SDR: A regulatory saviour?

In October last year the UK’s Financial Conduct Authority (FCA) proposed a package of measures aimed at clamping down on greenwashing, initially targeted at the retail investor market.

Known as the Sustainability Disclosure Requirements (SDR), among the measures were three dedicated sustainable investment labels (Sustainable Impact, Sustainable Focus and Sustainable Improvers) as well as disclosure requirements and restrictions on the use of sustainability-related terms in product naming and marketing.

Impact on operations

Despite an initial intention for SDR only to apply to retail investors, the pension sector is keeping a keen eye on the measures with a mind to the likelihood of the remit expanding.

Following the consultation period on SDR, Edina Molnar, vice president in pension fund consultancy Redington’s investment team, said: “In their current form, the proposals would allow firms to market certain products as sustainable to institutional investors but not to retail clients. We believe that this divergence would introduce significant complexity and could make it harder for institutional investors to assess the robustness of ‘sustainable/ESG’ products.”

Molnar also suggested there was an “urgent need” for a UK taxonomy to provide a baseline for labelled assets – and that the SDR measures should ideally have moved “in tandem” with the implementation of the taxonomy.

The Institutional Investors Group on Climate Change (IIGCC) echoed some of Molnar’s points, namely that, under the current plans, the three categories of labels created by the FCA are intended to be mutually exclusive.

According to the IIGCC, this is a “serious concern” as many investors are pursuing sustainable objectives through elements such as blended finance, ETFs and fund of funds, all of which may escape one overarching definition. In addition, the holdings within the funds can be fluid, with the direction of the fund shifting over time.

However, James Corah, head of sustainability at CCLA, an investment manager for charities, religious organisations and the public sector in the UK, remains optimistic and suggests that SDR can act as a “catalyst for change” in the investment industry.

“We really recognise and support what the FCA are trying to achieve in terms of consumer choice. Most importantly, the SDR defines sustainable investment products as aiming to have as positive environmental social outcome. Quite frankly, if sustainable investment products aren't aiming to build a better world than there's no real point in them,” he said.

“While there's still lots to work through, the SDR just getting that down as the grounding principles of what sustainable finance products should be doing is a huge step forward.”

In the consultation paper for SDR, the FCA stressed the need for “additionality” when labelling sustainable investment funds, namely whether a proposed activity will produce some “extra good” in the future relative to a specified baseline.

Additionality was seen by some respondents as important in distinguishing between the Sustainable Impact products and the Sustainable Improvers category, though the difficulties in evidencing additionality was also raised.

Cadi Thomas, head of ESG research at pensions advisory Isio, said: “With regards to labelling, the additionality clause which applies to the Sustainable Impact label may be problematic for many of the impact products that we currently rate. On disclosure requirements, we welcome standardisation of industry data and, in particular, ESG metrics.”

Thomas also noted that while the SDR is currently voluntary in nature, she anticipated that for sustainable investment managers to keep pace, all will soon feel the need to comply.

Intertwined with the SDR labelling system is its proposal of an “anti-greenwashing” rule that would apply to all regulated firms and will look to further establish that sustainability-related claims are “clear, fair and not misleading”.

Melville Rodrigues, head of real estate advisory at Apex Group, said: “This approach from the FCA lends itself to institutional investors adopting SDR labels criteria as benchmarks for assessing sustainable products.

“The UK funds sector must prepare for the ESG regulatory paradigm where anti-greenwashing measures and sustainability labels are here to stay. I would urge UK managers to get ahead of the curve, and be aware of the opportunities presented by SDR product labels.”

Relationship with SFDR

Data from KPMG’s Regulatory Barometer shows that delivering ESG and sustainable finance remains the top priority across the UK and EU regulatory landscape. The SDR regulation may prove to act as a key part of this, acting as a counterpart to the EU’s Sustainable Finance Disclosure Regulation (SFDR), and potentially an improvement on it.

SDR is a dedicated labelling service, as opposed to the “de facto” way in which the SFDR has become one. Prior to a 1 January 2023 deadline for Level 2 of the SFDR’s Regulatory Technical Standards, requiring greater transparency in disclosure, big names such as BlackRock and HSBC downgraded Article 9 (impact) Exchange-Traded Funds to Article 8 (sustainability-linked) en masse.

This prompted discussion over whether they were ever ESG-backed in the first place, and even what the exact function of the SFDR is.

According to Stephen Metcalf, head of UK sustainable investing at RBC Wealth Management: “[With SDR], our manager research and due diligence process will change. SFDR’s Article 8 only provides an anti-greenwashing disclosure regime, not a green label. Under this, there is no prescriptive asset allocation or minimum investment thresholds – there is no commitment to sustainable investments. A product name alone may be enough to form the impression of promoting sustainable criteria.

“This is very different to what the FCA is proposing, and many Article 8 funds will not qualify for a sustainable label under the SDR. This will overall be helpful to fund selectors, who at present have to deal with a great deal of dispersion in the Article 8 space.”

Evolution of SDR

With the consultation period now over, it remains to be seen what the final version of SDR will be, and what its possible impact will be on retail, pensions, wealth management and more.

There are also similar proposed measures in the US and Japan, and further under the International Sustainability Standards Boards umbrella. An ongoing consideration is what passporting can be achieved between different jurisdictions, and how much double reporting may ultimately be needed.

Hugo Kimber, chief executive of ESG data firm Carbon Responsible, said: “There's a lot of positive support for [these measures]. It will now be for bodies such as the FCA to engage and consult in a way that's going to allow for very rapid refinements and to meet a degree of global conformity and interoperability.

“Regarding some of the concerns that sit around more complex financial products, for example within pensions, there will need to be a gradual elaboration of what each of these labels within SDR really mean.”

Meanwhile, Tom Wieczorek, head of analytics product management at fintech firm Confluence, anticipates a “teething period” for SDR that is not dissimilar to the tricky adjustments facing those currently making disclosures under the SFDR regulation.

“There's going to be a period of adoption, when managers start reporting and people start disclosing, when they're going to find out what doesn't work as intended or the actual effects of a particular disclosure”, said Wieczorek.