The EU SFDR and UK SDR examined | Global law firm

Introduction

Last November the Financial Conduct Authority (FCA) published Policy Statement 23/16 (PS23/16) containing final rules and guidance on sustainability disclosure requirements (SDR) and investment labels (UK SDR regime). The rules and guidance are currently limited to UK asset managers and essentially the requirements comprise of two components, naming and marketing requirements so that products cannot be described as having a positive impact on sustainability when they do not and a product labelling regime designed to help investors understand what their money is being used for, based on sustainability goals and criteria and naming. PS23/16 also saw the FCA introduce an anti-greenwashing rule which applies to all FCA authorised firms.

Many asset management firms that are subject to the UK SDR regime were already subject to the EU Sustainable Finance Disclosure Regime (EU SFDR). In particular, many would have invested in systems and processes to classify products according to the EU SFDR provisions. Whilst the FCA has said that the regimes are compatible and that much of the information used for product categorisation and disclosures under the EU SFDR may be used to meet the qualifying criteria and disclosure requirements under the UK SDR regime there remains some important differences. The purpose of this briefing note is to cover many of these differences.

Different starting point

Regulatory authorities in the EU and the UK have introduced regulations that address growing concerns that sustainable investment products may not be as green as they claim to be. The EU SFDR has been around much longer than the UK SDR regime. At its core, the two regimes are said to be different in the sense that the EU SFDR is intended to be a disclosure regime whereas the UK SDR regime is a labelling regime.

This may possibly change in the future as when the European Commission (Commission) issued its consultation on the EU SFDR late last year it noted that the regime was in practice being treated as a labelling regime for so called Article 8 and Article 9 funds. However, this remains to be seen.

Anti-greenwashing

The UK’s anti-greenwashing rule, due to come into effect on 31 May, has raised a number of issues for market participants particularly given its broad scope. Essentially, the rule requires that all sustainability related claims must be ‘fair, clear and not misleading’. Whilst theoretically limited to financial promotions the rule is much wider as sustainability claims can be present in all sorts of different ways, not just in relation to specific financial services and products, but actually in claims that an institution makes about itself. The accompanying FCA finalised guidance sets out what firms need to do in order to comply with the anti-greenwashing rule and this includes sustainability references being correct and capable of being substantiated. This will be a real challenge for firms as it will require them to build an evidence base sitting behind the assertions which are made not only in all different types of communications but also stakeholder presentations. Another challenge for firms is that communications must be complete, they should not omit or hide important information.

From the EU perspective, anti-greenwashing has been an integral part of financial services policies. Outside the financial sector two of the most recent and visible initiatives have been the proposed Green Claims Directive and the proposed Greenwashing Directive. In the financial sector, there is, of course, the EU SFDR and also the European Securities and Markets Authority (ESMA) has proposed guidelines on fund names using ESG or sustainability-related terms. The key point to note is that, compared to the UK regime, the EU financial sector does not have a specific anti-greenwashing rule.

Scope

Both the EU SFDR and UK SDR regime want investors to be able to align their investment decisions with their sustainability preferences. But a key difference between the two regimes is territorial scope. The UK SDR regime is very UK centric, focussing on UK asset managers, UK domicile products marketed to UK investors. Whereas the EU SFDR is more far reaching as it applies to financial products based or marketed in the EU and financial market participants and their financial advisors. It essentially covers what is in the EU market but also what comes into the EU market.

Sustainability objective

Another important difference is the sustainability objective. Under the UK SDR regime all products using a label must have a sustainability objective which is an explicit statement of intention to invest ‘with the aim of directly or indirectly improving or pursuing positive environmental and/or social outcomes’. Such an objective also needs to be clear, specific and measurable. The EU SFDR identifies three categories of financial product each with a different transparency obligation but these are without a sustainability scope. Market participants are required to make an objective assessment of what their financial product does in terms of ESG and sustainability in order to apply the right transparency obligations based on the category in which the financial product fits under the EU SFDR. However, the Commission consultation mentioned above is now asking the market if labels are preferable and it will be interesting to see if there is any re-alignment with the UK SDR regime.

Sustainability asset thresholds

A further important difference concerns sustainable asset thresholds. The UK SDR regime provides that for each label at least 70% of assets must be invested by reference to a robust, evidence-based standard that is an absolute measure of environmental and/or social sustainability. From the EU SFDR perspective, there is a sustainability threshold for the so called ‘dark green funds’ under Article 9 but there is no specific link to a robust, evidence based standard. Instead these funds need to justify the proportion of their investment that is not aligned with their sustainability characteristics, but they are not confined, for example, by a fixed minimum percentage of its portfolio being aligned with these characteristics.

DNSH

Another difference concerns the ‘Do no significant harm’ (DNSH) principle, i.e. disclosures on how a sustainable investment does not significant harm the sustainability objective. The DNSH principle is something that appears not only in the EU SFDR but also the EU Taxonomy Regulation and the EU Benchmark Regulation. Indeed, ESMA published a useful paper last November regarding DNSH definitions and criteria across the EU sustainable finance framework. The UK SDR regime steers away from the DNSH principle with the FCA stating that the approach may be too restrictive.

