Last year marked a critical cultural shift, bringing with it a sharp change of pace on all aspects of environment, social and governance (“ESG”) considerations in investments – a trend we expect will continue to accelerate through to 2022 and beyond. The mandatory implementation of the EU’s Sustainable Finance Disclosure Regulation (“SFDR”) Level 1 disclosures as of 1 March 2021 has forced fund managers to conduct a wholescale review of their existing products and strategies to support the ESG claims being made across their product range through public disclosure materials.
According to the UK regulator, the Financial Conduct Authority (“FCA”), the sustainable investment funds market is the fastest growing market segment across Europe, showcasing a rise in investor appetite to increase allocations toward responsible investment. However, as this market continues to mature the FCA has, in its recent “Dear AFM chair” letter published on 19 July 2021, called into question the quality of authorisation applications for funds actively pursuing a sustainable investment objective or promoting ESG characteristics or themes. Whilst the FCA’s letter is targeted primarily at the retail segment of the funds market, unsurprisingly, investors participating in the alternative investment funds (“AIF”) market are also increasingly scrutinising the robustness of AIF funds’ ESG claims alongside the merits of the investment strategy itself.
Building trust in the market is at the heart of the FCA’s purpose; and the FCA expects firms to play their part to ensure that investors can accurately assess authorised funds’ ESG claims and enable the proper allocation of capital in pursuit of a net zero economy. The FCA has therefore put forward a set of guiding principles (the “ESG Principles”) to help fund managers comply with existing requirements and expects firms to communicate clearly with investors and avoid making misleading claims, at the time of the fund’s authorisation application, and on an on-going basis via periodic reporting. Although the EU’s SFDR has not been onshored in the UK, the FCA acknowledges that many UK firms with cross-border businesses in the UK are already complying with their obligations under SFDR, and so these ESG principles are intended to be complementary to the obligations under SFDR.
Importantly, it is worth noting that the ESG Principles are relevant where a firm is launching a product which is pursuing a responsible or sustainable investment strategy claiming ESG characteristics, themes or outcomes. In other words, the FCA is targeting funds making specific ESG-related claims (i.e., Article 8 and 9 funds under SFDR) and not those which integrate ESG considerations into their mainstream investment processes.
Predictably, the FCA expects that information on a fund’s ESG focus is contained within a fund’s constitutional framework, and that such information is reflected in the fund’s accompanying marketing materials in a manner that is clear, fair and non-misleading.
The overarching objective to the three core ESG Principles is consistency – the FCA is now challenging firms to demonstrate a fund’s sustainability/ESG focus consistently through its design, delivery, and disclosure.
Any fund holding itself out as following a sustainable strategy through its name will be expected to support such a claim through a clear and credible set of investment objectives aligned with such strategy. There are growing concerns around the misuse of terms typically associated with sustainable investment such as “green”, “ethical” and “responsible” in a fund’s name, and the FCA is clear that such nomenclature will be rejected if it does not align with a fund’s investment objective. In addition, the term “impact” or “impact investing” has specific connotations and, if used, the FCA would expect the fund to be seeking a non-financial (real world) impact, which is both being measured and monitored throughout the fund lifecycle.
In its pursuit of ESG characteristics, themes or outcomes, a fund’s investment objectives and strategy should be described and documented through its constitutional framework in a way that is specific, measurable and monitored. Trust in the market and ESG products hinges on investors’ ability to understand the basis on which sustainability claims are being made and to monitor how well such claims are being met. To that end, fund managers must provide sufficient information to enable investors to ascertain how sustainability outcomes, characteristics or themes will be sought, whether through one or more means, for example: (i) the application of negative screening; (ii) applying a positive screen to promote a particular ESG characteristic; or (iii) pursuing a positive impact through direct investment or by influencing change through active stewardship.
In the case of negative and positive screens, the FCA would expect a measurable characteristic such as a palm oil exclusion or emissions thresholds within the investment universe. Where stewardship is part of an active investment strategy, it should be clear how monitoring, engagement and voting activity are integrated with investment decisions, and how escalation and divestment decisions are made.
To get it right, fund managers must demonstrate that they are:
Next steps for alternative investment funds- where do we go from here?
UK fund managers must remain ready to adapt and evolve. In taking a holistic approach to the end-to-end product design and disclosure of any ESG -focused products within their offering, firms should consider the links between ESG regulatory initiatives both across the UK and EU, and tailor their approach and responses to the applicable regime, as appropriate. As we inch closer toward a net zero economy, investors and regulators will continue to drive the sustainability agenda forward – this will inevitably lead to mounting scrutiny over ESG claims made by fund managers, as well as their compliance with the evolving regulatory measures being imposed on the industry.