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ESG: Between a rock and a hard place for the FCA

ESG: Between a rock and a hard place for the FCA

The discussion on new ESG rules in the UK has gained prominence since members of the Financial Conduct Authority (FCA), namely Sacha Sadan (Director of ESG) and Mark Manning (Technical Specialist), gave evidence to the Treasury Sub-Committee on Financial Services Regulations on the 22nd of February.

The new ESG rules are the FCA’s proposed Sustainability Disclosure Requirements (SDR) and investment labels. The FCA consulted on these between the 25th of October to the 25th January. The final rules from the FCA are expected to be published in June of this year.

During the Committee’s Oral evidence session, MPs asked a number of supposedly simple questions in relation to the rules, which included whether the FCA had done a cost-benefit analysis that took into account the cost to consumers. MPs also asked the FCA for its views on calculations done by the Investment Association, which suggested 60 to 70% of current retail funds would be excluded as they would not be able to meet the proposed rules.

Without getting into the rules themselves, the entire discussion starting from the Oral Evidence session itself to, more recently, a letter from the Treasury Committee to the CEO of the FCA (asking the FCA to clarify the points above among other things) has become, for lack of a better word, quite political.

MPs are right to be concerned about the cost consumers might be faced when the new rules come. This is because, as funds previously labelled ESG become ineligible, customers may have to switch their investments, thereby incurring transaction costs. That is, of course, unless the product manufacturer (asset manager) makes changes to the fund so it could apply for an FCA label. However, the restructuring required would also likely incur costs and these would, ultimately, be passed down to the investor.

This is, rightly, an important consideration. But this whole discussion has missed a very big point – the FCA’s proposed rules for SDR, and investment labels would bring significant benefits. Not only do the proposed rules increase market transparency by giving retail investors the tools needed to navigate between products and correctly identify what is, and what isn’t, an ESG fund. Furthermore, investors can also identify what type of ESG fund a product is through the different labels the FCA has proposed – Sustainable focus, Sustainable Improvers and Sustainable Impact.

It’s important to mention the rules are not yet final and are almost certainly going to be tweaked based on the consultation responses. For example, – we might see changes around the balance between asset allocation and stewardship in the ‘improvers’ category, refinements to the ‘impact’ label and its definitions, and perhaps more flexibility for different fund structures (fund of funds for example).

We should also ask the question, what would happen if the FCA did not step in and propose these rules, preferring instead to leave it to the market? The ESG market in the UK would have continued as before but the risks of mis-selling and greenwashing would continue to rise – not necessarily because firms are deliberately trying to greenwash, but because there would have been no rules around what an ESG fund is supposed to be. If this were to happen, then the FCA would be criticised for failing to take action to address an evolving market failure and not protecting consumers. And yet, now that they are in the process of doing so, they are criticised – one can’t help but feel the FCA are caught between a rock and a hard place.

My concern is that MPs, politicians, and groups interested in maintaining the status quo will use these latest developments to push the FCA into providing more flexibility (or watering down) in its rules to prevent most funds from having to be reclassified. This is, perhaps, the worst outcome possible as it would have a major impact on the overall transition to a net zero economy.

A more sensible solution might be to provide some flexibility in switching and ensure that consumers do not bear the cost considering the new rules. The FCA have stated the final rules will be published in June 2023, with the labelling, naming, and marketing, consumer-facing and pre-contractual disclosure requirements – and rules for distributors coming into effect 12 months after the publication of the policy statement. Hopefully, for most funds, this will be enough time to restructure their products appropriately. However, some funds may not be able to adapt and, for those investors who find themselves stuck in a non ESG fund even after this, there might need to be some flexibility.

The other important development to keep an eye on is the response from the FCA to the Treasury’s letter. One of the questions in the correspondence queries why the FCA has not taken enforcement action against firms making misleading ESG claims and whether it intends to do so soon.

The obvious answer to this question is there were no ESG rules therefore it would be difficult to penalise a company for breaking rules that do not exist. The SDR and investment labels rule addressed the lack of rules by introducing an ‘anti greenwashing’ rule which reiterates requirements for all regulated firms that sustainability-related claims must be clear, fair and not misleading.

But that does not answer the real question about why apparently misleading claims in relation to ESG were not in breach of the fair, clear and not misleading rules that already exist in the FCA rulebook. The reality is the FCA have taken action and I’m sure this will be referenced in their response. In July of 2021, the FCA published a letter alongside ‘guiding principles’ in response to numerous ESG fund applications that had ‘fallen below expectations’. In other words, the FCA has been proactive in this area and the new ‘anti-greenwashing’ rule, which will become effective as soon as the Policy Statement is published, is the latest step in the FCA’s actions against greenwashing. This will give the regulator an explicit tool with which to challenge firms that are considered to be potentially greenwashing their products or services and take enforcement action against them as appropriate. The FCA has also fired a warning shot to Benchmark providers along similar lines.

With all that said, it is important to highlight that the FCA’s proposals have been widely welcomed by a number of organisations as a strong package of measures that will, undoubtedly, support the UK’s transition towards a sustainable financial system. This should not be forgotten.


David Cook

I am the Partner leading Penta’s international financial services practice focussing on providing clients with a borderless offer across London, Brussels, Asia and the United States. This is vital as the issues facing financial services are often international in nature and need to be considered on a cross-border basis. I have 20 years public policy experience as civil servant, regulator, diplomat and in industry.
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