Over the last few years we've seen a significant increase in investing that is linked to sustainability in some way.

There's been a huge rise in the number of environmental, social and governance, or ESG, funds available to retail investors, not just in the UK and Europe, but all over the world.

The fact that more and more people are thinking about the environmental and social impact of their investments is a great thing.

But the growth in ESG funds has created a challenge for regulators.

How do they ensure that the sustainability claims made by fund managers are backed up by solid evidence?

How can they minimize the risk of consumers being misled?

With increasing interest in ESG and sustainability, how can regulators ensure that firms are not overstating their claims to make funds more marketable to consumers in the UK?

The Financial Conduct Authority, the FCA aims to improve the credibility and trust of ESG and sustainable funds in the UK market.

Ultimately, the FCA wants to protect retail investors from being misled by sustainability claims.

As a result, the FCA has addressed these concerns by developing the Sustainability Disclosure Requirements and Investment Labels regime, or better known collectively as just SDR.

The SDR is a set of rules that governs how ESG or sustainable funds are sold and marketed in the UK.

These rules apply to fund managers as well as distributors like investment platforms and advisors.

The FDA finalized the details of the SDR at the end of 2023 and the new regime is being rolled out between now and 2026, but the most important changes will be implemented by the end of 2024.

The SDR regime has four main components, 3 mandatory elements and one voluntary.

The first mandatory component is an Anti greenwashing rule.

This underpins the entire regulation and applies to all FCA authorized bodies including advisors.

The Anti Greenwashing Rule is designed to make sure that any ESG related investment claims are, in the FCA's words, fair, clear and not misleading.

The rule formalizes many of the ESG guiding principles that the FCA established in its Dear CEO letter from July 2021, which is sent out to fund managers setting out its expectations on the design, delivery and disclosure of ESG and sustainable investment funds.

The second is the naming and marketing rules.

The FCA has been concerned that some fund managers have been freely using terms like ESG, sustainable climate or even impact in both fund names, disclosures and collateral to describe their investment process without a lot of evidence as to why these terms are appropriate to describe the way a fund is managed.

As the name of the fund is the first thing an investor sees, it is critical to the FCA that the naming convention accurately represents the funds investments.

Fund managers must now ensure that the naming and marketing of ESG or sustainable funds accurately and appropriately represent the environmental or social characteristics that are material to a funds investment process.

To use any ESG related terminology, at least 70% of the funds assets must align with stated environmental or social characteristics.

Certain terminology aligned with the sustainability investment labels regime can only be used if a label is applied.

We will discuss the labels in further detail shortly.

The 3rd element puts an obligation on fund managers to make proper disclosures about sustainability at both the product and the entity level.

This means organizations have to explain how sustainability risks and opportunities are being managed across the business as well as within each particular fund.

For funds with material sustainability characteristics, a new consumer facing disclosure document will be required to made available so that retail investors can easily consume and understand what a fund aims to deliver.

Finally, the voluntary element of the regime is the investment labels.

Fund managers will be able to apply for one of four new sustainability labels for their funds.

It's worth noting that these are entirely voluntary.

There's no obligation on a fund manager to apply for a label, and plenty of funds that have some form of environmental or social characteristics will not have a label.

The first label is Sustainability Focus, which covers funds and invest in assets that are clearly demonstrated to be environmentally or socially sustainable.

Sustainably improvers applies to funds that invest in assets that have the potential to become more environmentally or socially sustainable over time, but that perhaps we're not currently demonstrating high levels of sustainability.

Sustainably impact are funds that have a predefined positive and measurable impact in relation to an environmental or social outcome.

These products must specify a theory of change, setting out how the investment activities and the products assets contribute to a positive impact.

And finally, the 4th label, Sustainability Mixed Goals refers to funds that invest with a combination of the sustainability objectives of the three labels.

So it could be a blend of assets that fall under the sustainability improvers umbrella alongside some assets that would come under sustainability focus.

As part of the naming of marketing rules, only funds which are eligible for a label can use the terminology represented in the various labels.

Therefore, an example, funds currently using sustainability or impact can only continue using this in the name if they have a label.

Otherwise, these funds will need to be renamed to comply.

So what makes these investment labels different from a fund with just environmental or social characteristics?

Labeled funds need to meet some specific criteria in order to be eligible.

For example, each fund is required to have a specific sustainability objective alongside its investment objective.

This means that the fund must have the intention to ensure that its investments are made with the aim of pursuing a positive environmental or social outcome.

At least 70% of the assets in the fund should be invested in line with the sustainability objective and it should be based on a robust and evidence based standard and assets that are not aligned cannot be in conflict with the stated sustainability objective.

Fund managers also need to establish a set of robust and measurable KP is so that progress towards the objectives can be measured and they should also set out what action they will take if not enough progress is being made.

The FCA has set a high bar for funds to obtain an investment label.

Not all ESG related funds will apply or be eligible for one of the four labels, but these non labeled funds can still play an important role in helping investors meet their sustainability goals.

In fact, the FCA expects only a relatively small proportion of funds to be authorized to use one of the labels.

To give you an example, if you have a fund that meets the 70% materiality threshold for aligned assets, but the fund does not have robust KP IS or targets or invest in assets which may conflict with its objective, it would fall short of a label.

At the moment, the SDR and the investment labels regime only applies to UK domiciled funds, but the FCA will be consulting on how the rules should or could be extended to apply to funds that are domiciled in other regions like the EU through their overseas funds regime.

Now, we'll quickly touch on the implementation timeline.

The SDR rules were first published in November 2023 and some aspects of the new regime have already taken place.

At the end of May 2024 the anti greenwashing rules came into force, while at the end of July was the earliest date at which asset managers could start to use the four sustainability labels on their funds.

The naming and marketing rules as well as pre contractual product level disclosures come into effect on the 2nd of December 2024.

However, the FCA has provided a temporary extension for funds using one of the reserve terms and is in the process of applying for an investment label.

These funds will have until the 2nd of April 2025 to be compliant with the naming and marketing rules as well as the product disclosure rules.

There will be additional annual reporting obligations starting with funds that have a sustainability label to begin publishing their first annual report starting in July 2025 at the earliest.

There are two deadlines for entity level disclosures and these are dependent on the size of the firm in question.

Larger asset managers, those with more than £50 billion in assets under management, need to start making required sustainability disclosures from the 2nd of December 2025, while asset managers with more than £5 billion of AUM need to do so from the same date in 2026.

The STR regime applies to investment firms, investment platforms and advisors.

Advisors have a particularly important role to play in ensuring that the information required under SDR is communicated clearly and in a timely fashion to their clients.

Advisors will also be expected to provide additional disclosure statements for funds that are domiciled overseas explain that they are exempt from the SDR for the time being.

Advisors are covered by the anti greenwashing rules so any sustainability related claims need to be supported by clear evidence.

There are a couple of areas where the FCA is still working out with the best approaches.

We have already mentioned the application of STR to non UK funds, however providing investment advice and assessing suitability is still a development.

While we expect the FCA to issue guidance in due course, for the time being advisors should take note of the anti greenwashing regulations as well as of course existing Consumer Duty and Conduct of Business Sourcebook or Cobs rules.

Portfolio management services is another area of key interest for advisors and distributors.

We know a lot of advisors use these services to build and run model portfolios and they are not covered under the current SDR rules.

But the FCA has been consulting on how to move forward, and proposals are expected to be published at some point in the second quarter of 2025, per the FCA.

In the meantime, Vanguard will continue to offer as much support as you need during the imlementation of this new regulation.