New framework aims to broaden sustainability reporting and embrace double materiality but faces long path to law.
The UK’s Sustainability Disclosure Requirements (SDRs) are intended to create an integrated and streamlined framework that brings together sustainability-related reporting requirements under one roof for corporates and financial institutions.
They were developed by HM Treasury, the Department for Business and the Department for Work and Pensions to cover “the next step in putting the UK’s finance sector in a better position to achieve the goals of the Paris Agreement”, according to briefing papers.
Critically, SDRs could eventually give asset owners deep insight into the environmental and social impacts of firms in their portfolios. However, SDRs will have a long wait for legislative approval and feedback from stakeholders could see changes made. In this explainer, ESG Investor looks at the initiative’s progress to date, next steps and implications for investors.
What are SDRs and why are they being introduced?
SDRs were designed to broaden UK sustainability reporting, which currently focuses almost exclusively on climate-related risks, to cover a much fuller range of issues. The UK has based its climate reporting regime on the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD), but SDRs go beyond this, both by requiring double materiality and by looking at other environmental impacts and risks on top of those arising from climate change.
SDRs were first mentioned in July last year by Chancellor of the Exchequer Rishi Sunak at the annual Mansion House speech in the City of London. In some respects, they were to be part of a new chapter for UK financial services, post-Brexit, applying to companies, pension schemes and financial services firms, at entity and product level.
“SDR will use the same framework to ensure a direct link from investors, through the financial system to the businesses they are invested in and their relationship with the environment,” says the UK government.
SDRs will create an integrated framework for decision-useful disclosures on sustainability across the economy. This will enable the flow – the government says – of comparable information on how both corporate and financial flows impact and are affected by sustainability factors.
How will this work alongside TCFD-based climate reporting rules?
The SDR proposal comes as the UK continues to roll out rules around climate disclosures, which will be integrated with the broader requirements.
As announced in November 2020, all major UK corporates and financial institutions will be subject to climate reporting in alignment with TCFD recommendations.
Applying from 1 January 2022, for example, investors regulated by the Financial Conduct Authority (FCA) have new rules around climate disclosure obligations, based on the recommendations of the TCFD. Large occupational pension schemes have been obliged to report in line with TCFD-based rules since October.
Climate-related and other sustainability disclosure requirements for listed and large corporates, and regulated asset managers and owners will evolve with the introduction of SDRs, although the process for doing so is not yet clear.
Ultimately, asset owners should be offered a consistent framework for comparing the climate and other sustainability risks and impacts in their portfolios.
How has the planned SDR framework evolved so far?
In October 2021, the government set out its path in the Greening Finance: A Roadmap to Sustainable Investing policy paper, which listed SDRs as a key element. The paper aimed to show how the UK would go forward with sustainable investment, outlining how requirements for decision-useful information on sustainability would drive business and financial systems and shift financial flows “to align with a net zero and nature-positive economy”.
The requirements were welcomed as investors said they gave more detailed insight into environmental risks and impacts on a double materiality basis.
In November 2021, the FCA called for responses to a Discussion Paper that sought views on proposed SDRs for regulated asset managers and owners. The input received by last Friday’s deadline will inform policy proposals to be issued for consultation in Q2 2022.
“We expect a formal consultation from the regulator on SDR labelling system probably in the first half of this year – that is an ambitious timeframe – and finalising rules by the end of this year,” says Oscar Warwick Thompson, Head of Policy and Communications at UKSIF.
The timeline for the primary legislation is subject to the parliamentary timetable, but delays are likely.
“We see a consultation on final rules by the end of 2022 and would like to see SDRs brought in within the next several years,” says Warwick Thompson, recommending that asset managers should continue to measure their exposures and refine their TCFD reporting processes.
How will SDRs impact sustainability information flows for asset managers and owners?
The SDRs are likely to change the nature of reporting requirements if, as expected, they herald the introduction of double materiality.
In reporting terms, double materiality means that disclosures should both outline how sustainability issues impact companies and how companies’ activities impact sustainable development in the society and environment beyond their immediate operations.
The industry is split on the need for reporting beyond financial materiality with some considering it burdensome, while others, including some large asset owners, viewing it as essential to meeting sustainability goals.
Although the emphasis on double materiality is wanted by many, implementation and impact are harder to predict.
The EU’s reporting framework for sustainable investment is already based on double materiality, but the extent of the UK’s commitment is less certain, at least until the FCA’s consultation process is complete.
“SDRs will bring in double materiality explicitly,” said Matt Feehily, Senior Managing Associate at law firm Sidley Austin. “At the same time, the FCA is also looking to expand the scope beyond climate-related disclosures,” he says, adding that the UK’s current TCFD-based regime can be characterised as being narrower but deeper, compared to the EU’s pathway.
“The current UK rules already have climate impact aspects baked into them,” says Feehily. “We have the other environmental impacts that will follow in SDR as well. But we don’t yet know what the FCA’s more developed regime will look like and how it will approach impacts.”
How does the UK’s planned approach fit with international developments?
While the UK is attempting to steer an independent path, Feehily notes that it is explicitly trying to work within broader international frameworks and in step with other major jurisdictions, including both the US and Europe. For example, the UK has explicitly welcomed the formation of the International Sustainability Standards Board (ISSB), by the IFRS Foundation.
However, the ISSB’s standards are expected to focus on financial materiality, meaning they can only provide a baseline for rules in jurisdictions intending to adopt double materiality. The US is due to introduce climate disclosure requirements, but these are widely expected to have a much narrower scope than Europe’s rules, mirroring the TCFD’s recommendations.
“The fact that the EU regime is there in principle, if not yet fully operational, will mean it is interesting to see whether the FCA looks to align with that or not,” says Feehily.
SDRs will also need to align with the framework provided for sustainable activities expected to be provided by the forthcoming UK Green Taxonomy.
As the UK’s sustainable investment framework takes shape, Feehily says a big issue to overcome is the lack of good data and metrics, recommending asset managers and owners use the time ahead of reporting deadlines to address this challenge.
Why are SDRs a departure from existing disclosure requirements?
While the SDR’s wider scope is important, it is double materiality that is the biggest change. It is seen as a fresh perspective, says Warwick Thompson, potentially combatting a narrow response to environmental and sustainable development challenges.
In its response to the FCA’s Discussion Paper, UKSIF said consistency is needed between the EU Sustainable Finance Disclosure Regulation (SFDR), which outlines reporting requirements for ‘green funds’, and SDR while avoiding some of the flaws of the former.
This is because the SDR regime entails the introduction of new labelling requirements for UK-registered funds as well as new reporting requirements for companies whose stocks and bonds are contained in their portfolios.
Benjamin Maconick, ESG associate at law firm Linklaters, says SDRs will mean a more formal framework around sustainable investments. “The FCA consciously designed SDR as a labelling system. They started from the premise that there should be concrete labels and layers of regulatory disclosures. They recognised that if you want to make this useful, then you need to make the disclosures easily digestible and have a clear labelling system.”