On 16 November 2023, the FCA published the findings of its review of how Authorised Fund Managers (AFMs) comply with embedding the FCA's Guiding Principles on the design, delivery and disclosure of Environmental, Social and Governance (ESG) and sustainable investment funds.
The review focused on 12 AFMs of varying sizes, managing authorised retail funds (both active and passive) that included a reference to ESG and/or sustainability-related terms in their name (for example, 'responsible', 'ethical', 'climate' or 'social').
In respect of each of the principles, the FCA sets out good practices, which it came across during its review.
The FCA's findings will be relevant, primarily, to AFMs, their governing bodies, and portfolio managers of investment funds that market themselves as having ESG or sustainable characteristics.
What does Simmons think?
It is impossible not to look at these findings and try to see where we might be headed with the FCA's Sustainability Disclosure Requirements (SDR) and investment labels rules.
The Guiding Principles sets out the FCA's expectations for ESG/sustainable investment funds under current rules. The long-awaited SDR and investment labels rules will create new, higher standards for such funds. But AFMs should be looking at the Guiding Principles and the FCA's findings now to help them prepare for the new SDR and investment labels rules when they are published - which are expected in Q4 and we are told will be "shortly" - as well to ensure compliance with the existing Consumer Duty obligations.
Certain of the concepts picked up by the FCA in its draft SDR and investment labels rules are reflected in these findings - eg governance and oversight arrangements in relation to ESG/sustainable funds, a key focus on the role of stewardship, interaction between product and firm level disclosures and a focus on "unexpected assets" in ESG/sustainable funds.
To the extent that the FCA maintains the broad framework for the SDR and investment labels rules as proposed in CP 22/20 (and there is nothing in these fundings that suggests a departure by the FCA from this framework in the final rules), all firms impacted by SDR and investment labels should be looking closely at the FCA's findings here.
More broadly, all authorised firms may want to look at some of the good practice identified by the FCA and consider how this could be applied to their product offering (whether or not ESG/sustainability related) in light of the FCA's Consumer Duty rules - particularly the "consumer understanding" outcome.
What's the background?
In July 2021, the FCA sent a Dear Chair letter to the chairs of AFMs. (See our summary of the Dear Chair letter here.)
The letter contained a set of Guiding Principles stating the FCA's expectations and giving detail on how AFMs should design and deliver a fund's ESG and sustainability objectives, while providing disclosures that align with the ESG and sustainability claims made.
The Guiding Principles are headed as follows:
The design of responsible or sustainable investment funds and disclosure of key design elements in fund documentation
The delivery of ESG investment funds and ongoing monitoring of holdings and
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
The FCA's subsequent Asset Management Portfolio Letter, sent in February 2023, noted that the regulator would publish a review of AFMs' ESG and sustainability oversight practices and how they have implemented the Guiding Principles.
The findings, published today, are also intended to support the Consumer Duty, which came into effect on 31 July 2023 - this requires a firm to deliver good outcomes for retail customers, irrespective of whether they have a direct client relationship with those customers.
How does this relate to the FCA's Sustainability Disclosure Requirements (SDR) and Investment Labels rules?
In October 2022, the FCA set out a series of proposals of relevance to AFMs (CP22/20), including:
an anti-greenwashing rule for all authorised firms.
investment labels for products seeking positive sustainability outcomes
naming and marketing requirements
consumer-facing and detailed product-level information and
disclosures on how the firm is managing sustainability risks and opportunities.
See our overview of the proposals in CP22/20 here.
The FCA has now indicated that the long-awaited final rules "will be published shortly" and that they "will set higher standards and help firms address some of the findings in this review".
AFMs should, then, consider the potential impact of the new rules on their firm and investment products, taking what action is necessary to comply once new rules come into force.
While the the Guiding Principles are anchored in existing rules such as "fair, clear and not misleading" and "acting in best interests", the new SDR and investment labels rules will set higher standards. But all AFMs, firms providing portfolio management services to AFMs, and indeed all firms who will be in scope of the SDR and investment labels rules, should be closely reviewing the FCA's findings on the Guiding Principles.
