Over the last 18 months, asset managers have faced a significant volume of new ESG regulations and requirements, and evolving interpretations of those rules. These firms are seeking to meet their clients' evolving preferences and expectations, while minimising regulatory and reputational risks. Even where new regulations are not yet finalised, asset managers should already be making changes to prepare and embed the relevant ESG considerations across impacted functions.
Within the context of ESG regulation, the potential for greenwashing remains regulators' greatest concern. This concern is being expressed in a variety of new rules and disclosure requirements. However, all incoming rules depend on or presume a common understanding of what is meant by the term “sustainable”. The slowing development of taxonomies (frameworks that set out defined sustainable activities) means that firms need to create their own frameworks or depend on evolving industry practice.
ESG financial services regulations directly impacting UK and EU asset managers can be divided into three phases, as set out in the table below. This article explores the latest developments and the key challenges facing firms.
Amid frequently expressed concerns about “greenwashing”, European regulators have been the first movers on disclosure requirements for asset managers and their funds and portfolios. In the EU, ambiguous regulatory requirements and a high volume of clarifications under the Sustainable Finance Disclosure Regulation (SFDR), often issued late in the day, have been particularly challenging for firms.
The SFDR regime remains a work in progress. Asset managers need to adopt a coherent and comprehensive approach to monitoring, understanding and implementing further regulatory guidance. This guidance can have significant operational impacts for firms. For example, the ESAs' June 2022 clarifications (that Article 9 funds should only make sustainable investments — leading to classification downgrades across the industry) and the Commission's July 2021 Q&A (that third-country AIFMs marketing AIFs in the EU are also subject to the requirements). The Commission's pending response to the ESAs' September 2022 questions is likely to require close attention by firms, in particular regarding the definition of a sustainable investment and the interpretation of “contributing to” environmental or social objectives. Meanwhile, firms have also had to monitor and implement clarifications by individual EU Member States.
As the regime develops, immediate areas of focus for EU firms include the production and publication of the detailed SFDR level two1 product disclosure requirements for Article 8 and Article 9 funds, and the publication of entity-level disclosures by the end of June 2023.
In the UK, larger asset managers are focusing on developing entity- and product-level disclosures in line with the FCA's TCFD2 requirements by 30 June 2023. Smaller firms also need to start preparations to disclose by 30 June 2024. The FCA's proposals for new Sustainability Disclosure Requirements (SDR) will require even more attention and resources from asset managers to ensure effective implementation — see our previous article with more detail on the FCA's proposals here. Although the proposed disclosures will extend aspects of the TCFD climate-focused requirements (for example, the entity- and periodic product-level reporting), the new SDR consumer-facing disclosures, pre-contractual reporting and disclosures regarding broader sustainability considerations will need significant work.
Introducing product labels
In addition to disclosure requirements, the EU was the first out of the blocks with work on a sustainability label (Ecolabel) for investment products, but it has delayed issuing a formal proposal. Research published by ESMA has demonstrated the challenges around appropriately calibrating the labelling requirements. Given this delay, the German regulator issued its own proposals in 2022, but is taking time to consider its position.
The UK has now taken the lead and consulted on detailed requirements for three product labels, which it intends to introduce from mid-2024. Firms will need to scrutinise carefully the FCA's proposals, start mapping their existing product range to the proposed labels, and determine where any changes or uplifts to existing products could be required. If firms decide they do not want to use the labels or cannot meet the prescriptive requirements, a substantial piece of work will be needed to review the use of sustainability terms in those products' literature (see below). There are several challenging aspects within the proposals and firms should track how these feed through to the final rules. For example, the application of the rules to segregated mandates, the meaning of “unexpected investments”, a greater emphasis on stewardship, and how the impact of stewardship and engagement can be measured in practice.
Although the FCA has sought to align SDR with the SFDR disclosure categories where possible, there are substantive divergences and SDR implementation will require significant effort. There is also continued uncertainty regarding the final shape of the UK's Overseas Funds Regime and whether/how the product labels will apply — a further consultation is expected.
Restrictions on fund names and marketing
Around Europe there is a common focus on fund names and the use of ESG terms. The outcome of the latest proposals will require fund managers to review their products and documentation.
ESMA has proposed guidelines on fund names. It does not intend for the guidelines to interfere with existing requirements under the SFDR or the EU Taxonomy, but it has proposed quantitative thresholds with minimum investment holding requirements where EU funds use ESG- or sustainability-related words in their names. The final guidelines are expected by Q3 2023 at the latest. Any SFDR Article 6 funds using ESG terms will be particularly impacted by the proposals.
In the meantime, some Member States have implemented their own requirements. For example, France requires consistency between what is said in marketing material and the actual investment management of the fund (by imposing minimum standards on products that hold themselves out as having ESG characteristics), including rules on fund names.
The FCA's SDR proposals aim to codify aspects of its existing guiding principles but go further by restricting the use of specific terms. Under the proposals, if a product does not qualify for and use a label, it will not be able to use ESG-related terms in its product disclosures and marketing materials in relation to retail clients (for example, “ESG”, “environmental”, “sustainable”). The proposed restrictions go as far as capturing “any other terms” that imply sustainability characteristics. Such terms are widespread in existing documentation and industry has expressed concerns that this will prevent managers from providing accurate descriptions of how they embed sustainability factors in their investment processes. If the proposals become made rules, significant work will be needed to remove these terms from documentation, or uplift products to ensure they are eligible for a label and to use the terms.
Embedding sustainability risks, factors and preferences
Since August 2022, EU firms have been required to embed sustainability considerations in their day-to-day operations. ESMA guidelines to complement the underlying rules have also been finalised (suitability) or consulted on (product governance). In addition, the EBA has published a report that sets out how regulators should incorporate ESG risks in their supervisory approach.
The UK has chosen not to implement similar requirements to date. Although the concept of considering investors' sustainability preferences is now firmly embedded in the EU, the FCA has stated that it will explore how best to introduce rules on product suitability for financial advisers in due course. This will be covered in a separate consultation paper.
As the work of the International Sustainability Standards Board progresses, many jurisdictions are introducing mandatory reporting by listed corporates in relation to climate change risks, but to different timeframes, and with different sizes and types of corporates impacted. Without alignment, it will remain challenging for managers to gather the data and information they need regarding their investments for the purposes of their own disclosures.
Some asset managers will themselves be caught by corporate reporting requirements that apply to public and private companies more broadly (for example, the EU Corporate Sustainability Reporting Directive), in addition to the disclosures described above.
Tackling the challenges
To be well positioned to meet the new requirements, asset managers should already be making changes to embed ESG considerations across relevant functions. These changes should include:
- Navigating the different sets of rules and divergence from a regulatory change perspective (including guidance at the level of EU Member State).
- Embedding sustainability considerations within the firm, including across the front office, the product governance function, and compliance and marketing teams.
- Managing reputational risks and complying with regulatory requirements, while developing products that legitimately distinguish the firm in the crowded ESG market.
- Defining what products qualify as sustainable, in the absence of a common taxonomy.
- Deciding how best to fill the corporate reporting disclosure gap until new regulations come into force.
Please get in touch with us if you require KPMG's assistance with approaching and implementing any of the above requirements.
1 The SFDR “level two” requirements, or officially the “SFDR Delegated Regulation,” became effective on 1 January 2023 and added additional detail, including reporting templates, to compliment the core SFDR requirements.
2 Task Force on Climate-related Financial Disclosures