In October the UK’s Financial Conduct Authority (FCA) published a consultation paper setting out their proposals for a new regulatory instrument to govern the use of certain terms in the names and marketing of investment products.1 While this was perhaps not the most compelling topic to discuss with family members over Christmas dinner, it nonetheless represents, in our view, the greatest ever shake-up of the UK’s sustainability investing market.
The need for an SDR regime
It is important to state at the outset that WHEB remains very supportive of the principle of FCA action in requiring more rigour in the use of key terminology in sustainability investing.2 Key terms like ‘sustainability’, ‘sustainable’, ‘green’, ‘ESG’, ‘responsible’ and ‘impact’ have become much used – and abused – and the FCA is right to regulate the use of these terms. Done in the right way, the regulations will ensure that these terms have validity, represent something distinct and meaningful that supports the transition to a more sustainable economy and that ultimately will enable consumers to navigate the sustainability investing market effectively.
WHEB is also very supportive of most of the proposals contained in the consultation paper which we think are a sound basis for building transparency and trust in sustainable investment products. However, there are some critical aspects where we believe the proposals would have the opposite impact to what the FCA intends and actually reduce transparency and make the market more confusing for consumers.
The sustainable impact label
The key area of disagreement for us is in the definition of the sustainable impact label. The vast majority of WHEB’s investors invest with us because they want to put their capital into businesses that are providing solutions to critical social and environmental problems, and, almost as important, they do not want to put their capital into businesses that are contributing to these problems. It is this enterprise contribution – the positive impact of the companies that we invest in – that is central to our clients’ investment objective.
The current proposal for the sustainable impact label however does not focus on the enterprise contribution at all. Instead, it is based on the precise and direct measurement of the contribution that the investor makes through their engagement with companies, their influence on asset prices or on decisions to allocate capital to underserved markets. We recognise the distinction between the enterprise contribution and the investor contribution and believe both are important.3 But by focusing on the investor contribution in this way, the FCA is seeking to redefine impact in a way that does not reflect current market practice or understanding and contradicts how this term has been defined elsewhere.4
In our view, the current proposals will dramatically reduce the size and scale of the impact fund market in the UK. They will create a label that will only be useable by illiquid, unlisted and often sub-market rate of return products. Consequently this label will be largely irrelevant to the retail market. What’s more, many strategies that currently define themselves as impact will likely be forced to use the ‘sustainable focus’ or ‘sustainable improver’ labels, conflating different types of strategies under a single label. The result will be reduced transparency and consumer choice and increased consumer confusion – the opposite of what the labels are intended to achieve.
'Computer says no'
We are conscious that just objecting to something is not very helpful. Fortunately, we believe that some relatively minor tweaks to the label definitions would align the FCA’s proposals with the market and drive the higher standards the market desperately needs.
Market participants have already categorised sustainability investment strategies into three broad types:
1) strategies that invest in companies or assets with leading standards of social or environmental sustainability including for example companies that have already aligned or have credible, validated strategies for aligning with the Paris Agreement.
2) strategies that invest in companies or assets that aim to deliver measurable improvements in the standards of social or environmental sustainability of those assets including for example companies that are not aligned with the Paris Agreement.
3) strategies that invest in companies or assets that provides solutions to critical social or environmental problems and that have an explicit objective to achieve a positive measurable contribution to these problems.
The FCA’s labels should mirror this structure with the ‘sustainable focus’ label covering (1), ‘sustainable improvers’ as (2) and ‘sustainable impact’ as (3). But the FCA should also go further and drive higher standards by requiring investment managers to provide clearer reporting and documentation to underpin their claims to each label. The current proposals do this very well in our view.
Pragmatism in portfolio management
Perhaps one of the most important implications for advisers, wealth managers and retail consumers, is the proposal for model portfolios, fund of funds and pensions products that build diversified portfolios. Under the current proposals, portfolio management services can only use a label if 90% or more of the value of all constituent products in which they invest qualify for the same label.
We think this threshold is unworkably high. It does not, for example, account for the need to hold other asset classes such as government bonds and cash or equivalents, which are unlikely to qualify for the labels. In combination with the 90% rule being restricted to a single label, it would likely lead to very few portfolio management services being able to use a label, and those that do becoming very narrowly based in a way that does not provide appropriate diversification for consumers.
Again, we think there is a relatively simple solution. We suggest reducing the 90% hurdle to 70% and allow mixing across labels for portfolio management services to use a broader ‘sustainable’ label, combined with increased transparency on the exposure to the discrete fund labels contained within. This would also allow the regulations to be extended consistently to include pensions products, which are currently out of scope.
There are other amendments that we plan to propose in our response to the consultation paper which we will be publishing on our website once it has been finalized. In the meantime, we strongly encourage UK market participants to respond to the consultation which runs until 25th January. WHEB stakeholders who are keen to discuss any of the points raised in this blog or in the consultation are very welcome to contact Seb Beloe at email@example.com
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1 Financial Conduct Authority, Sustainability Disclosure Requirements (SDR) and investment labels Consultation Paper CP22/20, October 2022 (https://www.fca.org.uk/publication/consultation/cp22-20.pdf)
2 WHEB for example published a blog supporting the FCA’s ESG and sustainable investment principles in July 2021 https://www.whebgroup.com/news/wheb-responds-to-the-fcas-new-esg-and-sustainable-investment-principles and a similar response following the FCA’s ‘Dear Chair’ letter https://www.whebgroup.com/assets/files/uploads/20210723-response-to-fca-dear-chair-letter-final.pdf
3 For example see WHEB’s white paper ‘Impact investing in listed equities – WHEB’s perspective’ (https://www.whebgroup.com/assets/files/uploads/20211014-impact-investing-in-listed-equtities-whebs-approach.pdf)
4 For example the Global Impact Investing Network (GIIN), the International Finance Corporation (IFC) and most recently the European Securities and Markets Authority (ESMA) all define impact based on the intention of the investor to have a positive impact and the measurement of positive impacts and outcomes.