Direction may not be known until the dust settles on the EU regulatory landscape, experts say.
Europe has led the way in the formation and implementation of sustainable investment rules, setting a framework the rest of the world is widely expected to follow.
With Brexit firmly in the rear-view mirror, the UK is keen to forge its own regulatory path, which means figuring out how UK-based investors, financial institutions and firms can best aid the transition to a greener, low-carbon economy.
It’s expected that the UK regulatory landscape will look similar to the EU, but asset managers operating in both markets will need to account for at least some degree of divergence when marketing and managing their funds, experts warn. The extent to which the markets will differ remains unclear, largely because the EU landscape itself is far from settled.
“The UK currently has the luxury of waiting and seeing what works and doesn’t work for the EU,” says James Tinworth, Funds and Financial Services Partner at law firm Fieldfisher.
One of the most notable outstanding issues for the EU is addressing the level of detail needed by asset managers complying with the Sustainable Finance Disclosure Regulation (SFDR), with Level 2 expected to come into force from January 2022.
SFDR Level 1 went live in March 2021, requiring asset managers with European ESG-labelled funds to categorise their products across three progressively greener categories – Articles 6, 8 and 9. Level 2 will require asset managers to supplement these categorisations with underlying supporting evidence, with reference to the EU Taxonomy of sustainable economic activities.
Carbon-intensive sectors – agriculture, nuclear and gas – have been excluded from the Taxonomy as the European Commission (EC) debates whether, and to what extent, these industries can be classified as sustainable. A new legislative proposal for rules to establish technical screening criteria for gas, nuclear and other technologies in the energy sector is expected by Q4 2021.
In the meantime the UK, which did not onshore SFDR, is expected to use the Taxonomy as a jumping off point for its SFDR equivalent. At this stage, there is relatively little to go on to predict the UK’s rules for sustainable investment.
The most recent update to the Financial Conduct Authority’s (FCA’s) Regulatory Initiatives Grid indicates that final rules for Task Force on Climate-related Financial Disclosure-based (TCFD) disclosures for asset managers, life insurers, pension schemes and listed companies will be published in Q4 2021.
However, progress on the UK’s Green Taxonomy won’t be expected until next year at the earliest.
“I don’t think we can expect too much more detail on any of this before COP26 [November 2021],” says Julia Vergauwen, ESG Funds Lawyer at law firm Linklaters.
In the absence of details about the degree of divergence between the UK and EU, the UK will want to ascertain that “EU markets remain viable for UK-based investors”, said Floortje Nagelkerke, Partner at Norton Rose Fulbright, speaking at a recent Responsible Investment Live event.
UK TCFD-aligned rules are due to come into force from April 6, 2022, ensuring that climate-related disclosures are more decision-useful.
“The UK is more focused on climate-related disclosures right now, but there are a few things pointing to the [broader] direction of travel, such as the UK indicating there will be disclosure requirements for sustainable and ESG-labelled products,” Fieldfisher’s Tinworth says.
The FCA is working on developing “guiding principles” for the “design, delivery and disclosure of ESG/sustainable fund products”. The regulatory body will also be publishing “next steps on guiding principles” for the investment industry by Q2/Q3 2021.
The FCA’s reference to principles indicates that the UK will adopt a more pragmatic, flexible and less prescriptive approach, Vergauwen says.
“This will make it easier for asset managers who are already compliant with the EU’s SFDR to then comply with UK requirements, because they will likely already have the relevant policies and procedures in place to meet UK demands,” she says.
The Bank of England, HM Treasury and FCA are collaboratively developing the UK’s technical screening criteria, which will be used to “define what economic activities are environmentally sustainable”, according to the regulatory grid. This, in turn, will inform the basis of the UK-specific green taxonomy.
“The UK Green Taxonomy will apply to the asset management industry, including funds, in order to better mitigate greenwashing. The UK has been clear that the taxonomy will be science-led and science-based,” Vergauwen explains.
With technical screening criteria due to be finalised by the end of 2022, it probably won’t apply until 2023 or later, she adds. “Meanwhile, the bulk of the EU Taxonomy will apply from January 2022, so there’s definitely a discrepancy in timings.”
Europe’s growing pains
There are pros and cons to “going first” when shaping a new area of regulation, says Dale Gabbert, Head of Funds at Fieldfisher.
Positively, it means that Europe’s approach is most likely the strategy that will be adopted and copied by the rest of the world.
But the EC also has to endure the headache of building new regulations for an industry that’s still in its infancy, he says.
There has been no shortage of growing pains, with delays to the Taxonomy Regulation and SFDR Level 2 making compliance more difficult for asset managers.
