ESG investors often find selecting a fund which meets their environmental and ethical preferences involves wading through an alphabet soup of acronyms and buzz words which provide little illumination as to how their investments are going to reflect ESG criteria in their investment portfolio. In a bid to help improve consumer communications, the financial regulator (the FCA) is introducing a series of reforms over the course of 2024.

One of these is an ‘anti-greenwashing rule’, which requires fund providers to ensure the claims they make about the ESG characteristics of their fund actually match up with what’s going on in the portfolio. But they have also introduced four new investment labels which you might start to see on fund literature. The labels cover what the FCA believes to be four different approaches to ESG investing, and which it hopes will help consumers make more informed decisions. In order to use the labels, funds will need to have an explicitly stated sustainability objective and at least 70% of the fund’s assets will need to be invested accordingly. The new labels are as follows.

SUSTAINABILITY FOCUS

Funds falling into this category will need to invest more than 70% of their portfolio into assets which are environmentally or socially sustainable.

SUSTAINABILITY IMPROVERS

These funds will need to demonstrate at least 70% of their portfolio is invested in assets which have the potential to improve environmental or social sustainability over time. Fund providers will need to identify the period of time over which improvement is expected to happen and engage with companies in the portfolio to keep this on track.

SUSTAINABILITY IMPACT

To qualify as a Sustainability Impact fund, providers will need to ensure their funds aim to achieve a pre-defined, measurable and positive impact on environmental or social outcomes.

SSUSTAINABILITY MIXED GOALS

These funds will need to invest 70% into assets that meet a combination of the above three approaches. Many funds will employ a combination of approaches to ESG investing and this category provides a label for funds which might not qualify for any of the other categories in isolation.

The FCA says the sustainability characteristics of a fund must conform to a robust, evidence-based standard which is an absolute measure of environmental and/or social sustainability. In some cases, fund providers themselves may develop their own standards, but it seems likely many will defer to existing frameworks to define the standard for their funds. In either case the regulator is trying to get funds to provide evidence they are actually delivering on ESG promises rather than simply having good intentions.

NEED FOR MONITORING

Fund providers will need to monitor compliance with these labels and undergo an independent assessment to judge if they are meeting the right standard. They will also need to issue a suite of disclosures to keep investors informed of their ESG activities. Interestingly the regulator says governance alone is not a sufficient outcome to target for a label, rather they see good governance as a means of achieving positive environmental or social outcomes.

Passive funds will be included in the labelling regime, though they don’t normally control the composition of the index they are tracking, which could mean the index provider taking action which would mean the fund no longer qualifying for a label. The regulator seems to afford them some leeway here, but says they are still expected to take reasonable steps to make sure the fund maintains the ESG standards laid out to investors. This will include communicating with index providers if there looks like being a mismatch between the components of the index and the sustainability objective of the fund.

There will be funds out there which apply some sort of ESG lens to their portfolio, but don’t qualify for any of these labels. As well as not being able to use one of these labels, these funds won’t be able to use the words ‘sustainable’, ‘sustainability’, and ‘impact’ in their names. That still leaves other related names which could be used, such as ‘responsible’, ‘ethical’ or ‘stewardship’. The FCA has also issued rules on how these funds are marketed to investors, and the disclosures they need to make, again as a barrier to what is seen as funds talking the ESG talk but not walking the walk.

IMPACT REMAINS TO BE SEEN

Whether these rules help consumers make more informed choices remains to be seen. There is likely to be a bedding in period as firms adjust to the labels and the quite onerous requirements attached. Beyond that, as the FCA itself states there is no single definition of “sustainability’.  These labels are really an attempt to provide some standardisation across a landscape which is varied and extremely nuanced.

At some point we are expecting the UK Green Taxonomy to be published by the government, a common framework to set clear definitions of the economic activities and investments that can be defined as environmentally sustainable. The fact the regulator is pushing ahead with rules to govern the large ESG fund industry before this framework has been published tells us the authorities are rushing to erect some regulatory scaffolding around a haphazard building that has popped up very quickly.