Financial services regulators globally are identifying sustainability and Environmental, Social and Governance issues as key areas of concern, with the aim of encouraging greater investment in longer term and sustainable activities.
The European Union stresses that the aims of sustainable finance regulation are to tackle pollution and to assist in the transition to a climate-neutral economy, whilst improving efficiency in the use of natural resources. In the UK, the Financial Conduct Authority (FCA) has published a long-awaited consultation paper on a new regime of sustainability disclosure requirements and investment labels for the UK.
All these rules are aimed at preventing the so-called “greenwashing” of financial products by providing more reliable information related to sustainability. Investors will make better investment choices if given information as to how an investment will meet their sustainability goals.
Here in Australia, responses to a government consultation on mandatory climate disclosures closed on 17 February 2023. The consultation asked which entities should be included in the initial phase of deployment, as well as which additional bodies should be subject to the rules alongside listed companies and financial firms.
Even if these disclosure regimes are not yet in force in Australia, Australian managers that have designs on marketing their funds outside Australia or attracting investors from outside Australia should realise that they are competing internationally for global investment and should benchmark their disclosures against their international peers.
The four key major pillars of EU legislation are:
- The Sustainable Finance Disclosure Regulation (SFDR) which obliges certain financial services firms to disclose information about their policies and products, on their website, in pre-contractual disclosures and in periodic pre-contractual disclosures. The SFDR took effect in March 2021.
- The Taxonomy Regulation which sets out an EU-wide taxonomy providing investors and businesses with a common language to assess which economic activities may be viewed as environmentally sustainable.
- The EU Corporate Sustainability Reporting Directive which introduces more detailed sustainability reporting obligations for certain categories of undertakings. Third country entities may need to comply if they or their EU subsidiaries have debt or equity securities listed on an EU regulated market or if they meet certain criteria (see Hogan Lovells alerter EU Corporate Sustainability reporting: impact on non-EU entities).
- The Low Carbon Benchmark Regulation, which introduces a set of minimum requirements for climate transition benchmarks to ensure a common approach with other ESG objectives. The Regulation is aimed at tackling “greenwashing” whereby financial products are wrongly characterised as green when they fail to meet basic environmental standards.
Moves towards requiring greater disclosure are also afoot in the U.S.
On 21 March 2022, the U.S. Securities and Exchange Commission (SEC) proposed its widely anticipated rules requiring climate-related disclosure for public companies. The proposed rules, which are intended to provide investors with consistent, comparable and reliable climate-related information, are modelled in part on the Task Force on Climate-Related Financial Disclosure (TCFD) framework and also draw upon the Greenhouse Gas Protocol (see Hogan Lovells alerter SEC proposes climate-related disclosure rules).
Two months later, the SEC proposed new rules relating specifically to private funds and registered investment advisers requiring more specific disclosures in fund marketing materials, annual reports, and adviser brochures based on the ESG strategies, if any, that such funds pursue.
Funds with a particular ESG focus may in some cases be required to disclose the greenhouse gas emissions associated with their portfolio investments.
Most critically, funds claiming to achieve a specific ESG goal would be required to describe the specific goal(s) they seek to achieve and summarize their progress on achieving those goals.
Accordingly, the SEC announced a new three-part framework for ESG-related investment products that would apply in future to private funds:
- “ESG integration” strategies that consider one or more ESG factors alongside other, non-ESG factors in investment decisions; in such strategies, ESG factors may be considered in the investment selection process but are generally not dispositive compared to other factors when selecting or excluding a particular investment.
- “ESG-focused” strategies focus on one or more ESG factors by using them as a significant or main consideration in selecting investments or in engaging with portfolio companies.
- “ESG impact” strategies have a stated goal of seeking to achieve a specific ESG impact or impacts that generate specific ESG-related benefits; these impact strategies generally seek to target portfolio investments that drive specific and measurable ESG outcomes (see Hogan Lovells Private Capital Alert: SEC releases long-awaited ESG proposal for investment companies and investment advisers).
In the UK, the proposed rules set out in the FCA consultation will bring into force the UK’s Sustainable Disclosure Requirements (SDRs), the UK’s equivalent to SFDR. The aim of the new rules is to make the UK “a trusted centre for sustainable investment and place the UK at the forefront of sustainable investment internationally”.
The SDRs aim to do this by “setting robust regulatory standards to protect consumers that raise the bar and build a strong foundation for sustainable investment products” (see Hogan Lovells client alerter The FCA released Consultation Paper CP22/20 on the UK Sustainable Disclosure Requirements).
In the consultation, the FCA says it wants to clamp down on greenwashing and introduce sustainable investment labels, disclosure requirements and restrictions on the use of sustainability-related terms in product naming and marketing.
