Doing exactly what it says on the tin: regulators crack down on sustainable investment
Paul LeeHead of Stewardship& Sustainable Investment Strategy
Find me on LinkedIn
Sustainable investing, it’s the word on every investor’s lips. So, to ensure you’re well-versed with the latest happenings in this space, we’ll be speaking to a member of our Sustainable Investment team each quarter and sharing their responses via Investment Edge.
This quarter, we spoke to Paul Lee, our Head of Stewardship & Sustainable Investment Strategy, about why regulators are so concerned about sustainable investment and how we can avoid consumer confusion by doing exactly what it says on the tin.
Why are regulators so concerned about sustainable investment?Because the industry has become so interested in sustainable investment – and that’s arisen due to the burgeoning consumer demand for sustainable investment products, or at least, growing consumer expectations that their investments align with their values. Fund managers have created hundreds of investment products labelled as ‘sustainable’, ‘responsible’, ‘ESG’, ‘climate’ or ‘impact’ – or multiple variations of these.
Regulators worry about these labels because they fear that each fund manager means different things by them – often, they mean different things when applying the same badge to different funds! – and there’s a risk that consumers may be misled. There are regular stories about sustainable funds holding fossil fuel companies, such as ExxonMobil or Chevron. That may be entirely justified under the terms of the fund, but is it what consumers might expect given its labelling?
Greenwashing is a word that’s increasingly bandied about in relation to investment approaches. Regulators are keen not to let fund managers get away with it. Germany’s DWS has been fined by its regulator, and it won’t be the last.
An old advert commended a product for doing exactly what it said on the tin. Regulators worry that some investment products may be failing to do that – some may not even be delivering exactly what they state in the small print.
What are regulators doing about it?Essentially, they’re moving to inject more standards into this wild west of labelling.
The EU developed its Sustainable Finance Disclosure Regulation (‘SFDR’) in 2021 and created technical standards last year. SFDR creates three basic categories of sustainability funds, known slightly confusingly as Article 6, Article 8 and Article 9 funds (after clauses in the regulation itself). Briefly, the Article 6 category is for all funds that integrate ESG criteria in the investment process; Article 8 funds include sustainable investments but have a broader investment objective, while the Article 9 category is the toughest to meet as funds must have a clear sustainable investment objective.
Reflecting the SFDR while attempting to learn lessons from it, the UK’s FCA proposed its own Sustainability Disclosure Requirements (‘SDR’) in October 2022, with a consultation that ended in January this year. Under SDR, there would be three main categories of fund: sustainable focus, for funds which invest with an environmental or social standard, and where at least 70% of the fund meets a credible ‘E’ or ‘S’ threshold standard; sustainable improvers, for funds investing in companies that are enhancing their sustainability approach, particularly where the manager applies stewardship to assist this progress; and the most exclusive category, sustainable impact, which would dedicate investment to solutions to real-world problems. It’s expected that stewardship could play a part in delivering these real-world effects, but the bulk of the impact should come from the investment approach itself.
SDR tried to be more specific and substantive than SFDR, focusing more on what’s actually delivered by funds in practice.
How are fund managers responding?Often with confusion and annoyance. Fund managers’ intitial response to the EU’s SFDR was pretty conservative, with very few funds seeking Article 8, let alone Article 9, status. However, the industry’s competitive spirit soon awakened, and there was a rush to assert that funds qualified for Article 9. More recently, this move has reversed as managers became concerned about suggestions of greenwashing – and the number of funds claiming to fulfil Article 9 has dramatically reduced.
As for the annoyance, that was particularly concerning the UK SDR proposals, especially by fund managers that had recently won regulatory approval for a product with one of these labels, which may no longer qualify. Given the effort involved in the approval process, the annoyance isn’t surprising.
Fund managers have also simply started removing ESG, sustainable or climate labels from some products. However, a number of these are US-based, so this change may be in response to the political backlash against ESG investment seen in some parts of that country.
More formally, fund managers responded to the FCA’s consultation, highlighting their concerns. By all accounts, the response from the collective industry body, the Investment Association (‘IA’), was more than 50 pages. The volume of responses overall has led the FCA to rethink its approach. The IA, and the industry as a whole, was seeking greater pragmatism and less prescription from the FCA. It pressed for less detailed requirements around labels and for greater use of disclosures – not least recognising the limitations on the quality of currently available data.
It may well be that the FCA heed at least some of this advice. It seems unlikely the FCA will abandon its plans altogether, but the updated version of SDR may well be more pragmatic and flexible. Notably, in the last couple of weeks, the European Commission has issued a Q&A regarding Europe’s SFDR that has made clear that this will be applied in a much less prescriptive way than many feared. Essentially, investors will be expected to be transparent about what they mean by particular language and what they do in relation to individual funds; the regulator will not compel every firm to do identical things under the same labels. The UK may well follow suit.
How might we respond?We must recognise the realities of the risk of consumer confusion and misunderstanding. Clear disclosures about the investment approach and process of each fund is required, and there needs to be sufficient transparency to ensure that consumers wouldn’t be surprised to find the fund invested as it does given the label that’s been put on it. Investment professionals must operate openly and responsibly. Greenwashing won’t wash.
Our due diligence on funds that make sustainability claims must be especially rigorous, allowing us to understand what these funds do and deliver in detail. And given the focus in SDR on improvers and impact, and the importance of stewardship in delivering both of those, that due diligence needs to encompass stewardship (engagement and voting – in asset classes where there are votes). Fund managers claiming to be able to deliver change at their investments must possess the processes and resources required to do so, and be able to demonstrate a track record of effectiveness in their engagement approaches.
Only the fund managers that can genuinely demonstrate real integration of sustainability into their investment approach and delivery of change through their engagement should be confidently labelled as sustainable. Otherwise, we risk misleading our clients by not delivering what it says on the tin.