EU, UK ESG fund disclosure update

A) UK-Sustainability Disclosure Requirements latest

1. UK sustainability labelling countdown continues

The Financial Conduct Authority (FCA) have again updated their ‘Sustainability disclosure & labelling regime’ webpage for UK fund firms, as their 31 July milestone fast approaches.

The ‘Investment labels’ section now sets out the procedures asset managers must follow, to notify the FCA of their planned use of SDR fund labels; four scenarios are presented:

• Existing authorised funds: considered to already meet SDR label criteria (i.e. without product changes);
• Existing authorised funds: deemed to require changes to pre-contractual disclosures to adopt an SDR label;
• New funds: considered to meet the SDR label criteria;
• In-scope unauthorised local AIFs: including firms simultaneously applying for FCA authorisation.

The FCA will only review and approve proposed amendments to existing funds, together with applications to launch new sustainable products.  It is stated “the FCA does not approve labels, but firms are required to notify us when they use, revise or stop using a label”.

Those planning to use an SDR product label must notify the FCA via their online Connect application.

NB: A reminder the FCA state that both Consumer-facing and pre-contractual disclosures “must be published at the same time as the label is first used”, with relevant naming and marketing rules met from the start.

2. SDR enthusiasm “wanes” as UK firms “struggle”

“Enthusiasm has waned in the past six months as asset managers realize that the criteria to get a label are more stringent than expected, and the demand for labelled products, at least at the beginning, won’t be as high as initially thought. An additional factor dampening managers’ enthusiasm for labels is that many funds marketed in the UK aren’t even in scope.”
Hortense Bioy, Sustainable Investing Research, Morningstar Sustainalytics [9 July 2024]

Since our last update, SDR has attracted increasingly downbeat media coverage.

Morningstar Sustainalytics’ latest SDR research points to the challenges now faced by UK asset managers, e.g.

• Lack of clarity on qualifying KPIs: to evidence products meet sustainability objective;
• Interoperability difficulties with EU-SFDR: such as ‘sustainable’ EU-UCITS excluded from UK-SDR scope;
• How to apply a label for fund of funds (FOF): i.e. not clarified in the FCA policy statement.

These have prompted many managers to adopt a ‘wait and see’ approach, before applying for an SDR fund label.
NB: this assessment has gained prominent reportage (e.g. Bloomberg, IPE and Professional Advisor).

Elsewhere, a separate SDR report by PwC and the UK Sustainable Investment and Finance Association (UKSIF) made similar findings, with additional challenges including:

• ‘70% sustainable investments threshold’ uncertainty: g. how exactly to apply a suitable “robust, evidence-based standard” for each SDR label;
• Product governance: the impact on asset managers’ product lifecycle monitoring frameworks;
• Managing greenwashing risk: some firms fear the AGR may “create litigation risks”;
• Disclosure and reporting: firms have expressed concern about the “added SDR reporting burden” beside other ESG disclosure regimes (such as SFDR, which requires “divergent approaches”).

NB: Ignites Europe and Funds Europe have also conveyed similarly pessimistic market sentiment.

3. Interim SDR status, outlook

In January, Morningstar’s initial SDR analysis forecasted 300 existing funds might adopt an SDR label during 2024.

By May, the Investment Association reduced that number to circa 230 funds, with 14% of firms aiming to apply before 31 July 2024.

So far, however, official notices of firms confirming their adoption of any SDR product label have been very scarce.

In addition, asset managers are now reportedly nervous, ahead of the SDR ‘hard’ deadline on 2 December 2024.

Local firms have until this date for the FCA to formally approve modified ‘sustainable’ fund documentation as fully compliant with their new SDR naming and marketing rules. This is based on a formal change (e.g. fund’s name, investment objectives, policy and/or strategy) that will also require subsequent investor notification.

Until now, available SDR implementation guidance did not include contingency for re-submission (i.e. in the event of FCA rejection).  With scant time remaining, we understand some in the industry are now coalescing, to request the FCA to either delay or water-down the legal application of their December SDR milestone.

Watch this space for more details.

4. Still no news: SDR distributor template

The FCA rules state distributors are obliged to communicate SDR labels and provide CFD access to retail investors, using “a relevant digital medium” or “the channel they would ordinarily use to communicate information”.

Although FinDatEx’s European MiFID and ESG templates currently contain some specific SDR data items, there remains no official industry update on whether additional information is required, or indeed whether another separate local template is deemed necessary, to assist local distributors meet all their SDR obligations.

More to follow.

5. FCA publish OFR policy statement

On 17 July, the FCA published a policy statement with final rules and guidance necessary to implement the Overseas Funds Regime (OFR).  This follows the entry into force of their legal EEA-UCITS ‘equivalence’ decision.

‘Environmental, social & governance considerations’ (p.10) includes a recap of the UK Government’s OFR roadmap pledge, to consult on the application of the SDR regime to EU funds within the OFR, during Q3-2024.

The roadmap also contained a placeholder for the UK Government “to lay any legislation required to implement its decision on SDR and labelling for OFR funds”, before end-2024.

