"...the financial sector can only support the transition effectively if consumers can trust firms to deliver on their promises. 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. That’s why environmental, social and governance (ESG) issues are so high on our regulatory agenda."

Nikhil Rathi, FCA CEO, COP26 speech

While the EU led the way with the Sustainable Finance Disclosure Regulation (SFDR) coming into force in March 2021, the UK government announced its intention to introduce the UK SDR and sustainable product labelling in the Chancellor's Mansion House speech in July 2021. More recently, it elaborated on its plans in the government's October 2021 roadmap to sustainable investing. Many firms in the UK grappling with how to avoid inadvertent "greenwashing" will be relieved that the consultation process has begun.

In its discussion paper, the FCA states that it wants customers to be able to effectively navigate the market for sustainable financial products with sufficient information to assess which products meet their needs and hold firms to account for their sustainability claims. This is consistent with the overall objective of the disclosure requirements under the SFDR which is to allow end-investors to make informed investment decisions in line with their sustainability preferences.

The FCA says this will help consumers and meet certain information needs of institutional investors, as well as advance the FCA's objectives to protect consumers from buying unsuitable products, enhance competition and protect and enhance the integrity of the UK financial system thereby enhancing trust in the market for sustainable investment products.

Progressing work on disclosure rules and labelling falls under the second theme under the FCA's strategy described above, "trust". In particular, the FCA aims to:

• increase the provision of sustainability-related financial information to consumers and other stakeholders;
• build trust in the market for ESG and sustainable investment products by combatting potential "greenwashing" (where sustainability claims made by firms do not bear scrutiny) and enabling consumers to make informed choices;
• play a role in educating consumers about sustainable investing and the different sustainability-related characteristics of products;
• foster competition by more reliably distinguishing products;
• encourage better management of sustainability risks, opportunities and impacts across the financial system;
• support market demand and innovation for greater investment in responsible and sustainable investment strategies; and
• reduce market fragmentation by establishing clear categories for sustainable investment products.

The FCA seeks views and feedback from stakeholders on several aspects of policy design.

Sustainable product classification and labelling

Rather than labelling only those products that make sustainability claims or are marketed as sustainable, the FCA seeks views on a classification and labelling system which covers the full range of investment products available to retail consumers. The SFDR also gives rise to product classification requirements, including a category for those products that do not have a sustainability focus without distinguishing between retail and institutional products. However, the SFDR's classification requirements apply only to those products that fall within the scope of the SFDR, such as AIFs, UCITS and MiFID portfolios. On the other hand, the FCA's proposals suggest that a broader range of products may need to be labelled when compared to the approach taken under the SFDR.

The diagram below illustrates a classification and labelling approach on which the FCA seeks feedback. It proposes three levels of sustainable classifications with "Sustainable – Impact" on the right requiring the highest level of entry-level criteria, and "Not promoted as sustainable" on the left requiring no sustainable entry requirements as such a product would have no sustainability goals.

In assessing what activities are considered sustainable, the FCA envisages this would be based on the UK Taxonomy "or other criteria". As the ability to label a product "sustainable" will be directly linked to the proportion of underlying assets meeting sustainability criteria set out in the UK taxonomy, the devil will be in the detail as these proposals develop in parallel with the development of the UK Taxonomy Technical Screening Criteria. If a particular activity is not classified as sustainable under the UK Taxonomy, it will not count towards this classification assessment.

The FCA recognises that many UK firms are using the SFDR product categories and suggests how products classified under the SFDR could be mapped against the UK framework – this is also shown in the diagram below. The FCA is keen to hear views on further considerations and/or challenges it should consider in this context.

The FCA identifies a number of existing initiatives relating to the labelling and classification of products and asks stakeholders for views on how best to leverage those initiatives. Examples highlighted by the FCA include those published by the Investment Association, the CFA Institute, the Investing and Saving Alliance, British Standards Institute and the International Organization of Securities Commissions.

The FCA believes that the classification system should be supported by objective and clearly defined criteria, mappable against existing standards, and simple and intuitive to understand. The FCA welcomes views on its suggested potential foundations for minimum classification criteria.

