Changing regulations mean ESG will remain central to the advice process

The regulations governing how advisers must treat ESG investments are seeing considerable change.

Last October, the government published Greening Finance: A Roadmap to Sustainable Investing¹. This sets out the government’s strategy to drive sustainable investing and ensure the economy meets the target of net zero by 2050.

The government’s plan to improve the way information around sustainability is measured and disclosed is split into three parts:

Ensuring decision-useful information on sustainability is available to financial market decision-makers
Making businesses and investors use this information in business and financial decisions
Driving financial flows to companies which align with a net-zero and nature-positive economy

Sustainability Disclosure Requirements

The government is relying on new Sustainability Disclosure Requirements (SDR) which are already in development² by the Financial Conduct Authority. This should improve the visibility of the impact of the underlying holdings, as well as set out a new set of labels to describe the way investments deal with ESG and is likely to stay pretty close to the EU’s Sustainable Finance Disclosure Regulation.

Green Taxonomy

The government is also developing the UK Green Taxonomy to create a framework to determine which activities can be considered environmentally sustainable. This work is expected to produce an outcome similar to EU regulations which class investment funds under three categories:

Article 6 funds do not include any element of ESG in the investment process.
Article 8 funds, also known as environmental and socially promoting funds, include “environmental or social characteristics, or a combination of those characteristics”.
Article 9 funds have sustainable investment or reduction in carbon emissions as a clear objective.

This should help advice firms align clients with the appropriate level of engagement with ESG as part of PROD suitability. This is likely to see clients fall into one of four broad approaches to ESG and sustainability:

ESG and responsible investing is not a primary concern. The client has expressed no interest in ESG or responsible investing.
Considers ESG important and wants to invest in products that display good ESG processes and outcomes, but it is not a priority over other features.
ESG and responsible investing is a somewhat important and the client wants it included in investment selection, but not exclusively.
Clients have a highly developed set of personal beliefs and values and wants them completely incorporated into their portfolio.

Consumer Duty

Another factor for advisers is the new Consumer Duty³ from the FCA. The new regulations are not specifically targeted at ESG investing but they include several points which directly impact how ESG investments have to be treated.

The consumer duty includes three cross-cutting rules which the FCA expects firms to meet. These are:

act in good faith
avoid causing foreseeable harm
enable and support retail customers to pursue their financial objective

To meet this third point requires a full understanding of clients’ objectives, including whether ESG considerations are a factor.

The FCA also expects the Consumer Duty to drive positive outcomes in four areas: products and services; price and value; consumer understanding, and; consumer support. In order to demonstrate their efforts ensure positive outcomes for clients, advisers will need to digest all the relevant information provided by fund managers and be able to pass this on to investors in a way that they understand.

Even if clients have no interest in investing responsibly or sustainably, ESG factors have a clear impact on the performance of underlying investments and so clients will need to be aware of how ESG-factors will potentially affect investment performance.

The next steps

The government’s roadmap is going to see much greater disclosure of information on sustainability and ESG, while the new Consumer Duty rules mean advisers are under a stronger requirement to understand clients’ goals and objectives and ensure all products are appropriate.

In short, there will be a lot more information available about how investment funds operate and much greater scrutiny over how investment vehicles treat ESG issues in their investment process.

Meanwhile advisers are under greater regulatory pressure to understand their clients’ attitudes to ESG and ensure they are kept suitably informed about how ESG affects investment performance. Incorporating independent ESG ratings into fund research can help identify the most appropriate investment vehicles and adviser should lean on providers’ improved disclosure to effectively communicate the impact of clients’ investments.