Making sense of UK ESG regulation

In an industry already known for its alphabet soup of regulatory acronyms, the growing prominence of environmental, social and governance (ESG) investing is rapidly adding a whole new layer of letters to the mix. TCFD, SFDR, SDRs, CSRD…¹  to anyone whose day job doesn’t revolve around financial services regulation, it’s an opaque broth to navigate. And the complexity doesn’t end there. in this post-Brexit world, divergent approaches between the UK and the EU add further complications for clients and firms that invest cross-border.

What, then, is driving the approach in the UK? How does it differ from the EU’s position? And what are the key pieces of incoming regulation that investors need to know about?

Ambitious UK climate targets…

The UK government legislated in 2019 to deliver net zero GHG emissions by 2050. In the run-up to COP26 last November, the UK made further commitments that set the political backdrop to recent regulatory developments, including:

• an interim target to reduce UK GHG emissions by 78% by 2035; and
• the aim for the UK to become the world’s first net zero-aligned financial centre.

With such ambitious targets, the focus for the UK is now switching to delivery.  And the financial sector is set to be central to the government’s approach.

…are supported by growing consumer interest in sustainable investing

Unsurprisingly, government action coincides with a massive increase in consumer interest in sustainable investing. Recent research conducted in the UK for Invesco³ found that 79% of retail investors consider sustainability is important for how their money is invested – and an even higher proportion are interested in sustainable investing overall. The principal factor driving such interest is a desire to contribute to positive outcomes, with almost half of those surveyed citing climate change as one of the main reasons for their interest in sustainable investing. However, it’s also clear from the research results that lack of personal knowledge, concerns about financial performance and a lack of trust in sustainable investment funds remain significant barriers to translating ‘interest’ into ‘investment’.

Government and regulators hope both to tackle some of those barriers and enable financial flows to support the decarbonisation of the economy through requiring clear ESG disclosures and by preventing ‘green-washing’⁴ , ensuring investors and consumers get the decision-useful sustainability information they need. But the picture risks being complicated by divergent UK and EU approaches, spanning from corporate reporting right through to investment product disclosures and labelling.

UK divergence on disclosures

At the corporate level, rather than adopting the EU’s approach embodied in the Corporate Sustainability Reporting Directive (CSRD), the UK has embarked on a two-stage process of implementing global corporate standards – first, through the adoption of the global framework recommended by the Taskforce on Climate-related Financial Disclosures (TCFD), which is currently being rolled out across the economy; and second, through the planned adoption of a broader framework of Sustainability Disclosure Requirements (SDRs), which will be founded upon the new global baseline standards currently being developed by the International Sustainability Standards Board, a global body established to deliver a comprehensive global baseline of sustainability-related disclosure standards.

At the investment product level too, the UK and EU’s approaches are diverging. The EU has adopted the Sustainable Finance Disclosure Regulation (SFDR), which focuses on mandating investment firm- and product-level sustainability disclosures – but which has also created something of a de facto labelling system through the categorisation of products in alignment with Articles 6, 8 or 9 of the regulation.

Rather than on-shoring the SFDR, the UK is taking a different path: first, mandating climate-related product disclosures in line with elements of the TCFD recommendations; second, publishing plans for broader sustainability disclosures, building on the data from corporate-level SDR reporting; and third, introducing a new sustainable investment labelling regime for retail products. Under the labelling regime, products would be categorised into one of five buckets, ranged along a spectrum of sustainability from products that aren’t marketed as sustainable at one end, to ‘impact’ products at the other.

With the UK’s SDRs framework still in development, exactly how different the two disclosure regimes will be remains to be seen – but already, differences in requirements are emerging, such as in relation to Taxonomy disclosures where the UK plans to mandate all investment products to report on their degree of alignment with the forthcoming UK Green Taxonomy; whereas, in the EU, only a small proportion of products with environmental objectives are required to make such (EU) Taxonomy-related disclosures.
 

Taxonomy alignment?

It is only in the substance of the Green Taxonomy – a framework to define what counts as a ‘green’ investment – that the UK has really been content to follow the EU’s lead. In the absence of a global framework, the government concluded it would be inefficient to develop a UK version from scratch.  As such, the scientific metrics in the EU’s Taxonomy will form the basis of the UK’s Taxonomy too, but with tweaks applied to adapt the framework to the needs of the UK market. The scale of those tweaks is not yet known ahead of a first public consultation on the UK Taxonomy, expected shortly.  However, given the centrality of both new nuclear power and hydrogen to the UK government’s Net Zero Strategy and the prime minister’s Ten-point plan for a green industrial revolution, the UK may well look to go further than the EU in supporting these two energy sources.
 

What does this mean for investors?

Ultimately, it will take time to determine whether the incoming tide of ESG regulation is truly helping or hindering investors to select products that meet their sustainability preferences. In the UK, so much of the regulatory agenda is still in development. What’s clear, though, is that it will require a relentless focus from government and regulators – in both the UK and EU – to ensure that end-investors’ needs are central to the design of their respective disclosure regimes, enabling consumer engagement while incentivising market innovation. If they get it right, the prize for governments will be the large-scale deployment of capital to sustainable assets, helping achieve their ambitious decarbonisation commitments.