This is also indicated within the FCA’s revised OFR webpage [i.e. ‘Future policy initiatives’ section].

NB: it was recently reported that at least one major legal firm is now advising clients to assume SDR rules will apply to overseas funds sold in the UK.

6. The IA respond to SDR ‘Sustainability Focus’ label adopters, portfolio managers

The Investment Association have also recently:

• 4 July: briefed member firms planning to apply the ‘Sustainability Focus’ label;
• 14 June: formally responded to the FCA consultation on extending SDR to portfolio managers.

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B) EU SFDR latest

1. ESAs propose ‘major improvements’ to SFDR Level 1 regime

On 18 June, the three European Supervisory Authorities (ESAs) published their eagerly-awaited joint advice on how to improve the Sustainable Finance Disclosure Regulation (SFDR) framework.

This was supplied as input to the EU Commission (EC) ‘comprehensive’ SFDR assessment, alongside industry feedback obtained during the ‘targeted’ consultation in 2023.  Notable ESA suggestions relate to:

• Creating a new SFDR system of product classification: based on clear ‘sustainable objective’ rules and criteria to reduce greenwashing risks, to replace the informal ‘article 8/9’ product distinction since 2019.
• Two ‘sustainability’ product categories (as a starting point): ‘sustainable’ and ‘transition’;
• Introduce Sustainability indicator(s): to “grade” products, in accordance to how sustainable their underlying investments are;
• Improved legal definition of ‘sustainable investments’: including alignment with the Taxonomy regulation.
• ‘Relevant documentation’ for product disclosures: “essential information” should be presented to retail clients “in the form of a Key Investor Document”, while professionals “may benefit from more details”.
• Disclosure information provided to investors in a digital format, which allows layering.
• ‘Appropriate’ disclosures for financial instruments currently outside SFDR scope, given interim greenwashing risk; this includes MiFID II structured products.
• A rethink of principal adverse impacts (PAI) transparency: including mandatory ‘minimal disclosure’ of “select key PAI priority indicators”, for all financial products;
• ‘Interim measures’ to improve NCA information flow: following “mixed” pre-contractual and periodic disclosure experiences.

The ESAs strongly recommend their proposals are consumer-tested “to have a stronger evidence basis for changing the regulatory framework and to therefore ensure more successful outcomes”.

NB: although the ESAs propose the new product categories are adopted by fund firms on a voluntary basis, they also invite the EC to “test a mandatory regime, similar to how SFDR currently works.”

2. ESMA unveil ‘holistic long-term vision’

In our June update, we covered the European Securities and Markets Authority (ESMA) new Greenwashing report.

This was part of their reply to the EC’s 2022 request for input related to ‘greenwashing risks and supervision of sustainable finance policies’.  This week, ESMA published the final part of their EC response.

ESMA’s latest Opinion is named ‘Sustainable investments: Facilitating the investor journey’.

This is a 21-page list of ESG policy recommendations to enable the EU Sustainable Finance framework to reach an ‘ideal end-state’.

As per their Greenwashing report, ESMA’s Opinion is based on the ‘Sustainable Investment Value Chain’ (depicted on page 3). It is “broadly aligned” with the ESA’s SDR Level 1 advice (i.e. said to relate to “the medium term”).

Some of ESMA’s recommendations are already covered by the ESAs (e.g. product categorisation system). Others will most likely capture industry attention, such as:

• EU Taxonomy as ‘central point of the Framework’: “embedded in relevant legislation” as the sole, common reference point for EU sustainability assessment;
• SFDR legal definition of ‘sustainable investments’: should be phased out, in favour of “a single definition of sustainability”, based on direct references to the EU Taxonomy;
• A legal definition of ‘transition investments’: should be incorporated into the EU framework;
• EU Taxonomy should be ‘completed’: “including with a social taxonomy”, to “eventually support science-based and comparable disclosures”;
• ‘Minimum’ sustainability disclosures for all financial products: e.g. “a small number of simple sustainability KPIs” covering “basic environmental and social sustainability characteristics”;
• EU Formal alignment: product names, marketing material and sustainability profiles;
• ESG data quality: regulate ESG data products, improve consistency of ESG metrics across the Framework;
• Improve standardisation of sustainability disclosures: including machine-readability;
• A new EU-wide stewardship code for market actors: applied to asset managers, institutional investors and investment service providers.

NB: as always, only the EC can now decide how much of the above advice will be applied to the EU-SFDR regime in due course.  A reminder that draft ‘SFDR II’ Level 1 proposals are unlikely to appear until Q4-2024 / Q1-2025.

3. SFDR Level 2: update, forecast

Meanwhile, back in the short-term, we still await an EC statement on their adoption of the draft SFDR ‘Level 2’ technical specifications, delivered by the ESAs last December.

There remains no interim target date for outgoing Commission, whose remit will end on 31 October.

If they choose to adopt the draft SFDR RTS, a formal co-approval from both the new EU Parliament and Council is required, to enable legal publication.  This subsequent EU scrutiny period may last between 3-6 months.

