Protected status for ESG investment products could mark the beginning of the end for greenwashing for UK investors.
Before long, any asset manager thinking of slapping a ‘sustainable’ or ‘ESG’ label on its investment products for UK clients should think twice – at least.
The Financial Conduct Authority (FCA) is consulting on proposals to clamp down on so-called greenwashing by, in effect, giving protected status to key terms connected with ESG-led investing.
“It is about protecting investors, so that when they think what they are buying is a sustainable investment, it really is,” said Elena Tedesco, Portfolio Manager at Vontobel, the private bank and asset management group. “It is the same product protection, in a way, as that enjoyed by champagne.”
Hers was one of a number of welcoming responses to the FCA proposals from the industry, although they are aware of potential pitfalls.
“My initial take is that there’s quite a lot to like in these proposals,” said Andy Pettit, Director of Research for EMEA at Morningstar. “They are looking at it very much from a consumer perspective.”
James Alexander, Chief Executive of the UK Sustainable Investment and Finance Association (UKSIF) said: “Overall, we’re really pleased with the proposals. This is a very important piece of regulation.
“The FCA sees it as part of its mandate for consumer protection. It thinks there is a problem about greenwashing.”
Under the proposals, part of the watchdog’s consultation on Sustainability Disclosure Requirements, there will be three categories of labels for sustainable investment products. The first is ‘sustainable focus’, for products investing in assets that are environmentally or socially sustainable; then ‘sustainable improvers’, for products investing in assets to improve environmental or social sustainability over time, and finally ‘sustainable impact’, for products investing in solutions to environmental or social problems “to achieve positive, measurable real-world impact”.
Products that do not fit any of these categories will be unable to use any ESG-related terminology in their marketing. And while protecting the typical investor on the street is a clear focus for the UK watchdog, the rules apply to all UK-regulated funds, whether targeted at institutional or retail investors.
The FCA said: “We initially set out five categories for the labels, including a label for ‘not promoted as sustainable’. However, we listened to stakeholder feedback to simplify the regime by reducing the number of labels, focusing on those which reflect sustainable outcomes.
“The three labels we are proposing aim to help consumers navigate the market by distinguishing between different types of sustainable product, according to the nature of its objective and the primary channel by which each can plausibly achieve or encourage positive sustainability outcomes.”
Will Charles, Partner in the Litigation & Arbitration Group at law firm Milbank, said: “It is difficult to assess the effectiveness of the labels proposed by the FCA at this stage. Their adequacy will likely become clearer once firms have begun using them to classify their investment products, and once consumers have had the opportunity to engage with them in due course.”
Alexander said: “There is essentially one label – sustainable – with the three categories below that.” Of the ‘improvers’ label, he said: “We’re very excited about this and the potential. A lot of the economy is not in the place it needs to be.”
Some have argued for Europe’s fund labelling regime, framed by the Sustainable Finance Disclosure Regulation, to include a similar ‘transition’ fund category, including Eurosif, which represents national sustainable investment bodies.
Jeremy Irving, Partner and Head of Financial Services at law firm Browne Jacobson, said regulation of green funds was “vital stuff” due to the strong levels of demand and innovation.
But how easy will it be for the unscrupulous to find their way round the new system and continue to claim unjustified ESG credentials for products?
“You need to look at the triggers,” said Irving. “They include complaints to the Financial Services Ombudsman, to the companies themselves, information arising from litigation and possibly whistleblowing.
“All this will make its way to the FCA, which will take things from there.”
“Look under the bonnet”
Alexander acknowledged that the proposals were a key step along the path to eliminating greenwashing, rather than the ultimate solution. “Ingenuity can sometimes know no bounds. But at least with the new regime it will no longer be possible to bury caveats at the back of fund documents,” he said.
Tedesco noted that enforcement and investigations relating to the new rules would deter market players from abuses. “We expect regulators to continue catching up with the real economy on this front and adopt more laws and tools to cover the deep realm of ESG investing.”
She added: “However, rules alone are not enough, because ESG investing means different things to different people depending on their beliefs and risk appetite, for instance. Some care about labour rights more than climate change, others want to use exclusions to avoid allocating capital to ‘sin sectors’ such as gambling and alcohol, some want to invest in the ‘just transition’ of our economies to a more sustainable paradigm.
“Given the multitude of approaches, the best way to avoid greenwashing is looking under the bonnet of the funds under scrutiny.”