PAI

The EU SFDR includes principal adverse impacts (PAI) which are used to measure the impacts that companies have on the environment and wider society. The EU has identified 64 adverse impact indicators that must be calculated, of which 18 are mandatory to report, and 46 are voluntary. The UK SDR regime does not use PAI but instead includes a requirement to identify material negative environmental and/or social outcomes that may arise in pursuing the sustainability objective.

Escalation plans

The UK SDR regime provides that firms must set out an escalation plan to be able to take action when assets do not demonstrate sufficient progress towards the sustainability objective and/or KPIs. Assets subject to such action remain within the 70% minimum threshold applicable to all labels. Firms must also review and consider whether it remains appropriate to use a label at least annually. This applies across all labels and the FCA’s rules do not require divestment from assets as part of the escalation plan. The EU SFDR does not place a requirement on firms to have in place an escalation plan. Of the four narrative disclosures that the EU SFDR mandates at the entity level arguably the closest that come to this requirement are either the summaries of engagement policies or references to responsible business conduct codes and standards for due diligence, reporting and good governance. In most cases firms will need to expand these so as to set out an escalation plan.

Appropriate resources

The EU SFDR contains no specific requirement on appropriate resources whereas the UK SDR regime does. Under the UK SDR regime, firms must have in place appropriate resources, governance, and organisational arrangements, commensurate with the delivery of their labelled products’ sustainability objective.

Index-tracking products

The EU SFDR contains no specific requirements for index-tracking products. Perhaps, the nearest the EU has got to is the guidance published by the European Supervisory Authorities last May 2023 which sought to clarify the position for active and passive Article 9 financial products using an EU Paris-aligned Benchmark or an EU Climate Transition Benchmark.

The UK SDR regime does, however, set out certain requirements for index-tracking products. When constructing a passive product with the intention of using a sustainability labels, managers are to ensure that the chosen index aligns with the sustainability objective for their product. Managers should also consider the most appropriate KPIs to track the performance of the products towards the sustainability objective. The FCA also expects the manager’s stewardship strategy to include its approach for stewardship in respect of passive products. Whilst the FCA has not prescribed how managers should do so, it does expect them to disclose how the index providers’ methodology aligns with the product’s sustainability objective in pre-contractual disclosures. Furthermore, it expects managers to consider what would be decision useful for their clients and consumers.

Independent assessment

Under the UK SDR regime, for all labels, firms need to obtain or undertake an independent assessment of the standard for sustainability to confirm that it is appropriate for asset selection and fit for purpose. The independent assessment can be carried out either by a third party or via a firm’s internal processes as long as those carrying out the assessment are appropriately skilled. Firms also need to disclose the basis on which the standard is considered to be appropriate and the function or third party that undertook the assessment. Firms also need to ensure that the independent assessment remains valid on an on-going basis.

The EU SFDR only requires limited third-party verification of disclosed documentation. The Corporate Sustainability Reporting Directive goes further in the sense that it also requires assurance on the sustainability information that companies report and provides for the digital taxonomy of sustainability information. In addition, the position under the EU SFDR may be changing in that the Commission consultation solicited views on whether there should be mandatory third-party verification of product categories or self-declaration by the product manufacturer.

Taxonomy alignment

Another notable difference is taxonomy alignment. The UK aspires to develop its own green taxonomy although there have been delays. The EU has its own green taxonomy that helps companies and investors identify environmentally sustainable economic activities to make sustainable investment decisions but at present does not have a social taxonomy that aims to provide a classification system to determine whether an economic activity is considered socially sustainable.

ISSB

The UK remains a strong advocate of the standards developed by the International Sustainability Standards Board (ISSB). The ISSB issued its first standards in June last year. The FCA has already said that, where appropriate, it will consider updating product level disclosures requirements once the UK’s own green taxonomy is in use, and entity-level disclosure requirements in line with future ISSB standards. In addition, it will consult on updating its Taskforce on Climate-Related Financial Disclosures (TCFD) aligned disclosure rules for listed companies to reference the ISSB’s standards.

The EU has instead developed the European Sustainability Reporting Standards (ESRS) although it has sought to ensure a high level of alignment between these and the ISSB standards. In Q&As issued last summer on the adoption of the ESRS the Commission stated that “the EU goes further than any other major jurisdiction to date in terms of integrating the ISSB standards into its own legal framework”.

Incidentally, the market has previously queried the relationship between the ISSB standards and the TCFD standards. From a UK perspective in the 45th edition of Primary Market Bulletin the regulator noted that the ISSB standards build on the TCFD framework and IFRS S2 is consistent with the 4 core recommendations and 11 recommended disclosures published by the TCFD. The TCFD has now been consolidated into the IFRS Foundation and a comparison of IFRS S2 with the TCFD recommendations has also been published.

Conclusion

As illustrated above there are a number of important differences between the EU SFDR and the UK SDR regime that firms operating in both the EU and the UK need to get to grips with and many of these are summarised in the table below. But it feels that from the EU perspective change may be on the horizon following the outcome of the Commission’s consultation on the EU SFDR. Indeed in some Member States there have already been calls for the creation of labels. For instance, the Dutch Authority for the Financial Markets advocated the creation of three new sustainable product labels – “transition products”, “sustainable products” and “sustainable impact products”. Firms therefore need to keep a close eye on developments.