The EU Taxonomy was delayed last year when a coalition of NGOs, shareholder associations and sustainable investment associations called on the EC to better ensure that the Taxonomy was “rooted in climate and environmental science”. They argued that it “ignored or weakened” the scientific advice of the Technical Expert Group (TEG).
Last month, further clarifications for all six of the amended Delegated Acts within the Taxonomy were published, covering fiduciary duties, investment and insurance advice. The six Delegated Acts focus on: climate change mitigation, climate change adaptation, water and marine resources, transition to a circular economy, pollution prevention and biodiversity. The first of the six Delegated Acts will be formally adopted from the end of May.
But these latest changes are still subject to scrutiny, with Nathan Fabian, Chair of the Platform on Sustainable Finance, the TEG’s successor body, warning that the Platform will study the existing adopted criteria “to understand where they deviate from expert recommendations, and the evidence used to support these changes”.
As a ‘living document’, the Taxonomy will be adapted and expanded over time as climate-related priorities change. Theoretically, the technical screening criteria used within the Taxonomy should provide asset managers with more clarity ahead of SFDR Level 2.
But with the regulatory technical standards (RTSs) yet to be finalised, asset managers have been reluctant to comply with SFDR reporting requirements, Gabbert points out, despite the fact that the European Supervisory Authorities (ESAs) advised that the draft RTSs be used as a reference point in the interim.
Level 2 requires asset managers to address a number of mandatory and voluntary principle adverse impact indicators (PAIs) on sustainability factors. These must be publicly disclosed on managers’ websites to augment their SFDR-aligned categorisations of ESG products. PAIs include environmental and social issues such as anti-bribery, anti-corruption, respect for human rights, climate and environment, and social and employee matters.
In February, the ESAs recommended that the number of mandatory PAIs is reduced from 32 to 14, but this reduction has yet to be officially approved by the EC.
“Asset managers are deciding to not comply with SFDR right now, even if they could theoretically categorise funds as Article 8 or 9,” Gabbert says. “It’s difficult to sign up to something when you don’t know the final concrete reporting rules.”
By launching SFDR Level 1, Europe was the first to offer its asset managers the opportunity to categorise green-labelled products in this way, but introducing a regulation that still contains a number of gaps was always going to promote hesitancy, Tinworth agrees.
“SFDR is not fully formed. The EC is letting the market figure it out for itself,” he says.
Demand for data
An ongoing hindrance to the development of sustainable investment frameworks is the lack of high-quality and reliable data needed to inform compliance. Any UK-based regulation that is introduced will need to factor in these issues, panellists at Responsible Investment Live noted.
“You need the appropriate data to meet regulatory requirements. Without it, it’s incredibly difficult,” said Caroline Herkströter, Partner at Norton Rose Fulbright.
Compliance with SFDR requirements is particularly challenging when asset managers don’t know if they can trust the ESG-related data gathered from their fund holdings, noted Elise Attal, Head of EU and UK Policy for the Principles for Responsible Investment (PRI).
“PRI signatories consistently report that a lack of reliable and comparable ESG data is a substantial hurdle to SFDR compliance,” she said.
As a result, asset managers and asset owners often buy multiple sets of data from an array of third-party vendors and then conduct in-house analysis to produce more comparable information. This practice is both time-consuming and costly.
The European Securities and Markets Authority (ESMA) has written to the EC, calling for third-party ESG vendors to be regulated, better standardising the quality and reliability of ESG-related data.
Cost of compliance
Data costs are only one of the overheads facing asset managers adapting to a new landscape.
“If you just keep churning out reams of regulation and make it apply to all managers, then that’s inherently anti-competitive. It’s much harder for boutique managers to comply with the rules, making that business less viable,” Gabbert says.
Regulators in both Europe and the UK need to be conscious of the challenges for asset managers in too many regulatory requirements being introduced at once, he notes.
“We don’t want asset managers to have to run multiple sets of material in order to comply with multiple roles,” Gabbert adds. “That’s time-consuming, to the detriment of actually managing money or liaising with investors on ESG-related issues.”
Voluntary measures will alleviate some of the pressure for UK asset managers, giving them more flexibility and time to comply while coming to terms with EU requirements.
From this perspective, it’s in the UK’s best interests to ensure that its future taxonomy and ESG-labelling disclosure framework does not diverge too much from those of Europe as this will keep costs down, he says.
“Nonetheless, I don’t think there will be a complete bonfire of all European regulation – not on something so front and centre like ESG,” Gabbert tells ESG Investor.