Travers Smith's Sustainability Insights: The impact of labelling impact

Travers Smith's Sustainability Insights: The impact of labelling impact

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A regular briefing for the alternative asset management industry. 

Labelling investment products is a tricky business. On the one hand, it is important to make the labels clear and meaningful to investors, and to guarantee some minimum standards so that even unsophisticated investors know what they are getting.  At the same time, too much prescription will limit investor choice, narrowing the range of products in the market, and curb innovation – which is not in the interests of investors.  If done badly, labels can also distort investment and capital allocation decisions in ways that undermine policy objectives and increase investor risk.

But the fact that it is hard does not mean that it should not be attempted.  If done well, fund labels can increase investor confidence and – when the labels are for sustainability-focused products – curb "greenwashing", a pernicious practice global regulators are actively trying to stamp out.

The UK's attempt to create three flavours of sustainability label (which we wrote about in November) is therefore welcome – and so is the careful and consultative process that has been followed as the proposals have been developed.  In contrast to other recent UK legal and regulatory reforms, the FCA's proposals have been widely tested with interested parties and continue to evolve in response to feedback.  And, importantly, the industry has actively and constructively engaged with the regulator throughout the process.

The latest stage of this process ended this week, when the consultation on draft rules closed.  For the impact investment community, and for private funds managers looking to add impact-specific strategies to their business, the "Sustainable Impact" label is of great interest: it will, no doubt, further increase appetite for both public and private impact funds.

One very important feature of the UK proposals is that they are based on "intentionality" – meaning "the investor’s deliberate intention to achieve the product’s stated objective", rather than underwriting outcomes.  For the impact label specifically, the FCA says that the manager would need to target pre-defined, positive, and measurable social or environmental impact and invest in line with a clearly articulated "theory of change".  The impact managers would also seek to avoid negative environmental or social impacts, while using "rigorous, evidence-based" KPIs to capture the "investor contribution" to the targeted positive outcomes. 

The impact label deliberately sets a high bar.  It seems particularly suited to private markets funds, because the FCA says that the "primary channel" for an investor to demonstrate the "additionality" of its contribution to real world outcomes is by investing new capital to companies or projects that offer solutions to environmental or social problems.  Stewardship is said to be a secondary way to demonstrate impact, but the clear implication is that it would be more difficult for funds that buy equities in the market, without providing new capital, to qualify as labelled impact funds.  No doubt public fund managers will push back against that.

For example, the Impact Investing Institute is concerned that this focus on "investor contribution" might overshadow the importance of the "enterprise contribution".  Many would argue that, if the underlying investee companies are solving real world problems, a fund that allocates capital to those companies should qualify for an impact label, even if it is only buying their shares on the secondary market.  An impact fund manager's contribution might be through stewardship, but most of the real-world impact comes from the economic activities of the underlying company. (This is, broadly, the approach taken by the SFDR's Article 9 category – although the SFDR's well-known uncertainties mean that it has been a minefield for firms seeking to adopt it.)  The final FCA rules might, therefore, be more flexible to accommodate that concern.

It will also be important, to avoid some of the issues that fund managers have encountered with the SFDR, to be more precise about what kinds of enterprise contribution qualify as "positive real-world impact".  This is not well defined in the current rules and will therefore leave the door open to expansive interpretations, and possible overlap with the other labels: Sustainable Improvers and Sustainable Focus. 

The impact label deliberately sets a high bar... and seems particularly suited to private markets


Another issue that the FCA has been grappling with, and which is not fully resolved in the current proposals, is how labelled products should avoid, measure and report on the negative impacts, or "harms", associated with their investee companies' activities.  The EU's current approach to "do no significant harm" is fraught with difficulty, and the UK proposals expressly reject it.  They do offer some alternatives, including a requirement for funds to report on their "unexpected investments", but for impact funds they also say that the manager must explain in its pre-contractual disclosures how they assess prospective investee companies to ensure that they avoid "unintended negative consequences".  In its response, the Impact Investing Institute rightly points out that some industry-wide "significant harm" themes would be helpful, and over time metrics could be developed to enable consistent reporting.  The PRI has expressly called for a clearer "do no significant harm" test to be introduced. 

The FCA is aiming to publish its final rules in the middle of 2023, and its objective – a clear and stretching label for investment products that deliberately target measurable real-world positive outcomes – is clear.  The current proposals are not perfect, and the regulator will have to continue to balance various competing objectives as it fine-tunes them.  The process has, so far, been a good one – and we hope and expect there will be further refinement following this latest consultation round. (The BVCA response, which identifies some important issues for private markets is here.)

Correctly calibrating the UK labels is particularly important if, as many will hope, they are to be adopted beyond the relatively limited sphere of UK retail, and gain currency among international and institutional investors.  That seems like a big ambition – especially for as long as the scope is limited to UK managed funds – but perhaps, in time, the UK's approach to sustainability regulation will catch on.

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A series of regular briefings for the alternative asset management industry.

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