What the FCA found - overview
AFMs generally showed an intent to follow the Guiding Principles in the design, delivery and disclosure of their ESG and sustainable funds
In some cases, though, AFMs failed fully to embed the disclosure principle. As a result, some key information was difficult to identify and some disclosures failed to include information that would make it easier for investors to make fully informed choices about the products in which they invest
Governance arrangements over ESG and sustainable investment funds were adapting to maturing market practice and expectations
Oversight of older funds could raise specific challenges - for instance, where a fund had been adjusted to incorporate ESG and sustainability objectives and policies post-launch, records of key governance decisions and discussions could often be more limited.
Although some products referred to ESG or sustainability in their name, they failed to show an explicit ESG or sustainability objective
How AFMs designed their approach to stewardship generally fell short of expectations - the FCA often found it difficult to identify the nature of stewardship activities from fund literature alone and identify clear examples of progress from engagement
In some cases, fund holdings appeared inconsistent with a fund's ESG or sustainability objectives
Key ESG and sustainability information was often not explained or put in context in disclosures
It was often difficult to reconcile firm- and fund-level disclosures
The contribution of an individual fund to firm-wide ESG and sustainability goals was often not disclosed
In some cases, key ESG and sustainability information was not clearly presented and made accessible
In light of these findings, the FCA flags its expectation that AFMs will review:
their ESG and sustainable fund ranges to assess whether their disclosure material meets the requirements of the FCA's rules and Guiding Principles
their oversight and controls frameworks to ensure that they manage the risks of misleading or inaccurate information and appropriately embed the Guiding Principles in their processes.
What the FCA found - a more detailed summary
Principle 1: Design
(a) Issues found
Some funds either failed to have an explicit ESG or sustainability objective or were inconsistently aligned with a stated ESG or sustainability objective and/or approach.
AFMs took an inconsistent approach to setting specific ESG and sustainable investment objectives at the product design stage.
While AFMs set ESG investment policies and strategies, some did not set any specific ESG or sustainability objectives for funds with ESG or sustainability-related terms in their names, in addition to the financial objectives.
Some AFMs explicitly set a wide range of ESG and sustainable outcomes in fund documentation, such as the fund prospectus, but only committed to achieving at least one of those outcomes.
The design of AFMs' stewardship approaches fell short of the FCA's expectations.
In many cases, it was difficult to identify the AFM's stewardship approach and engagement activities from fund literature alone and it could be a challenge to identify how firm-wide stewardship activities related to fund-level objectives.
(b) Good practice
The FCA held up as examples of good practice AFMs which
develop and/or use appropriate ESG and sustainability scoring systems (or benchmarks that are suited to the AFM's funds) and demonstrate an understanding of the underlying methodologies and limitations - including relevant third-party methodologies
demonstrate more effective stewardship approaches, embed their stewardship activity within investment teams, and which provide investment managers with ownership of engagement activity with the support of a central stewardship resource
have active engagement policies and initiatives with investee companies to further their ESG and sustainability approach and/or use voting as a means of influencing investee companies to pursue ESG and sustainability objectives
make efforts to measure and record the outcomes of their stewardship activity with investee companies and how this furthers the ESG and sustainability objectives of their fund range.
Principle 2: Delivery
(a) Issues found
Some funds included holdings in the oil, gas, mining and manufacturing sectors, explaining that these were included because the underlying companies were on a path to achieving net zero emissions, even where the companies had set no Scope 3 emissions targets. The absence of such a target was not explained in the fund literature and it was unclear how these holdings were treated in the firm's ESG and sustainable investment framework.
Where a holding may appear contradictory to a fund's ESG or sustainability investment strategy, the AFM should consider explaining this to investors.
AFMs need to consider how their fund communications and financial promotions comply with the requirement to be fair, clear and not misleading and they should have a credible, defined and documented approach to how they treat holdings in their investment frameworks.
