This blog post was first published by Compliance Monitor on April 6, 2022.
A key plank to the Government’s regulatory ESG agenda is simple: investment in sustainable projects and companies will assist the UK in meeting its environmental targets. Consumer interest appears to be aligned: there is a genuine appetite to advance the climate agenda through investment.
To achieve its objectives, the Government is focused on disclosure and transparency. Naturally, the efficacy of the disclosure model is rooted in trust, as acknowledged by Nikhil Rathi, when speaking before the COP 26 in November last year, “Recently, we’ve seen growing scepticism about some companies’ and financial firms’ ‘‘green’’ claims. We can’t let this greenwashing persist and risk the flow of much-needed capital to help secure our futures”.1 However, it is also rooted in harmonisation, relying on a common understanding of how a business’ green credentials can be measured and described. If investors cannot properly compare the credentials of different companies and products, the disclosures, even if accurate, arguably become meaningless.
Accordingly, in the last 18 months the FCA has become increasingly focused on developing the climate and sustainability disclosure regime, for both listed companies and regulated investments. Many of the rules already apply; some are still being formulated. However, notwithstanding that the obligations on firms, particularly asset managers and asset owners, remain under discussion, greenwashing cases will undoubtedly be a priority for the FCA’s Enforcement Division in the years to come. Beyond the obvious – deliberately publishing misleading or untruthful information – where might the regulatory risks lie? This article summarises the core elements of the regulatory regime, before identifying some of those risks and considering how firms may protect against them.
The Disclosure Regime
The FCA’s green disclosure regime has several strands. It applies to listed companies and asset management firms, at both an entity and product level. In December 2020 the Listing Rules were updated, requiring premium-listed issuers to make a statement in their annual financial report confirming whether they have made disclosures consistent with the Task Force on Climate-related Disclosures (TCFD). Where the issuer has not made such disclosures, they are required to explain why not, as well as describe any steps, current or planned, which would allow them to make consistent disclosures, including relevant timeframes.2 The TCFD recommendations are structured around four areas relating to climate-related risks and opportunities: governance, strategy, risk management, and metrics and targets. The application of these disclosure rules has now been extended to standard-listed issuers.3
Similar disclosure obligations apply to asset managers and certain asset owners. In-scope firms are required annually to publish a TCFD-aligned report at both an entity and product level. At an entity level firms must set out how they take climate-related risks and opportunities into account in managing or administering investments on behalf of clients and consumers. At a product or portfolio level firms must disclose a baseline set of consistent, comparable disclosures, including a core set of metrics such as greenhouse gas emissions, total carbon emissions and weighted average carbon intensity. These requirements are aimed at ensuring better outcomes for consumers through transparency and more information; a deeper consideration of climate-related risks and opportunities by in-scope firms; and coordinated information flow along the investment chain.4
Building on the TCFD-aligned disclosure regime, the FCA published a Discussion Paper in November last year, setting out proposals for additional transparency requirements for the regulated investment market, through product labelling and additional disclosures.5
The FCA proposes a labelling requirement based on a classification system that will cover the full range of investment products available to retail investors, including those which do not proactively make sustainability claims. To ensure that the system is meaningful, verifiable and capable of being supervised effectively, the Regulator will prescribe a set of minimum criteria for each product level classification.6 Firms will be responsible for ensuring that their products bear the correct classification, although the Regulator has not ruled out verification by independent third parties.
In respect of disclosures, the FCA plans to introduce a new set of rules – the Sustainability Disclosure Requirements (SDRs) – which build on the TCFD-aligned disclosures. These extend beyond the financial risks and opportunities presented through climate change, covering the impact that firms and investment products will have on the environment and society. As such, they address sustainability issues more widely.
Under the SDRs, firms will be required to produce both consumer-facing and institutional level disclosures. Consumer-facing disclosures, which will be less detailed and presented in simpler language, will set out the product’s sustainability objectives and the investment strategy pursued to meet them. The FCA’s Discussion Paper also proposes prescribing a baseline set of sustainability metrics to allow consumers to understand the sustainable performance of the product over time.
The disclosures aimed at more sophisticated and institutional investors will be more detailed and are required at both an entity and product level. The product disclosures will include more information on the sources of the underlying data, the methodologies used to calculate metrics, and further supporting narrative, contextual and historical information. The entity-level disclosures seek to reveal how risks and opportunities are incorporated into investment processes, and they are increasingly demanding information on firms’ impact on the environment and society.
