From tactics to strategy - how firms should respond to emerging UK sustainable finance regulation
February 2022
Those plugged into previous COP events are likely to have noticed the increased focus on finance at the November 2021 conference. Firms now have the outline of the UK ESG regulatory agenda for this year and beyond, notably through HM Treasury's Greening Finance: A Roadmap to Sustainable Investing.
In this article, we consider the main aspects of this UK roadmap, the key challenges, and outline why firms need to take a three-pronged approach to tackling this agenda - establishing a clear strategy, underpinned by data and the right touchpoints across the organisation.
A focus on definitions and disclosure
It is worth recapping the main features of HMT’s roadmap before we consider the challenges firms are facing and how they should respond. There are four main pillars, as we summarise in our At a glance briefing. The most airtime has been given to two components of the roadmap - UK Green Taxonomy and Sustainability Disclosure Requirements (SDRs).
Firms will welcome the extra clarity on the UK Taxonomy, where HMT has confirmed it will be adopting the structure of the EU Taxonomy1. But the Government may deviate from the EU’s approach to the Delegated Acts and Technical Screening Criteria, and it intends to consult on an approach during Q1 2022, before legislating by end-2022. Precisely when the UK Taxonomy will be in full operation will depend on the parliamentary timetable, but it’s expected to be two to four years after royal assent of primary legislation.
On the SDRs, the regulator is envisaging a three-tier regime comprising an investment product label, consumer-facing product-level disclosures, and more detailed disclosures at both entity and product levels (see Figure 1 below and our At a glance). It will consult on formal proposals in Q2 2022, with the implementation timings linked to the Taxonomy dates outlined above.
Figure 1: UK SDRs for asset managers, asset owners, and investment products
What is the purpose of the label?
There seems to be broad support for a UK labelling system. This would, in principle, help investors to more clearly delineate between the ESG focus across different investment products, and to make more informed decisions over their investments.
However, it will be important for the FCA to be clear on the purpose of the label. The proposed approach could be read as suggesting that the scheme would only support products focused on climate or net zero. Note, for example, the ‘transition’ label, which is usually a term associated with transitioning to a lower-carbon economy - as well as the link to the UK Green Taxonomy.
That said, the ‘impact’ label appears to be focusing on environmental or social impacts. Firms are likely to welcome some further clarity on whether the label is intended to cover products that have the full spectrum of ESG characteristics, or purely environmental aspects which appears to be consistent with the UK regulators’ broader narrative on ESG.
Making the label as simple as possible
Firms will want to see very clear definitions for each label so they have confidence in how to classify products - avoiding a repeat of SFDR, where there has been nervousness around what constitutes Article 8 and 9 funds and firms being at risk of accusations of greenwashing.
There has been some suggestion in the industry that the regulator could adopt an approach similar to Eco labels used on electrical products, which give a simple colour-coded graphic to illustrate some basic ESG metrics against which a product could be assessed. But could this create room for greenwashing? This approach would rely on firms having robust governance to underpin the application of the label, and could place more importance on the accompanying product disclosures.
Disclosures need to be decision-useful
There seems to be little dispute that it would be helpful to provide institutional investors with information on areas like methodologies underpinning ESG metrics, data sources and limitations, historical ESG information, and more granular details of performance benchmarks. Such disclosures would enable those investors to perform detailed due diligence, which will be expected of them when making decisions on behalf of their own clients.
But there is some debate around the extent to which retail investors will really value the disclosures being envisaged by the regulator. Will they, in practice, read a regulatory disclosure document, and is this the most decision-useful way of understanding the ESG features of a product? There may be lessons here from KIIDs under the PRIIPs Regulation. Some have suggested that placing heavier reliance on the labelling scheme might be a more appropriate way of telling retail investors about basic ESG information, perhaps combined with a greater focus on the robustness of product design and governance to provide further safeguards against greenwashing risk.
Alignment with SFDR
There had been fears that the SDRs might be wildly different to EU SFDR. This is why the FCA’s clear ambition to align where possible will be welcomed by firms. At a conceptual level, there are clear similarities between the two - both look to increase transparency over the ESG features of investment products, provide a product classification regime (even though this wasn’t intentional under SFDR), and link to the relevant broader taxonomy framework.