Significant measure of uncertainty
Vasiliki Katsarou, an Associate at Milbank’s Litigation & Arbitration Group, said the FCA’s focus on greenwashing was in keeping with its strategic objectives to protect consumers and ensure the integrity of UK financial markets. The proposals give the regulator wide scope to take a firm line on labelling.
“In that context, where firms do not use any of the FCA’s proposed labels, there are naming and marketing rules to prohibit the use of sustainability-related terms (such as ‘ESG’, ‘green’, ‘sustainable’, ‘net zero’). The example terms referred to in the proposals are expressly non-exhaustive, so it is clearly contemplated that other terms indicating or suggesting a sustainable investment product could also be caught.”
The FCA said: “Our naming and marketing rules set out a non-exhaustive list of terms that are restricted from being used on products that do not qualify for a label, and clarify that it applies to any other term which implies that a sustainability product has sustainability characteristics.
“We are also proposing an anti-greenwashing rule that will apply to all regulated firms. This rule reaffirms that sustainability claims must be clear, fair, and not misleading, and proportionate to the sustainability profile of the product or service.”
Kirsty Finlayson, Associate at Browne Jacobson, drew parallels with the food industry. “There have been accusations of greenwashing in terms of food labels, with labels often covering only one aspect of the environment. ‘Organic produce’, for example, looks ESG-friendly, but its organic nature is balanced out by the fact that more land is needed than is the case with conventional agriculture,” she said.
“This is the sort of thing the FCA will have to overcome in the financial services sector.”
Irving noted the FCA had also expressed an interest in directly regulating ESG ratings companies.
“It does have tools it can deploy over the sector with a certain degree of indirectness. But unless and until ESG ratings agencies are brought under tighter regulation, there is always going to be a significant measure of uncertainty.”
How many will qualify?
To remove at least some of that uncertainty, the FCA is proposing to strengthen the rules requiring funds to alert investors to any investments that could be considered “surprising” in the context of an ESG fund.
“We have clarified in the rule that ‘surprising’ investments are those that are inconsistent with the sustainability objective of the product. If there are fewer ‘surprising’ elements in the product, the disclosure would be more limited,” it said.
“However, the disclosure must include the type of investment concerned and the particular industry in which it arises, as well as why the firm is holding the investment.”
Alexander said: “If you would not expect to find a certain stock in the fund, then it has to be flagged. Will it work? We need to try it and see.”
A big question, said Pettit, is how many funds will eventually qualify for a label under the scheme.
“Firms are looking at how practical it will be to meet the categories. There is a cohort of funds that are involved in ESG-type investing, but don’t qualify. It is hard to see how they will describe themselves to investors without using some of the prohibited words.
“I imagine such firms will either push themselves further in order to qualify for one the categories or will back off.”
According to Morningstar’s latest analysis, 8,459 funds were classified as Article 8 under Europe’s SFDR at the end of September, meaning they had some sustainable characteristics, while 1,080 funds were registered as Article 9-compliant, meaning they have sustainability objectives.
“The beginning of the end of greenwashing”
Tedesco said too difficult a regime could lead to low levels of adoption, slowing growth of the sector, arguing: “Compliance should not be made too onerous.”
But Irving recalled that similar fears were expressed during previous moves to bring aspects of savings and investment within the regulatory net. He said: “There is no evidence of regulation causing decline in any area of financial services.”
Nor is this the end of the matter in terms of regulating ESG claims by investment companies. The FCA said: “We intend to consult on expanding the scope of the regime to include pension products and other investment products such as exchange-traded products.
“We also intend to build on the content by adding further disclosure requirements in line with future standards developed by the International Sustainability Standards Board (ISSB), to add more granularity and specificity to requirements at entity level, and a baseline of sustainability metrics at product level.”
The consultation is open until 25 January next year.
“Consumers must be able to trust that products claiming to be sustainable actually are. So our consultation includes a package of measures including labels, naming and marketing restrictions and disclosures – informed by stakeholder feedback and consumer research – to help consumers build trust in the sector. And we’ll build on these over time,” the FCA said.
Tedesco hoped that increased regulation of ESG investing would mark “the beginning of the end of greenwashing”, noting that global headwinds were also supportive.
“The main catalyst to speed up such process seems to be the current economic scenario, as now more than ever we need real action to tackle the energy/food crisis deriving from the war in Ukraine, the pandemic and climate change. Our societies can no longer accept greenwashing.”