The UK Government appreciates that an effective and enforceable ‘green’ disclosure regime requires a ‘common framework setting the bar for investments that can be defined as environmentally sustainable’.7 The taxonomy, once established, will need to be used and applied by firms when labelling products and making their related disclosures.
What issues may arise in a ‘greenwashing’ case?
At a basic level, accusations of greenwashing will be levelled where there is a disconnect between disclosures and the reality. However, assuming firms are well-intentioned, how might the risk of regulatory scrutiny present itself, and how can firms protect against that risk? Firms should consider the following:
1) Internal product consistency
Once implemented, the labelling and disclosure regime will be relatively complex. From its Discussion Paper, it appears that the FCA sees the three disclosures (institutional, consumer and the label classification) as three increasingly granular levels. Clearly, firms must ensure that there is consistency between them and that the fundamentals of the product are not distorted by condensing the detailed disclosure into a more accessible, consumer-friendly statement. It will be prudent to ensure that the disclosures and underlying analysis for the label classification are reviewed in tandem and compared against both the entity-level SDR disclosure and TCFD reports, to ensure consistency.
2) Consistency across products
Firms must ensure that, across their suite of investment products and portfolios, there is consistency in how the disclosures are framed and worded. Given that the underlying objective is to create a regime that allows consumers to make objective and helpful comparisons between products, the Regulator will expect firmwide consistency. While policies and procedures will protect against the risk of divergent approaches, ensuring that the disclosures and labels for every product are reviewed and analysed together will help to achieve compliance and increase internal harmonisation.
3) Data quality
The need for SDR product disclosures to contain information on the source of any underlying data, as well as the methodologies used to calculate metrics, raises a distinct risk. The FCA’s current CEO has acknowledged that the organisation is becoming a data regulator as well as a financial one. Moreover, the ESG credentials of companies and investments are increasingly being assessed through more complex data sets and ‘alternative data’, in respect of which the FCA has recently identified risks, both to market integrity and privacy.8 Therefore, disclosure of the underlying data sets and relevant methodologies may generate greater scrutiny from both the regulator and the investor base. Firms may need to bolster their controls to verify the quality and legality of their data use. Furthermore, any statements or conclusions in the disclosures that are based on complex data sets may need additional verification oversight and review.
4) Ensuring the objectives are being met
The sustainability objectives of a product or fund will be captured in the disclosures. As with any mandate or investment parameters, firms will need to ensure that, as the product’s underlying assets change, its objectives are still being met. Given the general challenges posed by measuring and monitoring the sustainability credentials of assets, this will be no mean feat. However, if able to, firms should consider gauging and quantifying the extent to which the product objective is being satisfied, before creating satisfactory parameters and incorporating them into their risk measures.
One should reasonably expect the FCA’s focus on climate-related and sustainability issues to continue sharpening, resulting in greater scrutiny of firms’ and companies’ claims about their green credentials. Persons in the investment and asset management industries will need to ensure that the public ESG statements about their products and assets reflect reality. The risks of misleading consumers in the context of sustainability disclosures will be nuanced and must be properly thought through in order to avoid regulatory censure as well as reputational damage.
2 They are also obliged to disclose: 1) where they have included some, or all, of their disclosures in a document other than their annual financial report, an explanation of why; 2) where in their annual financial report (or other relevant document) the various disclosures can be found. See Listing Rule 9.8
3 They will apply to Standard issuers for the accounting period beginning from 1 January 2022. The first annual financial reports that will be subject to the new rule will therefore be published in early 2023.
4 The deadline for the first public disclosures under this regime is June 2023.
5 DP21/4 Sustainability Disclosure Requirements (SDR) and investment labels, November 2021
6 The classification is not dissimilar to that stipulated under the EU’s Sustainable Finance Disclosure Regulation, which the UK Government chose not to adopt post-Brexit. The paper explains how classifications under the SFDR will be mapped onto the UK system. Further headache for firms with products marketed in the EU and UK, re mapping SFDR to the UK regime.
7 Para 1.5 of DP 21/4
8 Feedback Statement- Accessing and Using Wholesale Data, January 2022