The labels in the SDRs broadly map to SFDR classifications. For example, the FCA says ‘Sustainable - Aligned’ and ‘Sustainable - Impact’ funds would correspond to an Article 9 fund under SFDR, while the ‘Responsible’ label is equivalent to an Article 8 fund. However, the regulator’s mapping does raise some questions. Might a ‘Sustainable - Transition’ label feel more akin to an Article 9 fund, given the potential positive contribution such funds could make through the process of transitioning to a more sustainable outlook? Should funds ‘not promoted as sustainable’ systematically integrate ESG risks into the investment process, setting this as a minimum standard in the way that SFDR does through Article 6 funds? It will be interesting to see where the FCA lands on this since it is likely to be an area that the industry has strong views on. But, ultimately, any differences will create challenges for firms caught by both regimes.
Based on the Discussion Paper, the disclosure requirements themselves are also likely to differ. Arguably, the UK’s three-tier approach is more helpful since it distinguishes between different investor groups, tailoring the information to best suit their specific needs. But by taking a different approach, the regulator will be asking firms to introduce new controls and processes to generate the disclosures under the SDRs, which will add to workload both for initial implementation and on an ongoing basis.
Towards a more strategic response
Just a few months ago, firms were in tactical mode, dealing with one ESG regulation at a time. However, the nature of the conversation we’re now having with clients is changing - a direct response to the multiple overlaps between different ESG regulations.
As addressed above, the UK SDRs have some synergies with SFDR, but also with other initiatives. Take, for example, the UK and EU Taxonomies, the EU’s changes to MiFID, AIFMD, and the UCITS Directive, and the various UK TCFD requirements. Like SDRs, all of these impact the front office and product design, many influence disclosure and reporting, and all require a lot of data to understand ESG risk exposures and impacts.
It will be important for firms to think through how they can develop an operating model for dealing with new regulations that is as future-proofed as possible, is flexible enough to meet the requirements of multiple pieces of regulation as they develop, and is based on a forward-looking assessment of requirements and needs.
- Consider your wider ESG ambition and strategy: Firms need to define what ESG means in the context of their own organisations, and establish a clear strategy for achieving their vision. The more advanced firms are looking at how they can leverage incoming regulation such as the UK SDRs and Taxonomy to drive broader ESG-focused transformation across their business, facilitating value creation along the way.
- Identify the touchpoints across your organisation and involve the right people: Given the overlaps in initiatives mentioned above, firms will need to understand the various regulations they are in scope of, the impacts they have on various business functions, and the right people to involve to develop a response. Firms would be wise to consider their response to the UK SDRs and Taxonomy in this context, rather than in isolation.
- Lock down your data strategy to underpin this: By getting the right data, firms should be able to react to the various ESG disclosure requirements they face. While there may be differences in the specific requirements, establishing a central dataset that can be drawn upon will allow firms to be more agile in responding to regulation as it arises. This highlights the need for a comprehensive ESG data strategy, not least given the challenges firms are encountering in accessing the data to meet their ESG regulatory obligations. This will involve a mix of increased engagement with companies and counterparties that firms are exposed to, continuing to encourage ESG data providers to find industry-wide solutions, and leveraging technologies such as natural language processing and machine learning to extract unstructured ESG data.
Clearly, HMT’s roadmap is a major development in the UK’s regulatory framework for sustainable finance, and will generate some big-hitting initiatives of importance to financial services firms. Engaging with this at the outset will be critical, but it will be equally important that firms don’t lose sight of how this fits into the bigger picture - since it will be this strategic view that is likely to determine how successful firms are in meeting regulatory expectations in a way that makes business sense.
1. This means the UK Taxonomy will be made up of six environmental objectives and, to be Taxonomy-aligned, an economic activity must contribute to at least one objective, ‘do no significant harm’ to the remaining objectives, and meet minimum social safeguards. UK-registered companies will be required to disclose the proportion of their activities that are Taxonomy-aligned, while providers of investment products will have to do the same for the assets they invest in.
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