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UK-EU rule split risks complexity for ESG investors

ESG investment could become more complicated for British savers with a growing risk of divergence between European and UK sustainability disclosure rules.

While stronger standards for funds focused on environmental, social and governance goals (ESG) have been welcomed by many investment specialists, the industry has warned of increased confusion and high costs if the UK charts a sharply different course from Europe.

UK regulators are drawing up proposals on the sustainability disclosure requirements set to pass at the end of the year, following new EU rules which came into effect in March last year.

“A proliferation of differing sustainable finance disclosure frameworks by multiple jurisdictions carries the risk of adding to complexity, cost and confusion for investors,” said Johan Vanderlugt, sustainable finance specialist at Kempen Capital Management. “Challenges can arise when disclosure regulations differ too much, for example around interpretation, implementation and monitoring.”

The Financial Conduct Authority (FCA) is currently drafting a labelling system for funds, to categorise their sustainable credentials. The proposed framework includes five labels, to be mapped out against the existing three European categories.

The UK regulator acknowledges that many British firms have “already invested in systems and processes to classify [their] products” to comply with Europe’s Sustainable Finance Disclosure Regulation (SFDR).

Fragmented approaches could run the risk of not treating consumers fairly and consistently, says the Investment Association, a UK trade body, calling for “as little divergence as possible” in the scope of products covered.

“There is a risk that the [proposed labels] could also prove too complex and difficult for consumers to understand,” it adds.

The introduction of European sustainability disclosure rules helped drive global sustainable fund assets to almost $2.7tn at the end of the last quarter last year, according to data provider Morningstar. The region accounted for almost 80 per cent of global flows into sustainable funds in the same quarter.

Column chart of Quarterly global sustainable fund assets ($bn) showing Europe drives the boom in ESG investing

Nicolas Mackel, the chief executive of Luxembourg for Finance, a promotion agency, says that fragmented regimes would “increase costs” and, ultimately, investors’ fees.

Despite the anticipated cost burden of divergence, some professional investors hope that building its own rule book will offer Britain a chance to improve on areas where EU rules fall short. “The FCA has the opportunity to learn,” says Mirza Baig, head of ESG at Aviva Investors, which holds £357bn under management.

Critics of the European framework point to the breadth of some sustainability categories, which can be difficult to implement.

Sacha Sadan, head of ESG at the FCA, said some local regulators were looking to add to the EU framework to make it more effective. Both the French and German regulators had published their own guidance.

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Some investors worry that the rigid fund classifications demanded by both EU and British regulators could discourage investment in so-called “brown” companies — such as steel groups — working to improve their ESG credentials, notably through slashing emissions.

The UK legislation’s overarching goal is not “fully clear yet,” says the Investment Association. The trade body has called for “fewer, less rigid [labelling] categories”.

Environmental advocates have urged the regulator not to be too lax, however. “The FCA must resist industry pressures seeking to water down its labelling system,” says David Barmes, a senior economist at the think-tank Positive Money.

UK-based asset managers who market their funds on the continent or provide advisory services to European clients could find themselves caught by both regulatory regimes. The British rules, on the other hand, are only set to apply to financial firms authorised by the UK regulator, the FCA. For now, they are not set to apply to foreign funds marketing in the UK, although this hasn’t been ruled out later.

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