UK and EU
sustainability
regulations

Read this article to understand:

• The importance of a regulatory framework that recognises that sustainable investing can take many forms
• Why regulations that focus overwhelmingly on greenwashing could be hindering the flow of capital to the transition
• How recent developments in finance and global temperatures have upped the stakes
   

Following the 2015 Paris Agreement committing signatories to limit global warming to below two degrees Celsius above pre-industrial averages, the development of commercially viable renewable energy investments, and the Covid-led fall in emissions, there was a wave of optimism that the transition to a low-carbon world would materialise quickly.^1,2

Demand for “sustainable”, “green” or “ESG” funds soared, including among retail investors, and investment managers sold many such funds on the promise of delivering sustainable outcomes without sacrificing financial returns.³

But not all funds could deliver what they promised, and many investors struggled to understand the complexities of the interactions between returns and sustainability. In other words, it wasn’t clear what they were buying.

Understandably in this context, regulators saw greenwashing as a major risk for retail investors. It became a central focus of the EU’s Sustainable Finance Disclosure Regulation (SFDR) and the UK’s Sustainability Disclosure Requirements (SDR).^4,5

Yet with the second iteration of SFDR making its way through the final stages of negotiations, I fear we’re now focusing too much attention on this one risk, potentially at the expense of others.⁶

A narrow scope for the regulations

Starting in Europe, SFDR initially defined Article 8 and Article 9 disclosures, which became de facto product categories for funds that included an explicit sustainability objective (Article 9) or binding sustainability constraints on the investment process (Article 8).

Shortly afterwards, the European Supervisory Authorities introduced a clause that restricted the marketing of sustainability credentials to only Article 8 and 9 funds.⁷

In the UK, the FCA followed suit, arguably focusing even more specifically on preventing greenwashing through similar marketing restrictions, coupled with narrower product categorisations for retail investors.

Today, the draft text for SFDR 2.0 defines still more restrictive sustainable fund categories than SFDR 1.0. It proposes to materially restrict asset managers from communicating on sustainability in strategies that don’t fall under one of the new Article 7, 8 or 9 product categories. And it could require those strategies to include an explicit warning label stating they are not SFDR-compliant. Unlike with SDR, there will be no carve-out for professional investors or private-market strategies.

Could this narrow focus have unintended consequences?

While this direction of travel works to present retail investors with simpler options, it goes against having open and rich conversations with institutional asset owners seeking to partner with asset managers to deliver on their sustainability goals. The outsize focus on sustainable funds also excludes a large portion of the sustainable investing landscape from sufficient attention.

In light of the EU and UK’s climate commitments, the priority of sustainable finance regulation should be to support an orderly transition by helping align capital flows to a low-carbon future, while delivering on the risk, return and sustainability goals of end investors. The importance of maintaining a broad perspective was recognised as early as 2006, when the PRI was established.⁸

To this end, asset managers must be able to communicate with asset owners on the full scope of sustainable investing approaches that could meet their sustainability goals. This includes not only the provision of sustainable funds but also the integration of financially material sustainability insights into the investment process, as well as engagement with stakeholders across the value chain.⁹

All these approaches allow asset managers and asset owners alike to mitigate sustainability risk, identify opportunities and support the transition in different ways. And they don’t necessarily require a fund to have an explicit sustainability objective or binding sustainability constraints on the investment process.

Yet the new rules would restrict asset managers from communicating the way they integrate sustainability insights in their investment strategies, including where they might play a significant role in investment decision-making, as is particularly the case in private markets.

Although bilateral discussions could continue, the overall restrictions would hinder transparency and comparability. For instance, as we have seen with SDR, explicitly enshrining these kinds of constraints tends to impede asset managers’ ability to communicate the sustainability activity they undertake at firm level.

These rules would therefore make it more difficult for asset owners to assess whether a manager’s approach is credible and aligned to their own goals. They would have less information to decide how – and with whom – to allocate capital to both support the transition and receive competitive returns.

A stronger case for flexibility

Two recent developments further strengthen the case for taking a broader approach to sustainability regulation.

First, since 2022, sustainable funds have often fallen short of their stated return targets, and we no longer live in a world where sustainability sells itself.¹⁰ We’ve seen sustainable fund flows slow, in some markets substantially; and greenhushing (whereby companies don’t talk about their sustainability initiatives) has even made an appearance.¹¹ Anti-greenwashing therefore doesn’t need to remain the main driving force behind sustainable investing regulation.

Second, scientific consensus tells us the window to remain on a path to 1.5 degrees has likely closed.¹² That means sustainable investing over the next decade is likely to be characterised increasingly by portfolios’ resilience and ability to weather physical climate shocks. This is already having a significant impact on asset owners’ priorities, including the need to reconnect sustainability considerations with financial returns.

In this new world, sustainability will need to play an integral role in identifying viable investment opportunities and managing sustainability risks in portfolios, with or without an explicit sustainability objective or binding constraints.

What’s more, the next decade will be characterised by an increased role for private markets, whose decades-long investment horizons make sustainability an intrinsic part of financial analysis.^13,14

Looking ahead

More than ever, asset owners need information and flexibility to choose the right sustainable investing strategies and the right asset management partners to navigate the interplay of sustainability considerations and long-term risk-adjusted returns. All forms of sustainable investing activity should be given adequate attention or at least be permitted to be communicated.

As we have discussed at Investment Association forums in recent months, the extent to which incoming regulation could disproportionately focus on simplifying the sustainable-fund landscape matters. Enhancing a regulatory framework that supports all investors in their individual and evolving sustainable investing journeys remains key.

The goal of regulation should be to help investors manage risk, identify opportunities and support the transition, whereas if the system becomes too rigid, investors risk disengaging entirely. In the current context, that could come at a huge cost.