UK Sustainability Disclosure Requirements (SDR): Key insights and implications for firms

On the 12th of January, 2023, DLA Piper marked the year's commencement with a groundbreaking UK Sustainable Disclosure Requirements (SDR) event hosted by the International Monetary Fund (IMF). The event spotlighted the Financial Conduct Authority's (FCA) recently published SDR and investment labels consultation paper (CP22/20). This SDR initiative, initially released in October 2022, remains open for consultation until 25 January 2023, with the FCA planning to declare its policy statement and final rulings by summer 2023.

The FCA's SDR is designed to enforce naming and anti-greenwashing regulations across all FCA-authorized firms, while limiting labelling and disclosure requirements to select categories of in-scope firms. For instance, these requirements target UK alternative investment firms, UK portfolio managers, and UK Undertakings for the Collective Investment in Transferable Securities (UCITS) management companies. These rules are primarily geared towards firms with sustainability-focused strategies, though some regulations apply across the board, even to firms without a sustainability agenda.

The regulatory landscape will continue to evolve with further consultations anticipated over the next few months. These will examine the potential inclusion of overseas funds, financial advisors, and pension funds under the new regime. Similarly, it will seek alignment between the labelling and disclosure requirements and the forthcoming UK Green Taxonomy. It is crucial for all firms to stay actively involved in the consultation process, either individually or through industry associations, to ensure balanced regulation outcomes.

From a timeline perspective, the anti-greenwashing rules will come into effect as soon as the policy statement is publicized. Other regulations such as naming and marketing rules, the labelling regime, pre-contractual disclosures, and rules for distributors will be applicable a year hence. The sustainability product report and the entity-level disclosure obligations will be enforced from 30 June 2025, following certain phase-in requirements.

Below, we provide a succinct summary of the key points discussed at the SDR-focused event and a link to our recent client briefing on the SDR.

Insights from the SDR consultation paper

• The simultaneous rollout of SDR and labels demonstrates the UK's lessons learned from the issues encountered by firms executing the EU Sustainable Finance Disclosure Regulation (EU SFDR). The EU SFDR's Article 8 and Article 9 were not designed as labels but ended up being treated as such. The UK's method of introducing labels alongside the disclosure requirements seeks to ensure distinct differentiation.
• The qualifying criteria for labels demand high standards for Key Performance Indicators (KPIs). The consultation paper underscores the need for firms to maintain KPIs that are credible, rigorous, and evidence-based, posing potential challenges for some sectors and asset classes amidst evolving sustainability methodologies and data availability.
• Firms are prompted to reassess their governance structures and resources to ensure their compatibility with product sustainability objectives and the stated sustainability disclosures.
• Stewardship holds a significant position in the qualifying criteria for label use. Firms must examine their existing stewardship policies and practices, establishing credible, rigorous, and evidence-based KPIs that demonstrate the role of stewardship in achieving sustainability objectives. Active engagement with the FCA during the consultation process will be essential to navigate these challenges.
• Updating a fund's objectives to incorporate sustainability will likely require an application to the FCA. The consultation paper leaves it unclear whether the FCA will establish a special fast-track process for this purpose.
• Firms adopting a label will be required to notify the FCA within a month. The FCA assures that a dedicated mailbox will be provided for this purpose.

Labelling regime under UK SDR

In its quest for sustainable finance, the FCA initially proposed five labels under the SDR but decided on three after extensive feedback: sustainable focus, sustainable improvers, and sustainable impact. The FCA emphasises that there is no hierarchy among these labels, as each one aims to deliver a unique asset profile and cater to different customer preferences.

Businesses can opt whether or not to assign a label to their investment products, but the FCA stipulates a set of qualifying criteria that must be met:

1. Five general principles, encompassing: (a) sustainability objective; (b) investment policy and strategy; (c) key performance indicators (KPIs); (d) resources and governance; and (e) investor stewardship;
2. Complementary criteria that cut across different categories and specify what firms must do to satisfy each overarching principle;
3. Category-specific key considerations applicable to each label.

While the SDR rules focus on the environmental and social impact of the underlying assets, the measures taken by the fund and the fund manager to contribute to positive ESG outcomes are also crucial. Thus, the FCA SDR requirements assess the value added by the fund and the manager through active stewardship, asset selection, portfolio construction, and the pursuit of positive sustainability impact by diverting capital to underserved markets or remedying market failures.

The criteria for each label must be wholly met and continuously adhered to for a product to carry the corresponding label. Consequently, businesses must evaluate and implement the appropriate criteria throughout the product development process, ensuring ongoing monitoring and compliance.

During discussions, the following high-level points were noted:

• While the use of labels is not mandatory, if a product incorporates ESG design features as essential components, disclosures must be made. This aspect of the consultation raised concerns due to its vagueness regarding which features qualify and what would be considered a proportionate disclosure.
• The FCA has clarified that "ESG Integration" is now standard operating procedure, marking a departure from the previous discussion paper's ambiguity about the "ESG integration category." The FCA increasingly views integration as inherent to the concept of "fiduciary duty."
• The 'Focus' category is flexible, encompassing products with sustainability traits aimed at maintaining those attributes. Products must meet a credible, robust third-party standard or target a specific theme, with 70% of assets dedicated to that objective. This category's main influence is asset allocation, with stewardship playing a secondary role.
• The 'Improvers' category includes products transitioning from brown to green, requiring a framework for reasonable progress over time with clear metrics. Market sentiment strongly supports this transitional style label. Stewardship is the primary influence in this category, with relative asset allocation taking a back seat.
• The 'Impact' category features products with predefined, measurable positive environmental and social outcomes addressing market failures. The primary influence here is the introduction of new capital that wouldn't otherwise be available, with stewardship playing a secondary role.

