The EIRIS Foundation is pleased to have had the opportunity to respond to the FCA consultation on Sustainability Disclosure Requirements (SDR) and investment labels.
The EIRIS Foundation is a research, advocacy and advice charity pioneering the next steps in sustainable finance. Through our former subsidiary EIRIS (which we sold in 2015) we played a significant role in creating and providing research for a number of long-term ethical and green funds since 1984. We also provided a variety of guides to explain their approaches and the difference between them in the early years to help retail investors understand what was on offer. And for many years we have a provided an annual update on the total assets under management (AuM) of green & ethical funds in the UK, with some commentary of the evolution of the market.
So from our point of view there is a lot to welcome in the proposals in CP22/20:
- They highlight three very important elements of sustainable finance: Creating portfolios of companies contributing to a more sustainable future (“Sustainable Focus”); improve the sustainability quality of existing assets (“Sustainable Improvers”) and putting money to work in new ways that can deliver real world sustainability outcomes (“Sustainable Impact”).
- The emphasis on the need to be clear about the sustainability objective of a fund and deriving what follows from there.
- Generally introducing a lot more rigour into the marketing and disclosures of green and ethical funds and careful thought where disclosures should appear which may help to address our previous experience of considerable difficulty and inconsistency in how funds present their offers.
- The focus on evidence-based assessments of how consumers understand disclosures in practice and the matching encouragement to firms to take the same approach in developing their own communications to consumers.
- The work to align with and learn from the EU SFDR where possible, and to look for future alignment with ISSB and other emerging standards.
- The detail and rigour of the implementation guidance and associated principles.
But we should also highlight some omissions and challenges:
- It is not obvious what is gained by making the three labels mutually exclusive and requiring fund providers to choose between them.
We do not believe that many investors are looking for one of these elements (focus, improvement and impact) at the expense of the others, even if different people may seek a different balance. Indeed people may want to combine these approaches for financial reasons as well as sustainability ones: to lower the risk of very focused funds, and to increase diversification or to increase a particular exposure without going “all in”.
It is not always sensible (particularly over time) to suggest that consumers should arrange their own portfolio to that end and the rules proposed may prevent a fund of funds that seeks to provide a combination from being labelled at all under the 90% label alignment rules. If the investment is linked to pensions, insurance or other financial products it may not be possible for the consumer to combine individual funds anyway.
Mutual exclusivity will actively discourage individual funds from combining these elements for the consumer and may even deny such a fund the use of any of the labels in some circumstances.
Some practical examples:
- With the growth of impact investing options, it is increasingly possible for public market funds to put some of their cash or bond exposure into investment delivering real world outcomes related to their sustainability objective, or to make use of collective equity vehicles with such impacts. This is not the same as a fund devoted to impact, but would represent increased “sustainability value” for some (and possibly many) investors compared to a fund that did not do this. But it is proposed that focus or improvement funds will be barred from talking about impact in their communications when a more appropriate solution would be to require a clear statement of the percentage of the portfolio meeting whatever emerges as the impact requirements.
- A focus fund emphasising low carbon infrastructure may find that many such assets have not attended to human rights associated with land use or raw materials sufficiently. But rather than excluding such assets, retail investors might prefer to see a combination of social improvement with environmental focus. Our work with the Business & Human Rights Resource Centre in researching their most recent Renewable Energy benchmark highlighted exactly this dilemma as part of the accelerating conversation on Just Transition. Asking a manager to choose between labelling such a fund as focus or improver will only add to confusion for consumers. Especially when they might view the combination as a more valuable way to advance their sustainability objective than either approach individually.
- An Impact fund that cannot commit 100% of its assets at any one time to illiquid investment may have good reasons to invest in public markets with either a focus or improvers approach to sustainability and may be better regarded by investors than would be the case if they were to invest their current uncommitted assets in less sustainable assets. Such investors deserve to know whether that part of their portfolio would qualify for a label (viewed separately) and to benefit from the proposed related disclosures.
It would be better to allow funds to adopt more than one label if they wish to do so, and where appropriate to segregate assets and declare the proportion of their portfolio that meets the requirements for each label if their whole portfolio does not.
- Although there are a number of references to “what the fund invests in and what it does not” there is no attempt to address the green washing challenges of negative screening, which remains a significant part of the existing market.
Challenges that should be addressed include:
- References to topic (for example tobacco) without clarifying the criteria applied: production or sale; nicotine in any form or just cigarettes; whole products or major components suppliers; or whether a turnover threshold is applied and what that might mean in practice by means of straightforward examples: in this case the effect of the criteria on supermarkets for example.
- References to screens without clarity about whether those screens apply to any indirect holdings in other funds or just to directly held assets. Particularly important for funds of funds, but there are many products that mix direct holdings with funds for exposure to particular markets or themes.
Some of this could be seen as related to the proposals for disclosing unexpected investments. If a typical consumer would be surprised to know the details of actual holdings having read any published negative screens, then there is a greenwashing problem.
- The fact that no equivalent of the EU SFDR requirement to disclosure principal adverse impacts has been identified is unfortunate:
- This means that consumers, including those investing in unlabeled funds will be denied information on exposure to a number of potential ESG risks that could have financial implications even if the consumer is not interested in sustainability.
- It also means that an important lever to advance sustainable finance, and to help develop the UK as a marketplace with greater capacity to identity and then prevent, reduce, or mitigate ESG risks is not being deployed.
- For labelled funds, this may be particularly important for social factors, especially if the main focus of the fund is environmental. Consumers might be surprised to know that holdings involve violations of social standards, but if the sustainability objective was expressed in purely environmental terms, such things might not have to be disclosed as “surprising investments” at all under the present proposals.
- The analysis of such impacts can also contribute to a benchmark or starting point against which to understand the “sustainability add” of a particular focus or improver fund. For example a fund that says that part of its focus is to keep investment in controversial weapons below a given threshold, but one that is already many times that of the market exposure is clearly adding nothing at all in that regard.