complex sustainability information into a format that is more easily digestible; this practice has been successful in other sectors. The introduction of sustainability indicators would bring the SFDR more in line with the approach taken by the FCA under the SDR.

As an alternative (or in conjunction with the introduction of indicators), the ESAs have recommended the introduction of a product-classification system based on product categories and/or sustainability indicators to help consumers navigate the broad array of sustainable products and allocate capital more efficiently towards specific goals.

The categories should be simple, with clear and objective criteria or thresholds that identify the category into which the product falls. At a minimum, the ESAs have recommended introducing “sustainability” and “transition” categories.

In a separate proposal, the ESAs have highlighted that the nebulous definition of sustainable investment under the SFDR and the resulting discretion afforded to fund managers when applying it have brought flexibility at the expense of clarity, thereby creating confusion. The ESAs have suggested that the Commission making key parameters of sustainable investment under the SFDR prescriptive would provide greater clarity for investors and strengthen the comparability of the proportions of sustainable investments across financial products.

Implications for fund managers

The FCA’s introduction of the SDR will mean that all fund managers within scope will have to take greater care with respect to any ESG claims they make for their products. Those that wish to emphasise the sustainability credentials of the funds that they offer by using product labels will need to satisfy certain criteria before they do so, and to ensure that these criteria continue to be met throughout the life of the product. The voluntary use of a label (or even the emphasis on ESG characteristics in the promotion of products that do not elect to use a label) will trigger disclosure requirements, the details of which will be calibrated according to the target market for the product, with simple disclosures required for retail investors and more detailed requirements for institutional investors. How prevalent the voluntary use of labels will become remains to be seen, but it will no doubt be influenced by investor pressure.

The recommendations for reform of the SFDR, if adopted, will lead to significant work for those managers subject to the regime (broadly, European Economic Area [EEA]-based fund managers or those that actively market their funds in any EEA jurisdiction). Given the amount of time and resources managers have devoted to ensuring compliance with the existing regime, this will not necessarily be welcome news.

Those managers that are subject to both regimes (currently, only those UK-based managers marketing funds in the EEA, although the FCA intends to extend the SDR to overseas managers marketing in the UK in the future, albeit probably in a modified form) will need to comply with two sets of rules. There are some significant differences between the existing SFDR and the UK’s SDR (for example, under the SFDR, Article 8 products need not have a sustainability objective, whereas under the SDR, this is required to qualify for the use of a label).

If adopted by the Commission, the ESAs’ recommendations for reforming the SFDR will likely bring closer alignment between the two regimes, but the precise extent of that alignment will become clear only as and when the details are fleshed out. We are unlikely to see any meaningful developments on this front until at least 2025.