(b) Good practice
The FCA held up as examples of good practice AFMs which
maintain a strong focus on investment research and due diligence for asset selection that is embedded in the AFM's investment processes
carry out due diligence (DD) on third party data providers whose inputs the AFM uses to inform external disclosures and reporting around delivery, with the DD being focussed on gaining a clear understanding of the underlying methodologies, inputs and limitations of the data
maintain (on an ongoing basis) appropriate systems and controls to ensure data accuracy and compliance with underlying methodologies, identify and address errors by third party data providers and assess the appropriateness of ESG data for the delivery of the fund.
Principle 3: Disclosure
(a) Issues found
In many case, key ESG and sustainability information was either not explained or not put into context in disclosures.
Some AFMs failed to explain information about their funds' key ESG and sustainability-related features.
Some ongoing carbon emissions metric reporting showed that the emissions of ESG and sustainable investment funds were higher than those of non-ESG or sustainable funds, without any explanation given in the AFM's disclosures.
Firm-level disclosures are not easily reconcilable with fund-level disclosures.
Often, the fund prospectus had little detail on ESG and sustainability policy goals - investors were referred, instead, to firm-level policies that gave greater detail.
The contribution of an individual fund to firm-wide ESG and sustainability goals was often not disclosed meaning that the nature and extent of ESG and sustainability outcomes which a fund aimed to deliver was unclear.
AFMs often failed to present key ESG and sustainability information coherently and accessibly.
Documents, and cross-references in documents, were often not linked together in a clear and coherent way, which can make it challenging for investors to understand key features of the fund and its ESG or sustainability-related performance.
(b) Good practice
The FCA held up as examples of good practice AFMs which
provide clear disclosures about a fund's ESG and sustainability features, what it is designed to offer and how performance is measured on an ongoing basis
Ensure, when explaining (in the fund's prospectus and other consumer-facing communications) how they use benchmarks, that the methodology, limitations and ESG data, including for ESG benchmarks, are made clear so consumers are able to make informed and effective decisions
test how information about the fund's ESG and sustainability features is understood by investors
gather data about how investors use the ESG and sustainability information on their website and use it to inform ongoing disclosures
use links effectively in regulatory documents and factsheets so investors are directed towards additional explanatory material around the AFM's sustainability approach and its impact.
Governance
(a) Issues found
Overall, AFMs need to refine their existing oversight and controls.
Governance records and management information for older funds were often lacking, making it more difficult to evidence key decisions and the rationale behind them.
Effective oversight should mean that firms identify and appropriately manage risks of harm from practices that are inconsistent with existing regulatory requirements and the Guiding Principles, an issue that is of particular importance following the introduction of the Consumer Duty.
AFMs have a key role to play in ensuring that firms act to deliver good outcomes for retail customers who hold, or are looking to invest in, ESG and sustainable funds. AFMs should ensure that their strategies and intent are matched with appropriate oversight and control frameworks that are able to identify, monitor and manage the risk of poor outcomes.
(b) Good practice
The FCA held up as examples of good practice AFMs which
have in place a strong product governance structure around the AFM's ESG and sustainable investment fund range and identify, monitor and report risks relating to ESG through the governance structure
monitor ongoing adherence to the fund investment objective and policy, reporting any exceptions to the relevant committee, with Board oversight
monitor management information relating to ESG and sustainability objectives and aims in the product governance structure
ensure embedded investment policies and processes exist for ESG and sustainable investment funds and that the relevant staff is both aware of them and involved in their delivery.
What happens next?
AFMs are expected
to assess how they are meeting FCA rules and guidance in relation to their ESG and sustainable investment funds
prepare for the proposed SDR and investment labels regime
identify and address any shortcomings in the design, delivery and disclosure of their funds, and
ensure they are not conducting their operations in a way that causes harm to consumers.
The FCA notes that it will continue to
work with the AFMs included in its review in relation to its findings and
monitor the market in line with its usual supervisory approaches - this will include "challenging firms at our fund authorisation gateway where we find applications which are inconsistent with our rules and expectations or risk confusing or misleading investors".
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