The UK will take a different path from Europe on the regulation of sustainable investments but the extent of divergence is far from clear.
Post-Brexit divergence between the European Union (EU) and UK regulatory frameworks for sustainable investing could increase workloads for asset managers and hamper transparency for asset owners, experts say. It could accelerate allocations to greener investments, too, depending on the UK’s desire to exercise its independence in the cause of sustainability.
Ahead of its formal withdrawal from the EU in December, the UK government announced plans for its own ‘green’ taxonomy of investible economic activities. It also confirmed it would not be onshoring the European Sustainable Finance Disclosure Regulation (SFDR), which requires asset managers to justify the ESG labels on their funds.
These moves potentially allow the UK to establish its own disclosure and classification frameworks for sustainable investment products, potentially offering new opportunities but also creating extra work for asset managers serving both European and UK clients.
“We hope for as much regulatory alignment as possible. If there is too much difference between the EU and UK it will create double the work, double the standards and more confusion. In the ESG investing space, there are already a lot of regulations, standards and metrics. We need more standardisation, not deviation,” says Danny Dekker, Senior Responsible Investment Advisor at Netherlands-based Kempen Capital Management.
Constraints on divergence
But there are several constraints on the UK’s scope for taking a radically different path to Europe.
As underlined by recent negotiations over the post-Brexit EU-UK free trade deal, too much difference between partners can lead to conflict and consequences. This is a particularly sensitive issue in the finance sector, where upcoming discussions on regulatory cooperation and equivalence are already expected to be long drawn-out.
“The UK might consider its own ESG rule-set as not representing ‘meaningful divergence’, but the EU may think the opposite. This could jeopardise hopes of a mutual equivalence determination for MIFID, AIFMD, and other regulations, since they will also enshrine the EU Taxonomy and SFDR soon,” wrote Adrian Whelan, Global Head of Regulatory Intelligence for Investor Services at Brown Brothers, Harriman, in a recent blog.
A further consideration is COP26, the UN climate change conference scheduled to take place in Glasgow in November, where the host government is expected to play a leading part in brokering deals, fostering unity and raising ambition. This already challenging task could be harder still if the UK is seen to be striking out in a different direction to peers.
“We’re treading a fine line between forging our new path in the world and unifying everyone behind the COP agenda,” says Ruth Knox, Managing Associate at Linklaters. At Kempen, Dekker is hopeful the UK’s leadership role at COP26 will mean any divergence will reflect greater, rather than lesser, ambition.
Forcing the pace?
There are good reasons to think the UK will use its new-found post-Brexit freedom to force the pace of change.
It has already set itself tough targets on the way to net-zero carbon emissions in 2050, including a commitment to a two-thirds (68%) reduction by 2030 from 1990 levels. The UK government has also set out an ambitious ten-point plan for greening its economy, announced its intention to issue green sovereign bonds and become the first country to mandate compliance with the disclosure recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).
To boost its credibility as a green finance hub, it is possible the UK will draft tougher or more comprehensive rules for investment products that asset managers wish to market as sustainable to investors. Equally, since the UK’s Brexit referendum vote in 2016, the idea has often been floated of the City of London competing aggressively with Europe as a regulation-lite ‘Singapore-on-Thames’.
Faster or slower, tougher or laxer, few asset managers will warmly welcome having to follow two sets of similar regulatory frameworks, due to the inevitable increase in compliance costs. Further, the burden is likely to impact a wide range of firms.
Whether headquartered in London, Munich or further afield, many asset managers with a European presence have portfolio managers located in the UK and management companies and service provider relationships established in Europe, typically in Dublin or Luxembourg.
All such firms will need to comply with both European and UK regulations, no matter how far they diverge. As has become standard practice, most managers will look to comply with the toughest rules across the jurisdictions in which they operate, to reinforce compliance – and customer trust – globally.
How will UK differ?
At this stage, it is too early to tell whether and how far the UK will differ from Europe on key issues relating to the regulation of sustainable investment products.
Many asset managers had initially assumed that the UK would simply onshore SFDR, even though it was not scheduled to come into force until after the UK’s formal withdrawal from the EU. But this hope dwindled and was finally snuffed out late last year, with the Financial Conduct Authority (FCA) setting out plans for disclosures aligned with TCFD.
Indicating its intention to focus on disclosures relating to ESG products and activities, the FCA intends to consult in 2021 on TCFD aligned disclosures for asset managers, life assurance and contract-based pension providers. The consultation is expected to lead to disclosure rules at firm level covering strategy, policies and processes, as well as portfolio level disclosures. Rules are expected to be finalised by end-2021, then coming into force 2022. The initial focus on climate-related disclosures could at least limit the scope for explicit divergence from Europe.
Regardless of the formal situation, asset managers are set to comply with both UK and EU regimes as efficiently as possible. “If a fund needs to comply with the Disclosure Regulation, it will need input from its UK-based portfolio managers to do so. Further, the portfolio manager must comply with the law applicable to the fund that he or she manages,” says Julia Vergauwen, ESG Funds Lawyer at Linklaters, who expects this to repeat for taxonomy rules.