The 'Improvers' category was appreciated, and 'Impact' was deemed consistent. However, the 'Focus' category raised concerns due to the distinction between standard and theme components.

FCA's proposed categories

The FCA has proposed three categories of disclosures under the SDR: (a) consumer-facing disclosures; (b) product level disclosures (pre-contractual and ongoing sustainability); and (c) entity-specific disclosures. While there is no plan to standardise these disclosure templates at present, the FCA provides guidance on the scope, format, content, location, and frequency for each disclosure type. Firms should assess the merit of creating an industry disclosure template, adaptable to different sectors and asset classes.

High-level points noted during discussions include:

1. The FCA plans to add more detail to product and entity-level disclosures, aligning with the standards being developed by the international sustainability standards board. As with the SFDR, concerns arise if the disclosure requirements come into effect before the detailed guidelines are finalised, potentially leading to confusion, uncertainty, and unnecessary costs. If disclosure requirements change to align with international standards, firms hope the FCA will provide ample time for the necessary adjustments in internal processes and procedures.
2. Firms offering portfolio management services are not required to create their own consumer-facing and product disclosures. Instead, they must provide an index of underlying products and easy access to the relevant product label and disclosures. Some potential issues include:
• The consultation paper is unclear whether these firms must conduct regulatory due diligence on underlying disclosures, though it is likely they will need to from a commercial and investor expectations perspective. There is no acknowledgement of potential risks and liabilities these firms may face when relying on such disclosures.
• The paper does not detail what these firms should do if they disagree with the assigned label or statements in the underlying disclosures.
• Similar to concerns with SFDR, there are doubts about the sufficiency of data availability across the investment chain. Appropriate sequencing of disclosures will be key to mitigating this risk.
3. Seven categories of disclosures must be included in customer-facing disclosures, including "unexpected investments," which are holdings that might surprise consumers due to inconsistency with the sustainability objective. Firms must identify such holdings and explain their selection. If firms lack this data, they are expected to conduct a "customer testing" survey. Potential issues include:
• The unexpected investments disclosure requirement adds complexity to the data collection and disclosure process, seemingly without significant benefit to the investor, especially as firms are already required to identify the investible universe and their stewardship approach under the "sustainability approach" heading.
• There is no guidance on the scope, composition, and size of the "customer testing" survey and what firms should do if they do not receive enough customer responses.
4. Some disclosure requirements apply to both firms using a label and those adopting sustainability-related policies and strategies. Given some disclosure items are linked to the label and classification criteria, it is unclear how these firms should comply with these requirements and how this will interact with anti-greenwashing rules.
5. The product and entity-level disclosure requirements are designed to augment the existing FCA Task Force on Climate-related Financial Disclosures (TCFD). However, since TCFD disclosures were recently introduced, there hasn't been sufficient time for them to be fully integrated.

Regulations against greenwashing: guidelines on naming and marketing

The FCA under the SDR is initiating new “naming and marketing” rules. This aims to shield consumers from greenwashing by necessitating communications that are clear, fair, not misleading, and sync with the product or service's sustainability aspect. Hence, sustainability declarations must be proportional and not overstated.

Important points to consider:

• These “naming and marketing” rules under SDR would bar firms from advertising products that fail to qualify for any of the three sustainability labels. They cannot use specific sustainability-related terms such as ‘ESG’, ‘climate’, ‘green’, ‘sustainable’, 'Paris-aligned', and 'net zero'. The implementation of the naming rule seems feasible for new products. But, it could pose issues for existing products that contain potentially banned terms. This is particularly true as the FCA has not yet released a comprehensive list of terms that would violate this rule.
• Products labelled as ‘Sustainable Focus’ or ‘Sustainable Improvers’ will not be allowed to use the term ‘impact’ while naming and marketing under the SDR. This measure is designed to prevent any potential misunderstanding that these products meet the criteria for ‘Sustainable Impact’ products. It remains unclear how these rules will be applied in reality. It’s notable that an exception has been made for stating factual information in pre-contractual disclosures, summarising data in consumer-oriented disclosures; and complying with other disclosure necessities a firm is subjected to. However, the functioning of this prohibition, especially when factual statements are to be included in marketing documents such as a private placement memorandum, is yet to be understood.
• The anti-greenwashing rules under the SDR currently don't include a transition period for compliance. They will be in effect immediately after the FCA publishes its policy statement (anticipated in June 2023). Hence, it is advisable that firms start reviewing their marketing materials related to existing products now to ensure compliance when the rules become operative.
• Other concerns regarding this specific proposal are:
• These regulations may restrict funds from accurately describing the investment and governance actions taken as part of an ESG integrated investment strategy. This contradicts the wider ESG agenda, which encourages firms to actively consider and take positive steps in this area.
• The restricted application of the rules may result in inconsistency between both retail and institutional funds and UK and offshore funds (particularly those already compliant with the SFDR). The consequence could be that UK retail investors may receive less information about the relevant product than their EU or institutional counterparts.

We welcome your comments or thoughts on these proposals and stand ready to offer advice on the potential impact that these new proposals could have on your business operations within the SDR framework.