The UK’s new Sustainable Disclosure Requirements (SDR) aim to transform sustainable investing by providing clearer fund labelling that obliges greater accountability. Formulated by the FCA, the new regulations have been designed to combat “greenwashing,” ie, marketing investments as sustainable without sufficient evidence. The more clearly-defined standards set out in the SDRs seek to ensure that investors can have greater confidence in ESG funds' sustainability claims. There is a corollary effect, however, which is that meeting the stringent SDR standards requires significant input from a compliance perspective, meaning increased costs for fund managers. This in turn appears to be deterring many of them from seeking SDR certification, thereby reducing product availability for both institutional and retail investors alike. What are the SDR labels?The SDRs introduce stricter guidelines and mechanisms by which to distinguish funds according to their sustainability goals. The new labels, which include "Sustainability Focus", "Sustainability Impact", “Sustainability Improvers” and “Sustainability Mixed Goals” are all part of an effort to ensure that investors can gain access to the information they require in order to make meaningful capital allocation decisions in line with sustainability goals. The package of measures includes investment labels, naming and marketing rules, an anti-greenwashing rule for all FCA-authorised businesses and a set of disclosure rules. Challenges for ProvidersKey to the successful implementation of SDRs is the government’s Green Taxonomy, an agreed scheme of classification that will underpin the definitions within the regulatory framework. Unfortunately, it has yet to be finalised by the government, leaving businesses vulnerable to misinterpretation when seeking to comply. Where the UK has SDRs, Europe has the Sustainable Finance Disclosure Regulations (SFDR), which likewise seek to counter greenwashing by promoting transparency. However, where the SDRs set out quite a granular system of categorisation and promote active engagement and results, SFDRs relate to the promotion of sustainable objectives and are relatively less onerous to adhere to. The regulatory differential could lead to various outcomes. Potentially, active fund managers in the UK will be afforded greater strategic opportunities because they can boast of higher sustainable standards for their investments. However, the increased cost involved in complying with SDRs vs. SFDRs may push providers to register sustainable products in Europe rather than the UK, leading to an exodus of funds and a diminished pool of sustainable investments to choose from. The stringent documentation requirements of the SDRs present challenges for smaller ESG funds, which must provide detailed proof of compliance with sustainability goals. Many smaller funds are unlikely to have the infrastructure to manage these complex reporting demands efficiently, obliging further investment in technology and/or workforce the cost of which is likely to be passed on to investors through higher fees. Reducing choiceThere has not been wholesale adoption of the SDRs by the large fund houses. Major firms like Abrdn and Invesco have delayed applying SDR labels such as ‘impact’ and ‘improvers,’ reflecting the industry-wide struggle to meet the FCA’s standards in time. As of July 2024, when the labels were first available, only a few of the largest fund houses had implemented them despite the looming deadlines. Only about 300 UK funds are expected to apply for the SDR labels by the end of the year. Currently, of the 373 funds that classify themselves under an ESG-related label, approximately 30 have obtained an SDR label. Impact on low-cost fundsOne other corollary of the introduction of the SDRs is that they have had a particularly noticeable impact on index funds carrying the sustainable label, the great majority of which can no longer refer to themselves as such. MSCI is one of the largest ESG index providers in the industry with an offering of over a thousand ESG-labelled indices. However it has recently come under fire for greenwashing, with some critics arguing that its ESG ratings lack depth, focusing more on exclusionary screens rather than ensuring that sustainability objectives are actively met. It was these concerns in particular that motivated the FCA to introduce the stricter labelling requirements of the SDR. MSCI is having to remove ‘ESG’ from the names of over 100 of its indices in order to comply with updated fund naming guidelines, a change that will impact a considerable proportion of the sustainable fund market. ESG investments, especially those linked to indices like the MSCI ESG Leaders and Socially Responsible Investment series, have experienced enormous growth globally in recent years. In the UK alone, total assets in sustainable funds have increased from under £20 billion five years ago to over £90 billion today, driven by increasing demand from retail and institutional investors seeking to align their portfolios with environmental and social goals. This momentum is threatened by the changes implemented by the FCA in the SDR SummaryWhile the SDR rules are designed to combat greenwashing and enhance the quality of information available to investors, the knock-on effect is that fewer ESG products are available in the market, and those that are come at a significantly higher cost to investors. The central question remains: is there a better balance to be found between ensuring genuine ESG credentials and maintaining a diverse and burgeoning product universe? Is it more detrimental in the long run to undermine the momentum of fund flows into sustainable investments than to seek to enforce rigorously high standards? Time will tell if the SDRs will prove successful or whether the FCA has raised barriers to entry unfeasibly high.
Andrea Acimovic Head of ESG Research, Elston Consulting Comments are closed.
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