Just as investors thought they had their heads around European green funds rules, the UK regulator has revealed the proposals for its own sustainability disclosure regime.

At first glance, a second set of rules seems like a guaranteed headache and added paperwork for firms that market funds both in the EU and the UK.

But investors at financial institutions who work with European and international clients have welcomed the UK’s rules as a more stringent guide for ESG portfolios.

Stephen Metcalf, head of sustainability at RBC WM, said that under the EU rules a fund name alone can be enough to meet the requirements of promoting sustainable objectives.

‘This is very different to what the FCA is proposing, where anything with a sustainable label will have more prescribed conditions on what it can hold.’

‘Many Article 8 funds will not qualify for a sustainable label under FCA – this will be a big challenge,’ he added.

The FCA consultation paper notes that ‘ESG integration’ funds cannot qualify for the labels and advocates to ban funds that do not qualify for any label to use terms such as ‘ESG’ and ‘responsible’ for example.

Katie Soleil, a senior project manager at J Safra Sarasin, said under the Sustainable Finance Disclosure Regulation (SFDR) framework you could potentially have a ‘sustainable income’ fund that qualifies as an Article 8 fund.

But under the FCA proposal, this would be impossible; funds would either follow the rules and labelling or not.

‘It is good to get rid of this middle ground where you get into the greenwashing territory, where you are not really breaking the regulation, but you are not following the spirit of it,’ Soleil said.

The consultation period on the FCA’s proposed Sustainability Disclosure Requirements closes on 25 January 2023.

Compare and contrast

The biggest difference between the two regulatory regimes is that the UK’s goes further, including the introduction of green fund labels.

The EU framework has so far only focused on providing anti-greenwashing disclosures, which do not come with minimum investment thresholds or prescribed asset allocation.

Soleil said with the EU’s SFDR you almost get labelling through the back door, without having a clear framework.

‘In the UK they just said: here are the labels and this is what you have to do if you want to get this label. And this is exactly what SFDR should have done.’

There is no direct translation between the EU and UK disclosures, given SFDR is not a labelling regime, but they roughly compare as follows:

EU SFDR

• Article 6: all managed products.
• Article 8: funds promoting environmental and social characteristics.
• Article 9: funds with sustainable investment objectives.

UK SDR (proposed)

• Sustainable focus: funds investing in environmentally or socially sustainable assets.
• Sustainable improvers: funds aiming to improve the environmental or social sustainability of their assets over time.
• Sustainable impact: funds investing in solutions to environmental or social problems to achieve a positive, measurable real-world impact.

The UK’s labelling system has some clear differences, in line with what the industry has requested. For example, the ‘sustainable improvers’ category is absent from SFDR.

This category aims to capture investment strategies that are tracking improvements in companies over time, where investment teams can engage and flex their stewardship muscles. Consider the differences between a company that consumes little CO₂ today compared with a traditional chemicals group that has a promising decarbonisation trajectory.

Andy Pettit, director of policy research at Morningstar, said most ESG funds would either need to change considerably to meet the UK ‘sustainable focus’ or ‘sustainable improvers’ labels or rebrand themselves.

‘This certainly goes far beyond the EU SFDR, which simply requires ESG funds to elect their type and produce a set of disclosures accordingly,’ he said.

Making an impact

Another difference between the UK and European frameworks is a specific impact category, which at first glance echoes the EU’s dark green Article 9.

RBC’s Metcalf said Article 9 funds are often thought of as impact, but they are not, as it only invests in ‘sustainable investments’, which would more closely correspond to the FCA’s ‘sustainable focus’ label.

In his view, such a discrepancy could also mean that some funds that are marketing as ‘impact’ might not get a corresponding fund label in the UK.

‘Many Article 9 funds would not be able to label themselves “sustainable impact”. Again, this is very welcome as many current claims around real-world impact are spurious,’ Metcalf said.

The impact dilemma illustrates nicely one challenge that firms marketing both in the UK and Europe will be facing. The UK regulator has put sustainable objectives at the heart of its proposals, even for its least demanding ‘sustainable focus’ category.

This creates a problem, where Article 8 strategies under SFDR may not qualify for any kind of sustainable label in the UK, given they only promote environmental and social characteristics.

J Safra Sarasin’s Soleil said: ‘They are going to require that either Article 8 has to meet sustainable objective requirements, or you are going to suddenly get a lot of companies trying to shoehorn funds into Article 9.’

Challenges ahead

Investors will no doubt spend even more time discussing the finer differences between the EU and UK frameworks but one thing is clear: this will mean more time and expense for investment firms.

Many asset managers will have to decide how they are treating regulations, opting for a label here and a classification there. In some cases, this may even lead to asset managers launching different funds for different markets.

The more regulations that come into the mix, the more complicated it is when fund managers want to change their methodology, investment approach and investment thresholds, especially if they do not want to be too restrictive.

‘It just becomes another key performance indicator that the investment manager must adhere to. That’s where, potentially, there’s going to be the most amount of time spent,’ Soleil said.

Even disclosure documents may differ. The EU regime requires ESG information in annual reports, prospectuses and on websites, while the FCA proposals are targeting prospectuses, a consumer-facing summary and a sustainability entity report.

Yet for many investors, these challenges will help them shape better outcomes for clients in the long run. RBC’s Metcalf said he was overall pleased with what the FCA has proposed.

‘It seems to make a lot of sense, captures nuance that many other regulations in the space do not, and should bring more structure to the market.’