As a member of the Disclosure and Labelling Advisory Group, I had the privilege of advising the UK Financial Conduct Authority (FCA) during the development of the Sustainability Disclosure Requirements (SDR) and investment labels. I advocated for the labelling system that has since been implemented because labels make it easy for retail investors to identify products that meet certain minimum standards.
I am happy to see the Joint Committee of the European Supervisory Authorities have largely followed the FCA’s lead in their 18 June 2024 opinion to the EU Commission regarding improvements to the Sustainable Finance Disclosure Regulation (SFDR). However, the opinion does not fully reflect a key decision that was made during the development of SDR.
The FCA initially proposed a product classification and labelling system in which every product in the marketplace would be mandatorily assigned to a sustainability group and would be required to carry a label indicating its group. In response to feedback from a wide group of stakeholders, the FCA reframed its solution as voluntary product design standards.
This pivot was important for several reasons. First, it allowed the FCA to set aside the complexity of classifying every single type of product in the marketplace and to instead focus on developing the minimum standards that a product would need to meet to carry a sustainability label. Second, it was far more palatable for asset managers to be handed a design standard that defines a sub-market in which they can choose to compete than to have each product they offer forced into categories and to be required to put warning labels on vanilla investment products that they have been offering for years.
Ultimately, both the UK and the EU desire to create a sub-market of investment products that have certain sustainability characteristics. This is easier said than done because it requires setting standards that attract sufficient supply and demand. Low standards will attract many sellers. But low standards will also result in products that are not meaningfully different, and thus, investors won’t find value in products that are labelled as “sustainable”. If the standards are too high, few sellers will enter the sub-market, and it may be too niche to attract a significant number of investors.
It is still too early to tell if the UK has struck the right balance with SDR. Before making changes to SFDR, the EU should wait and see how the UK sustainable investment product market develops.
SDR is not the first voluntary standard, but it is the first to be backed by a regulator. There are numerous voluntary labelling programmes, typically managed by not-for-profit organisations, that issue labels for products meeting their labelling specifications. These voluntary labels have not had a significant uptake, perhaps due to a combination of challenges including a lack of awareness among investors, extra costs for asset managers, excessively high standards, and a lack of consequences for asset managers if a labelled product does not deliver as promised.
These problems are largely mitigated when a regulator is the labelling programme manager. The downside is that a regulator may not be as agile as an independent standard setter in adapting the standards to keep up to date with product changes in the marketplace. Features that are “sustainable” today may be “table stakes” in the future. It may be good for investors if a large proportion of products carry a minimum standards label, but that label could be less helpful in distinguishing between products of varying levels of quality.
As the EU Commission contemplates the Joint Committee’s opinion and how it might revise SFDR, there are two design principles that should be given the highest priority: 1) simplicity, and 2) precision. Simplicity means, for example, picking a framework that consists of a few product categories or a single sustainability indicator, but not both. Precision means creating classification and labelling rules that are clear and less subject to interpretation.
SDR is a relatively good example of simplicity and precision. Four labels allow for variations in the definition and interpretation of sustainability but are not so numerous that retail investors are overwhelmed with options. To use a label, all products must meet certain label-specific criteria in addition to five general criteria related to sustainability objectives, investment policy and strategy, key performance indicators, resources and governance, and stewardship.
SDR allows managers a fair degree of flexibility. The most prescriptive element is the 70% investment policy. I suspect that the EU will be much more prescriptive. In addition to an 80% investment policy, they will likely require certain exclusions such as those in the ESMA guidance for fund names issued earlier this year.
Looking ahead, I don’t expect much convergence of naming and labelling standards across markets. Different countries and regions have significantly different attitudes about sustainability, and these cultural differences have been – and will continue to be – reflected in naming and labelling requirements. Whatever path the EU Commission and other legislators and regulators choose to take, they should recognise that sustainability classification and labelling for investment products is far more complex and difficult than it appears.