Until recently, 1 January 2026 seemed a sensible placeholder for the L2 RTS legal application date, based on apparent EC readiness to provide “at least one year” for transition.  However, if the EC draft RTS adoption continues to drift, this may be change.

Once again, more to follow.

4. SFDR Level 3: latest Q&A updates

Yesterday, the ESA published an updated version of their consolidated SFDR ‘Level 3’ Q&A document.

This edition contains substantial additional content (i.e. sixteen new questions), covering:

• Scope Issues (Q4-5,5-6);
• PAI disclosures (Q26-29,27-29);
• Financial product disclosures (Q20-28,40-52).

 Firms are likely to focus on the ESA’s extensively updated ‘Financial product disclosures’ chapter, including:

• Detailed worked example of PCD EU-Taxonomy calculation, disclosure (p.40-43);
• Detailed worked examples of product ‘sustainable investment’ calculations at ‘ economic activity’ and ‘investment’ levels (p.43-48);
• Four pages of additional advice, covering product PAI look-thru calculation, FMP delegation arrangements, hedging/liquidity rules, ‘passive’ financial products, SPVs, website publication of PCD/PD (p.49-52).

5. ESMA ESG fund naming rules

On 14 May, ESMA finalised their ‘Level 3’ guidelines on ‘Fund names using ESG or sustainability-related terms’.

Since then, there has been no confirmation of the official publication in all EU languages (i.e. which triggers their formal application to existing EEA products, within nine months)†.

Meanwhile, Morningstar research in this area continues to attract industry attention.

Within latest analysis highlights (now available publicly), they point to:

• 4,300 EU funds with ESG- or sustainability-related names: may fall in the scope of the new guidelines;
• Circa 1,600 EU funds: exposed to stocks “potentially in breach” of ESMA climate benchmark exclusion rule.
  • 79% of these funds: classified as ‘Article 8’ products;
  • 21% are passively managed: holding almost USD19 billion of stocks potentially affected;
  • 70% of these funds hold fewer than five stocks that could potentially violate the exclusion rules;
  • 30% of these funds require portfolio adjustments (“which may be problematic depending on the type of investment strategy and portfolio size”).

It is now proposed impacted EU firms consider ‘re-positioning’ to ‘transition’ funds, or ‘rebrand’ (i.e. remove ESG-related terms). Either action would likely require a chain of events (e.g. amended prospectus, NCA approval, client notifications, etc) in the time available (i.e. akin to UK asset managers within SDR scope).

†NB: on 22 July, ESMA issued an updated version of their ‘Guidance Tracker’, which summarises the current status of all EU legal regime ‘Level 3’ advice, available to financial services firms and regulators.  At this stage, ESG fund name guidelines [row no. 99] remains un-translated, with no ‘date of application’ yet specified.

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C) latest ESG Market trends, opinion

1. SFDR product landscape as at end Q2-2024

This week saw the publication of Morningstar’s latest quarterly SFDR article 8 / 9 products report.

Latest Q2-2024 EU fund trends include:

a) ‘Sustainable’ products: QTR inflow/outflow

• Article 8 funds: EUR 26 billion inflow
• Article 9 funds: EUR 6 billion outflow
• Article 6 funds: EUR 64 billion inflow

b) ‘Sustainable’ products: market share per AUM

• Article 8 funds: EUR 5.6 trillion [57.6%]
• Article 9 funds: EUR 0.3 trillion [3.4%]
• Article 6 funds: EUR 3.8 trillion [39.0%]

2. AMF: no firm “fully complies with SFDR”

Earlier this month, the French funds regulator published the results of three separate reviews, each covering the local funds industry’s compliance with EU sustainable finance rules.

The Autorité des Marchés Financiers (AMF) conclude none of the asset managers they examined are “in full compliance with the SFDR regulation regarding the information required”, either at entity level, or at fund level.

One reason cited is “missing information”, due to “a lack of relevant external data available and/or insufficient historical data”.

The AMF also point to the complexity of the disclosed investor information, “…due to the use of technical terms making it difficult to access, particularly for retail investors”.  They also remind distributors of their obligation to ensure marketing materials are “accurate, clear and not misleading, even if they are simply relaying the promotional documents produced by the producer asset management companies”.

3. BaFin: call for 67% reduction in PAIs, one extra EU-ESG fund label

Finally for now, the German funds regulator recently proposed a two-thirds cut in mandatory principal adverse impact (PAI) indicators, as part of a reformed SFDR regime.

Contrary to the main SFDR objective of enabling greater transparency of sustainable investment firms, BaFin cite “insufficiently meaningful” disclosures, most notably in relation to the entity-level PAI statement. Ongoing, they say disclosed data “should be limited to a small amount of data points that are still important and meaningful”.

Elsewhere, BaFin propose the EC create three labelling categories for ‘sustainable’, ‘transition’ and ‘exclusion’ products; they also support a “more precise” SFDR ‘sustainable investments’ legal definition.

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Article written by Mark Kilbride