For asset managers that need to comply with SFDR, she adds, it should then be an easier task to then comply with TCFD because the procedures and service providers for data gathering are already in place.
Taxed by the Taxonomy
In November, UK Chancellor of the Exchequer Rishi Sunak announced a UK Green Technical Advisory Group would be established within HM Treasury to review the suitability of the EU Taxonomy as the basis for a classification of investible economic activities in the UK. There is no official timeline for this work to be completed.
“There is a real risk of fragmentation in relation to the taxonomy. It will be interesting to see if British exceptionalism could extend to these new standards that are being examined and potentially developed afresh with a UK lens. The EU taxonomy takes a highly prescriptive approach, in line with European law, while UK common law is more principles-based, and tends to be more pragmatic, more commercial and more driven by precedent,” says Knox.
The EU Taxonomy itself is still in an early stage of development and dates have not been fully set for its roll out in 2022. Technical criteria have only been issued for two of its six objectives, and the consultation exercise for these attracted high levels of criticism for not following scientific advice.
The UK could not only differ on the technical criteria it uses to assess whether economic activities qualify as sustainable, but it could also take a broader overall view, targeting social objectives more directly, or developing a ‘brown’ taxonomy, which some have argued would better incentivise transition from fossil fuels.
“On both the objectives and the underlying technical criteria of the taxonomy, there is scope for deviation. If the UK takes a markedly different approach on taxonomy, there is a risk of misalignment of sustainability objectives and the economic activities you want to stimulate. There is a risk of being less clear in the signals given to the financial community,” says Dekker.
“My assumption and hope is that the UK will stay mainly in line with the EU taxonomy. But, if there are deviations, we would try to ensure any single financial product we offer is aligned with both regimes, to the extent that may be possible.”
Fergus Moffat, Head of UK Policy at ShareAction, offers grounds for optimism for alignment, albeit admitting much remains uncertain. “In terms of the green taxonomy, the UK has recently signalled its intention to join the International Platform on Sustainable Finance. At a minimum, that at least indicates that the government is keen to maintain a degree of consistency across jurisdictions.”
Another area of uncertainty is that of carbon tax. The UK committed to exploring options for a carbon tax in Q4 2020, but a subsequently released energy white paper appeared to leave the door open for the UK to continue to participate in Europe’s Emissions Trading Scheme.
There is also potential for the UK to chart its own route on sustainable investments without damaging its green credentials, by making mandatory commitments to voluntary, industry-led sustainable reporting and disclosure frameworks. This might include the CFA Institute’s planned disclosure standard for sustainable investment products or the International Financial Reporting Standards (IFRS) Foundation’s plans to coordinate harmonisation of sustainable company reporting frameworks.
The CFA Institute is expecting to release an exposure draft of its proposed standard in May but has already discussed its adoption with a number of regulators.
“Regulators are welcome to use the CFA Institute ESG Disclosure Standards for Investment Products,” said Chris Fidler, Senior Director for Global Industry Standards. “They could mandate the use of the Standard or use it to inform their rule-making efforts. Whether or not a country adapts the EU Sustainable Finance Disclosure Regulation, for example, we believe our Standard can be a strong basis for regulators in establishing disclosure requirements for firms who apply ESG principles as part of their investment offering.”
Led by client demand
Regardless of future divergence between the UK and EU, Kempen’s Dekker asserts that all asset managers active in the region will have their work cut out this year complying with European sustainable investing requirements.
“Until March, the big challenge is one of interpreting Articles 7, 8 and 9 of SFDR, in terms of classification of your existing financial products. For some it’s clear, but the regulation leaves some aspects to the asset manager’s assessment, meaning there is uncertainty about where classification falls. After that, attention turns to the data availability and quality challenge of being ready for SFDR Level 2 and the first two objectives of the EU Taxonomy in 2022. This involves obtaining, assessing and integrating the data, then also reporting to clients,” Dekker said.
Ultimately, asset managers will respond strongly to client demand. With large asset owners keen to invest in high-quality products that support the transition to a low-carbon economy, managers will need to comply with and potentially exceed all regulatory requirements across major jurisdictions as cost-effectively as possible.
“EU-regulated funds are an established brand and already tested. Certain types of global asset owners are typically obliged to buy highly-regulated funds and even prefer to do so, even if not explicitly required to do so by regulation,” says Vergauwen.
The increased transparency of sustainable investment products that is offered by initiatives such as SFDR should make asset owners’ jobs easier when comparing funds and making allocation decisions. The interests of investors is likely to influence the decisions of policy makers as well as compel fund providers to exceed compliance across jurisdictions regardless of deviation.
“The level of interest in ESG investments tends to drive behaviour at asset managers, as they decide whether to take a minimalist or maximalist approach to compliance with applicable regulations,” adds Vergauwen.