The FCA also asks stakeholders how products tracking the Climate Transition and Paris-aligned benchmarks should be classified, and what is the role of derivatives, short-selling and securities lending in sustainable investing. Any guidance on the latter will be welcomed as under the SFDR draft regulatory technical standards, the European Supervisory Authorities require disclosure on how indirect investments, such as those made through derivatives, are compatible with the environmental or social characteristics promoted by Article 8 products or with the objective of sustainable investment under Article 9 products. This has created uncertainty within the market as it is unclear whether such investments may be classified as sustainable under the SFDR.

Additional entity-level criteria

The FCA additionally seeks views on whether minimum "entity-level" criteria should be required of firms delivering the product and managing the investments (e.g. the FCA-regulated entity, the parent or affiliate, or a delegated asset manager). In particular, the FCA questions whether it should consider applying a higher threshold of entity-level standards before products can be labelled as "Responsible" or "Sustainable". The aim would be to ensure that the firm's own approach is consistent with the product's aims and reflected in the design and delivery of the product. Such entity-level criteria could include meeting governance, systems and controls requirements; identifying how ESG considerations are integrated into investment processes to minimise risk and take advantage of opportunities; stewardship and using ownership rights, such as voting and engagement.

When compared to the SFDR, this should provide a helpful tool for firms when they come to implement any labelling requirements under the FCA's proposals, given that the lack of any pre-defined minimum criteria has led to a divergence in approaches to product classifications under the SFDR across the industry.

SDR disclosures

The FCA puts forward a tiered approach to the SDR disclosures:

• consumer-facing disclosures, aimed at consumers and containing key product-level disclosures; and
• detailed disclosures at product and entity-level on sustainability risks, opportunities and impacts, aimed at sophisticated or institutional investors and other stakeholders.

The FCA states that the sustainability-related disclosures would provide consumers and institutional investors with key sustainability-related information. The information provided under the regime may also be of interest to broader stakeholders, such as service providers, policy makers and non-governmental organisations.

The disclosure regime would build on the climate-related disclosure requirements for asset managers and FCA-regulated asset owners aligned with the TCFD. However, the SDR disclosures would also cover sustainability matters more broadly and extend beyond financial risks and opportunities to cover the impact firms and investment products are having on the environment and society. This is consistent with the approach under the SFDR which relates to environmental, social and governance factors and introduces the concept of principal adverse impacts, which requires product manufacturers to disclose the impact of their investment decisions on sustainability factors.

The FCA welcomes views from stakeholders on practical considerations relating to streamlining TCFD and broader sustainability disclosures, including jurisdictional or other limitations. It is keen to avoid duplication for firms, and to ensure clients are provided with consistent and coherent information. The FCA also wants to avoid fragmentation and overly burdening firms by being consistent with other sustainability disclosure initiatives as far as possible. On that basis, it will be interesting to see what approach the FCA will take to impact disclosure requirements and how far (if at all) it will diverge from the EU's approach to principal adverse impact reporting, which applies on a comply or explain basis (unless a manufacturer is considered to be "large", in which case, the requirements are mandatory).

As it currently stands, there is industry concern regarding the EU's approach under the SFDR as a result of the data gap between the information that product manufacturers are expected to disclose and the lack of information that is made available by investee companies regarding their approach to sustainability. Hopefully any future proposals by the FCA will seek to address this issue and provide guidance in order to assist UK firms with implementing any impact reporting requirements.

Consumer-facing disclosures

The FCA suggests that consumer-facing disclosures will likely follow a baseline level of prescription to ensure consistency and comparability. This baseline could include core metrics required under the FCA's proposed TCFD-aligned disclosure rules supplemented by other social and governance metrics. It anticipates the disclosure being easily read by consumers alongside the Key Information Investor Document (KIID) and asks for views on the level of prescription required, including the potential use of templates and/or and "ESG factsheet".  The required disclousres could include information on the following:

• investment product label;
• objective of the product, including specific sustainability objectives (for example, to reduce the carbon intensity of investments while providing a financial return to clients);
• investment strategy pursued to meet the objectives, including sustainability objectives;
• proportion of assets allocated to sustainable investments (according to criteria set out in the UK Taxonomy);
• approach to investor stewardship; and
• wider sustainability performance metrics (supported by brief contextual information).