The FCA is proposing to introduce sustainable investment product labels that will give consumers the confidence to navigate the investment product landscape more easily, divided into three categories: sustainable focus (for products investing in assets that are environmentally or socially sustainable); sustainable improvers (for products investing in assets to improve the environmental or social sustainability over time); and sustainable impact (for products investing in solutions to environmental or social problems to achieve positive, measurable real-world impact).
There will be naming and marketing rules to restrict how certain sustainability-related terms – such as “ESG”, “green” and “sustainable” – can be used in product names and marketing materials for products that do not qualify for sustainable investment labels. A general anti-greenwashing rule will reiterate requirements for all regulated firms that sustainability-related claims must be clear, fair and not misleading.
Consumer-facing product disclosures will help consumers understand the key sustainability-related features of an investment product – this includes disclosing investments that a consumer may not expect to be held in the product.
There will also be detailed disclosures targeted at a wider audience (for example, institutional investors or retail investors) that want to know more, including pre-contractual disclosures (for example in a fund prospectus), covering the sustainability-related features of investment products; ongoing sustainability-related performance information, including key sustainability-related performance indicators; as well as reports on how firms are managing sustainability-related risks and opportunities.
Unlike the EU SFDR, the FCA is not proposing to introduce pre-contractual, website and periodic template disclosures for the SDRs. The FCA states that the UK framework is designed primarily as a labelling regime with detailed criteria to determine eligibility. The regime differs to both the EU SFDR (which is positioned as a disclosure regime) and the SEC’s proposals in this regard.
The FCA confirms that products that do not meet the qualifying criteria under its proposals will not be able to use any of the sustainable investment labels under the proposed SDRs. Firms will need to consider how a product categorised under the EU SFDRs or under the SEC’s proposals would be treated under the FCA’s SDRs.
Australia – views sought
The Australian government consultation paper asks for views on the costs and benefits of meeting existing climate reporting expectations as well as the projected costs and benefits of Australia not aligning with global baseline standards for climate reporting.
The paper also asks other questions such as to the size thresholds that could be applied to determine the mandatory application of new requirements (for instance, market capitalisation, turnover, number of employees). The paper suggests that disclosure requirements could gradually be applied to smaller listed entities over time, as climate reporting capability becomes institutionalised in Australia.
Whilst large, listed entities are the initial focus of the consultation, views are also sought as to whether equivalent reporting requirements should apply to large entities that are neither listed nor considered financial institutions, such as trusts and partnerships.
With Australia-specific rules still some way off, it is worth noting that the EU rules outlined above will apply to non-EU investment managers which market alternative investment funds (such as PE and hedge funds) into the EU and which provide investment advice or portfolio management services to EU firms subject to the rules.
Non-EU alternative investment fund managers (non-EU AIFMs) will find themselves in scope of SFDR in respect of each fund they have notified in respect of private placement marketing in the EU.
The degree of disclosure required will depend on whether the fund has an ESG focus. These include SFDR Article 9 or “dark green” funds which have sustainable investment as an objective, or which promote social or environmental sustainability, which include SFDR Article 8 or “light green” funds.
Where funds have a particular ESG focus, managers will have to provide pre-contractual disclosures regarding how sustainable investment objectives are being met. Disclosures are also necessary under the Taxonomy Regulation.
For funds that do not have an ESG-focus, disclosures will still need to be made as to the manner in which investment decisions take account of sustainability risks as well as the manager’s assessment on how sustainability will impact the returns of the funds.
“Sustainability risk” is defined in the SFDR as an environmental, social or governance event or condition that could result in an actual or potential material negative impact on the value of the investment. The manager will need to provide an explanation as to why they feel sustainability risks are not relevant to the fund.
The consultation paper talks of a “potential guidance gap” for Australia, “as market expectations for certainty may not be met without government action and without efforts by businesses to continue to improve the quality of their disclosures”. The paper warns that this “may be costly for the economy if it affects the ability of firms to raise capital”.
The ambition is clear, to make disclosure obligations in Australia “credible and comparable to other prominent jurisdictions”. Funds and investors that invest in the EU, UK or United States should make sure they are ready to provide the level of disclosure that is required now and which is likely to be mandated in the future in Australia.
At a minimum, that means that the fund’s governance, strategy and risk management arrangements should be thoroughly and regularly reviewed to assess sustainability risks and opportunities.
Moreover, we recommend managers interested in marketing their funds outside Australia obtain advice on the application of non-Australian securities laws to their fund to ensure compliance at a minimum, and consider if adopting a ESG best practice standard will enhance their fundraising efforts.
Authored by James Wood, Kevin Lees, Melanie Johnson, and Nigel Sharman.