The U.K. maps out its ESG journey

For 14 days all eyes gazed upon Glasgow as world leaders met at the COP26 summit to discuss a global response to the climate crisis. There will now be furious debate about whether the various agreements and pledges are ambitious or specific enough to reach the goals required to address our climate emergency as commentators pick through the bones of the deal.

There were significant "wins" in the form of the US-China commitment to co-operate, global carbon trading rules and a focus on methane as well as CO2. However, its detractors will focus on lack of specificity of commitments, lack of ambition and also that several areas, coal in particular, were watered down as the politics and economic impact of the deal became apparent. What is true is that COP26 once more underlined the critical importance of climate change globally and also the role of finance as a powerful tool in the fight against climate change.

U.K. Prime Minister Boris Johnson used the occasion of COP26 to serve notice that the business community must shoulder the major responsibility for achieving sustainability, noting that "governments can mobilize billions to fight climate change, but the private sector can mobilize trillions."

In the run-up to the Glasgow conference, the U.K. government released a white paper called "Greening Finance: A Roadmap to Sustainable Investing," that sets important environmental, social and governance guidelines for U.K. companies, asset managers and financial services firms, including banks.

The U.K. roadmap includes the creation of a U.K. "Green Taxonomy" to define terms and seeks to align all U.K. businesses with the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD)¹, which was created by the multinational Financial Stability Board in 2015, to make recommendations about how companies should consistently report financial risks related to climate.

To be considered aligned with the sustainability taxonomy, funds must make a substantial contribution to at least one of the six taxonomy environmental objectives, do no significant harm to the other objectives and meet a set of minimum safeguards. If the ESG vernacular sounds familiar here that is because the U.K. plan draws heavily on the E.U. experience to date.

Of interest to U.K.-based asset managers, the roadmap outlines two steps the government task policymakers, such as the Financial Conduct Authority, the Bank of England and the U.K. Treasury, must take to ensure that investments are aligned with sustainability. The measures, called the Sustainability Disclosure Requirements² or SDR, require asset managers and others to disclose how they take account of sustainability and require managers with investment products to disclose the sustainability impact of those investments and the financial risks involved.

If SDR sounds familiar to the European Union's Sustainable Finance Disclosure Regulation (SFDR)³, it is. But there are subtle differences as well.

A rabbit is not a hare, cement is not concrete, a crow is not a raven, an alligator is not a crocodile - these things might seem similar enough superficially but there are material differences when you look closely at the details. And this is where a detailed comparison of the U.K. SDR and the E.U.'s SFDR show that while their spirit is the same, the letter of the respective laws are quite different in certain areas. The U.K. rules, while similar, are not the same and this inevitably will lead to an amount of confusion. While the E.U.'s SFDR has created categorization of funds known as Article 8 or Article 9 funds depending on the nature of a fund, the U.K. rules will adopt product classifications based on sustainability characteristics such as level of ESG integration at the provider, portfolio sustainability characteristics and portfolio impact.

Having similar rules might make it easier for managers who sell products both in the U.K. and Europe to comply overall, but it also means there will be two slightly different sets of reporting and disclosure documents that have to be prepared, even if the fund's portfolio constituents are exactly the same. In other words, the core operational process might be consistent, but the outputs will be different. This fragmentation can often lead to uncertainty and that leads in turn to additional work and costs.

One specific concern is that different and possibly contradictory investor disclosure documents may prove confusing to common clients with investments in both cross-border UCITS and U.K. Open-ended Investment Company (OEIC) funds.

Another challenge is that the U.K. is drawing up its own labelling system for U.K. domiciled funds. A discussion paper⁴ released by the FCA on November 3 said the proposal includes five label categories, which is broader than the three labels contained in SFDR.

The proposed labels include:

• "Not promoted as sustainable" in which the sustainability risks have not been integrated into the investment process;
• "Responsible" in which sustainability impact on risk and returns have been considered;
  
• "Sustainable Transitioning" funds that include assets that may not be sustainable but plans to adopt sustainability in the future. This appeals to the energy industry;
• "Sustainable aligned" funds with a high allocation to sustainable activities as defined in the taxonomy;
• "Sustainable Impact" for funds that are designed to deliver clearly positive environmental or social improvements.

The three labels which have been broadly adopted within the E.U.'s SFDR, based on Articles 6, 8 and 9, of the SFDR, have been dubbed brown, light green and dark green. But even then, the European Securities and Markets Authority (ESMA) recently proposed to add two new categories for funds with specific environmental objectives which align with the E.U. Taxonomy. Under the proposal certain article 8 funds would be split in two sub-categories for funds with specific environmental focus and those with wider focus and similarly, article 9 funds, where funds have a sustainable investment objective, would be broken up to create a subset of article 9 funds with explicit environmental objectives. Furthermore, these article 9 funds will be subject to an enhanced disclosure regime also to demonstrate explicitly how they impact the environment. So the shifting sands of SFDR itself illustrate how difficult it is to get ESG rulemaking right for all stakeholders.

There already has been pushback in the U.K. about implementing a similar plan because it is feared that a "brown label" will make a fund toxic to investors. In addition, the whole idea of using simplistic labels, while originally designed to increase transparency and disclosure, has been criticized for being primarily a marketing tool that undermines the whole idea of ESG. In Europe, where managers had to assign the labels beginning in March, some are finding they may have to downgrade their evaluations or face challenges when tougher disclosure rules come into force in 2022.

The FCA, like their E.U. counterparts, also sees the criticality of so called "ESG data providers" and will move to regulate these activities. The disclosure mandate must be underpinned by a robust data governance system to ensure the practice known as greenwashing is curbed and that ESG is not merely a marketing ploy but rather a risk management tool used to screen portfolio composition for a more sustainable future.

In summary, the U.K. is joining the global trend for ESG policymaking. While its standards stay close to global and previously issued E.U. standards, they are not identical. As such there will be work for global asset managers operating in multiple markets to assess what is identical and what is similar but requires work to adhere to the localized U.K. regime. It is this fragmentation which will remain a challenge for the foreseeable future, however, what is in no doubt is that ESG is Everywhere.

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