The new rules around sustainable investing

Environmental, Social, and Governance (ESG) investing refers to an investor's desire to invest not only for financial gain but also to have a positive impact on the environment, ensuring that a company has a positive impact on society while adhering to strong governance standards.

The term ‘ESG investing’ has also been used interchangeably to describe ethical investing which is to invest in line with one’s own belief system, and impact investing which is to invest for both a financial goal and a specific environmental or social outcome.

The history of ESG investing

You might think that ESG investing is a relatively new concept, but we can go back to the early 1950s with Howard Bowen's book "Social Responsibilities of the Businessman," in which he articulated that businesses have a moral obligation to serve not only their customers, but also the society in which they operate (and thrive). The UN's "Who Cares Wins" report in 2004 was another watershed moment in which the term 'ESG' was formally introduced into our common language. It served as the foundation for the launch of the UN Principles for Responsible Investment (PRI) in 2006, which encouraged the incorporation and adoption of ESG values into an investor's decision-making processes.

Demand for ESG products still exists

Fast forward to the present day, and while there have been additional (welcome) developments in the regulation and formalisation of ESG investing, there has also been a notable alignment of economic and social goals. 

Some notable examples include the strong emphasis from governments to adopt clean energy policies and labour policies across the western world, coming under further scrutiny with the ‘fair pay for fair work’ campaign.

This demand for ESG products is only likely to accelerate with further need for companies to adopt sustainable business practises.

Greenwashing & the number of ESG funds

Due to this rising consumer demand, the market has seen an increase in the number of financial products and services that claim sustainability features. However, this has increased the risk of greenwashing, in which companies' sustainability claims are exaggerated, misleading, or unsubstantiated.

Between 2021 and 2023, the FCA received over 1,700 applications to launch a new ESG or sustainability-focused fund (Source: Morningstar). This prompted the FCA to state that:

“We have seen numerous applications for authorisation of investment funds with an ESG or sustainability focus. A number of these have been poorly drafted and have fallen below our expectations. They often contain claims that do not bear scrutiny.” (July 2021).

What are Sustainability Disclosure Requirements?

In response, the FCA has introduced the Sustainability Disclosure Requirements, also known as 'SDR', with the goal of protecting consumers and ensuring a fair marketplace, published 28/11/2023.

The SDR are multifaceted, but the overarching goal is to assist consumers in making informed decisions based on their sustainability preferences, while also promoting fairness among firms that provide genuinely sustainable products and services.

The anti-greenwashing rule

The SDR introduces a new rule that requires all regulated firms, ensure that any sustainability-related marketing claims are clear, fair, and not misleading, as well as consistent with the product's sustainability profile. There are also limits on the use of sustainable terms in product names and marketing.

What is happening to the term ‘ESG Investing’?

To date, a fund could be marketed as 'ESG', 'Sustainable' or a range of other green descriptives with little oversight, however, the SDR has implemented a new fund labelling system with prescriptive guidelines on how funds can be marketed.

From 31st July 2024, fund managers can begin to use one of four labels which, whilst not meant to be hierarchical (an investor can choose a fund which aligns with their preference), will allow investors to identify suitable products and make comparison between funds far easier.

The four labels include:

Label Sustainable objective
Sustainability Focus To invest in assets that are environmentally and/or socially sustainable determined by a robust evidence-based standard of sustainability
Sustainability Improvers To invest in assets that have the potential to improve their environmental and/or social sustainability over time, determined by their potential to meet a robust, evidence-based standard of sustainability over time (this is required to be an absolute measure)
Sustainability Impact To achieve a predefined, positive, measurable impact in relation to an environmental and/or social impact
Sustainability Mixed Goals To invest in two or more of the above sustainability objectives

To use a label a fund must have at least 70% of its assets in alignment with one of the above sustainability objectives. It remains to be seen how many funds will apply for a label but estimates from Morningstar are that 300 existing funds will seek a label.
It should be noted that the SDR applies only to UK domiciled funds this is unlike the SFDR (the European Commission’s approach to regulating ESG funds) which applies to funds globally if they are marketed in Europe. 

These labels can be accompanied by the following images:

Source: FCA's Policy statement PS23/16

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This article is intended for general information only, it does not constitute individual advice and should not be used to inform financial decisions.

Investment returns are not guaranteed, and you may get back less than you originally invested.

Past performance is not a guide to future returns.

The Financial Conduct Authority (FCA) does not regulate cash flow planning or tax  advice.