FCA publishes welcome guidance on ESG and sustainable funds

Mis-selling

The FCA’s primary concern is that many such funds are being marketed to investors without adequately substantiating or explaining the fund’s investment strategy and goals, creating risks of greenwashing and misleading investors. The FCA gives specific examples of the numerous poor applications it has received for the authorisation of ESG funds and sets out its expectation of "material improvements in future applications".

The guiding principles

The annex of the letter sets out guiding principles to help firms comply with existing requirements for designing (or repositioning) and marketing their products in a responsible way. The guiding principles have implications for product design, resourcing and managing the ESG elements of a fund’s strategy and marketing, which are relevant for AFMs managing both private and authorised funds in terms of the supervisory expectations from the FCA.

The FCA provides an overarching principle, and three supporting principles.

Overarching principle: consistency.
A fund’s ESG/sustainability goal should be reflected consistently in the fund’s design, delivery, and disclosure. This captures the fund’s name, stated objectives, documented investment policy and strategy, and its holdings.

• Principle 1: the design of responsible or sustainable investment funds and disclosure of key design elements in fund documentation.
  References to ESG (or related terms) in a fund’s name, investment policy, financial promotions or fund documentation must not be misleading and should fairly reflect the materiality of ESG/sustainability considerations to the objectives and/or investment policy and strategy of the fund. Using terms like "sustainable", "ESG", "responsible" or related terms in a fund’s name can be misleading in the FCA’s view unless the fund has a substantive focus on ESG or sustainability that is material to the fund’s objectives and strategy. The FCA expect the investment strategy of funds that pursue ESG/sustainability characteristics to include key elements of the strategy, such as the specific E/S/G themes or "real world" (non-financial) impacts and (positive or negative) screening criteria. The FCA would not expect to see prominent ESG claims in fund documents, or ESG positioned as a key part of the fund’s offering, where the fund integrates ESG considerations into mainstream investment processes (i.e. where there is no material ESG orientation in the specific fund’s design or strategy). AFMs are also expected to have an effective stewardship approach for the exercise of their voting rights in respect of investee companies, to support the ESG/sustainability objectives of the fund.
• Principle 2: the delivery of ESG investment funds and ongoing monitoring of holdings.
  The resources (including skills, experience, technology, research, data, and analytical tools) that an AFM applies in pursuit of a fund’s stated ESG objectives should be appropriate so that the fund is reasonably capable of achieving its stated objectives. The way that a fund’s ESG investment strategy is implemented, and the investments held by the fund, should be consistent with its disclosed ESG/sustainability objectives on an ongoing basis. In particular, AFMs should take appropriate steps to monitor the research, data and analytical tools used in its investment process, assure the quality of inputs by conducting appropriate due diligence, and understand and consider carefully and gaps or limitations in such inputs which may hinder achievement of the fund’s stated objectives.
• Principle 3: pre-contractual and ongoing periodic disclosures on responsible or sustainable investment funds should be easily available to consumers and contain information that helps them make investment decisions.
  ESG/sustainability-related information should be easily available and clear, succinct and comprehensible, avoiding the use of jargon and technical terms where possible. Periodic fund disclosures should include evaluation against stated ESG/sustainability characteristics, themes, or outcomes, to demonstrate to investors how well a fund is meeting its stated ESG/sustainability objectives. Where a fund applies quantifiable targets, reporting should include relevant key performance indicators, along with supporting information, to enable investors to understand the performance of the fund in achieving its stated objectives. Performance against "real world" (non-financial) outcomes should also be reported in measurable and quantifiable way, where possible, and reporting should include examples of actions taken to support the aims of the fund.

Implications of the guiding principles

The FCA’s remit was recently expanded to include climate considerations. Rather than representing new rules, the guiding principles are derived from the FCA’s existing approach to fund classification and their existing disclosure rules. The FCA recognises that ESG/sustainability funds are the fastest growing segment of the market, and that "investors’ concerns about greenwashing could undermine the UK’s attempt to shift to a net zero economy".

The guiding principles are intended to complement the other UK legislative and regulatory developments in respect of ESG, including the potential introduction of Sustainability Disclosure Requirements and the FCA’s proposal for mandatory reporting by AFM’s against the recommendations of the Task Force on Climate Related Financial Disclosures. There are a number of key take-aways for AFM’s developing the ESG/sustainability focus of their funds.

• There is clearly heightened focus from the FCA’s supervisory team where AFMs use ESG/sustainability labelling or claims in the fund’s name or marketing material, but the fund design, underlying targets and risk management framework are not adequately set up to deal with the claims. AFMs should therefore ensure that sufficient scrutiny is undertaken at the product design stage, to ensure that applications for fund authorisations and repositioning run smoothly.
• The FCA has clear expectations about ESG resourcing, which is critical to developing an integrated approach to ESG, including whether the AFM has sufficient expertise, specialist staff, and appropriate oversight from senior committees and at board or partner level. Again, this should be assessed at the product design stage.
• If AFMs use ESG data, good governance is expected to assure the quality of inputs, validate models and assumptions, oversee third-party vendors, and use data outputs in a responsible way when taking investment decisions. AFMs implementing ESG benchmarking or scoring methodologies or aligning to ESG indices should consider how they measure up to these expectations.
• Finally, the FCA links its guiding principles on ESG with the requirement for AFMs to undertake an annual assessment of the value of their funds. The FCA has recently published the results of a review which determined that many fund value assessments were inadequate. If a fund has an ESG/sustainability component, the AFM will be expected to be able to explain how those considerations relate to the quality of the service provided to investors in the context of the fees charged to investors in the fund.