This approach is consistent with the one taken by the European Commission and the European Supervisory Authorities under the SFDR and draft regulatory technical standards which require product disclosures to be made in accordance with prescribed templates.

The FCA intends to carry out further consumer research to better understand what types of information consumers will find useful. It intends to publish the results of this research in 2022 and will use the findings to inform its further proposals.

Detailed SDR disclosures

To avoid unnecessary duplication and confusion, the FCA intends for its TCFD-aligned entity- and product-level disclosure requirements to be compatible with, and to act as a foundation for, the broader sustainability disclosures required under the SDR.

At a product-level, the aim is to facilitate the needs of those seeking more granular detail. The information could include:

• more information on the methodologies used to calculate metrics and, where proxies and assumptions are used, for these to be clearly explained;
• information on data sources, limitations, data quality, etc.;
• further supporting narrative, contextual and historical information;
• further information about UK Taxonomy alignment; and
• information about benchmarking and performance.

The FCA recognises that some of this information may be required under TCFD-aligned disclosures or other regimes, such as the SFDR, but may also go further than SFDR (such as product-level metrics). As well as seeking views on structure, content, and the necessary degree of prescription, the FCA is interested to hear views on alignment with the SFDR to the extent possible.

For entity-level disclosures, the FCA also envisages building on its proposed TCFD disclosure requirements for asset managers and asset owners. It would like to understand from stakeholders if there are any jurisdiction-specific considerations that it should consider, and any other challenges firms may face in producing sustainability-related disclosures in line with the TCFD framework. The FCA also seeks views on how stewardship and voting records could form part of disclosures.

The FCA is mindful that the government has confirmed that the global baseline sustainability reporting standards to be developed by the International Financial Reporting Standards (IFRS) Foundation's International Sustainability Standards Board (ISSB) will form a core component of the SDR framework. If TCFD-aligned disclosures for listed companies are replaced by the new standard, the FCA confirms that its intention is to be consistent in its disclosure requirements to support the flow of information along the investment chain.

Distribution and communication along the investment chain

While the FCA's proposed approach applies to manufacturers of products rather than distributors, it asks for views on the roles of other market participants in communicating sustainability-related information along the investment chain.

In particular, while the EU suitability requirements in this context were not onshored in the UK, the FCA considers it would be appropriate to confirm that advisers should consider sustainability matters in their investment advice and ensure their advice is suitable reflecting consumer sustainability needs and preferences.

Third-party verification

The FCA notes that there could be a role for independent third-party verification of product-level disclosures. However, there is a balance to be weighed between the potential benefits and cost and capacity implications of this approach. The FCA welcomes stakeholder views on whether there is a role for this and for which products.

What next?

The deadline for responses to DP21/4 is 7 January 2022. After considering the responses it receives, the FCA plans to consult on policy proposals in Q2 2022.

The FCA is working with the government to explore how best to introduce sustainability-related requirements on financial advisers and will develop proposals "in due course".

The FCA also announces that it is establishing a Disclosures and Labels Advisory Group (DLAG). The DLAG will meet regularly and provide it with feedback, technical advice and constructive challenge as its work develops.

Next Steps

The FCA has begun the formal discussion process for this crucial area and is explicit that it welcomes views in every respect, including challenges firms may face in light of the FCA's initial suggestions. It is now over to the industry and other stakeholders to digest, consider and respond to the FCA constructively as the pace increases and government imposed deadlines approach.

"...with partners international and domestic, it is time to walk the walk and take the next step on the journey to transform our sector. And with it, our economy and our future."

Nikhil Rathi, FCA CEO

To discuss issues raised in this briefing, please get in touch with one of the named contacts above. For information on our extensive ESG-related experience practice, please visit our ESG topic centre.