ESG rules in the U.K. look set to make life harder for firms marketing index-tracking and other passively managed strategies, according to lawyers advising the investment industry.
The Financial Conduct Authority has proposed a labeling system for environmental, social and governance funds that it says will be easier for retail investors to understand than the framework in the European Union. But the proposal is already "causing concern amongst managers of passive funds," according to Tristram Lawton, managing associate for financial services at Simmons & Simmons.
The worry is that the plan sets "unrealistic expectations as to what can be achieved and, importantly, can be evidenced as being achieved, through stewardship and engagement," Mr. Lawton said. "I don't think the requirement for active stewardship necessarily precludes passive funds from using the FCA's proposed labels, but it will make it difficult."
It's the latest indication that passive investing strategies can be hard to combine with ESG goals. Earlier this month, Vanguard Group exited the world's largest climate finance alliance, signaling that net-zero emissions targets aren't realistic for a firm that has 80% of its business in index-tracking funds. Others have since made similar observations, and even the net-zero alliance Vanguard left has acknowledged the issue.
Meanwhile, there's evidence the ESG market is shrinking. A report published this month by the US SIF Foundation found that sustainable assets now total about $8.4 trillion, compared with an estimated $17.1 trillion two years ago. It cited changes in methodology, and pointed to a tougher regulatory and political climate. SIF organizations in other regions are doing similar reviews, according to Lisa Woll, US SIF's chief executive officer.
The FCA unveiled its proposal for ESG labels back in October, with the explicit aim of fighting greenwashing. Sacha Sadan, the FCA's director of ESG, told Bloomberg the U.K. was trying to sidestep confusion over the EU's Article 6, 8 and 9 disclosure categories, which he said had become a "contest rather than actually a reflection of different things for different consumers."
The British plan encompasses three categories: "Sustainable Focus," which invests mainly in assets that achieve a high standard of sustainability; "Sustainable Improvers," whereby fund managers target assets that may not be sustainable now with an aim to making them so; and "Sustainable Impact," which targets solutions to social and environmental challenges.
"Qualifying for the FCA sustainability labels under these proposed rules is a much more complex task than categorizing a fund under (EU rules)," said Ben Maconick, a managing associate at Linklaters. As a result, "many fund managers will have to implement a fresh approach to product classification in light of these proposed rules, and may have to tweak their strategies to satisfy the detailed qualifying criteria for the labels."
In a written comment, a spokesman for the FCA said it's "crucial that the way ESG products are marketed and described does not mislead potential investors. If consumers don't trust funds which are marketed as sustainable they won't feel confident to put their money in these funds."
The upshot is that the number of U.K.-domiciled funds labeled ESG looks set to shrink. According to Morningstar, passively managed funds listed as sustainable made up 56% of the total market in October, which compares with 28% in all of Europe.
The U.K. Sustainable Investment and Finance Association says passive strategies can be compatible with sustainability goals. "There are plenty of stewardship approaches available for managers of passive funds," said James Alexander, its CEO. "You can be an active owner." That said, "you don't necessarily have the end goal of being able to divest if you don't achieve your stewardship goals."
The FCA spokesman said the watchdog's proposed labeling regime "aims to raise the bar by setting high standards to protect consumers. While the starting points for our proposals and the SFDR (Sustainable Finance Disclosure Regulation) are different, we recognize that firms will be subject to both, and so we have sought to remain compatible and complementary."