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Under the UK’s SDR at least 70 per cent of a fund’s holdings will need to be improving their sustainability © REUTERS

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Concerns are rising that passive, index-tracking funds may be completely absent from the UK’s upcoming “green” fund regime.

Under the Financial Conduct Authority’s new Sustainability Disclosure Requirements, due to come into force at the end of July, funds that are marketed as sustainable “should do as they claim and have the evidence to back it up”.

But the SDR rules may make it very difficult for any passive funds to comply. 

The Financial Times already reported in February that no exchange traded funds will be able to have a “sustainable” label as they are only available to UK-domiciled funds, while all ETFs available in the UK — even those listed on the London stock exchange — are domiciled overseas.

Now it seems even passive mutual funds may be struggling to meet the bar the UK regulator has set in order to tackle claims of fund industry “greenwashing”.

Issuers of passive funds will probably only be able to claim one of the FCA’s four green labels: Sustainability Improvers, designed for “products investing in assets that may not be sustainable now, with an aim to improve their sustainability for people and/or planet over time, including in response to the stewardship influence of the firm”.

This label is designed to be broadly analogous to the “transition” funds category in the EU’s Sustainable Finance Disclosure Regulation, specifically those funds that meet the toughest Article 9 criteria.

Under the SFDR disclosure regime, funds can claim to be transitioning if the companies in their portfolio are, in aggregate, decarbonising at a sufficient pace as to be compatible with the 2015 Paris Climate Accords.

But the FCA has decided to go one step further and apply the filter at the level of individual holdings, rather than the broad portfolio, with at least 70 per cent of holdings needing to be improving their sustainability. The remainder must not be in “conflict” with the sustainability objective.

The FCA said in its SDR policy statement that its approach “puts greater emphasis on the firm’s asset selection process. Firms must select assets on the basis of evidence that they have the potential to improve in time”.

This emphasis on selection may prove difficult for passive funds, which do not actively choose their holdings, but include every stock or bond in an index.

“My fear is that in the UK the improvers label is not going to be used by many funds because it’s very difficult to do,” said Hortense Bioy, global director of sustainability research at Morningstar.

“All the passive funds would fail [the test]. For the active ones it’s more feasible,” she added. “There is also the question of when [holdings] have improved, what are you going to do with these companies? It may become a non-label.”

Tom Gosling, an executive fellow at London Business School, agreed the FCA had set tight parameters, particularly for passive funds, but was supportive of this.

“The FCA have intentionally tried to set a high bar and I think they have got it right,” he said, welcoming the prospect of fund managers having to step up their engagement activities in order to qualify for a sustainable label.

“There are an awful lot of stocks you have to show you have an engagement with to qualify for the improvers label,” Gosling said, particularly for highly diversified broad-market passive funds.

If a fund “is only engaging with 10 per cent of the stocks in what way is it sensible to argue that it is having an impact on anything?” he asked.

Gosling said the driver for both SFDR and SDR was that there are funds “that are claiming [climate] impact that are not delivering impact”.

He was critical of the EU’s approach of measuring decarbonisation at the portfolio level, believing this failed to deliver the real world impact some might claim.

“That does not relate to impact or getting the world any nearer to net zero,” he argued.” All [funds] do is tilt away from heavy emitting sectors but it doesn’t change what is happening at all.

“It’s like someone saying they are sending less waste to landfill when they are throwing their rubbish bags into a neighbour’s garden instead. There is no plausible mechanism in which [these funds] do anything [except] make people feel better.”

Bioy believed it was a “philosophical” argument as to which approach was better, but noted that the UK appeared to be saying the $100bn of EU funds tracking Paris-aligned or climate-transition benchmarks “are not legitimate transition strategies”.

However, even if one believed the UK’s approach was superior, Bioy believed it was impractical for asset managers to use.

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“If you think that setting criteria at the asset level is more robust than at the portfolio level, if you end up with something that is not used, you may ask yourself if it’s the right thing to do,” she said.

The FCA said in a statement that “the qualifying criteria for labels has been designed to accommodate products investing in different asset classes and those with different investment strategies. This includes both active and passive strategies, and may therefore include products tracking a Paris-aligned or climate transition benchmark, provided that they meet the criteria.”

Several large passive fund managers declined to comment.

The EU is now consulting on possible changes to SFDR and Gosling “on the cards” that it would take steps to bring it in line with the UK’s approach.

“I think the FCA’s legislation gets closer to communicating what is happening [in terms of impact],” he said. “The FCA learnt from what happened in the EU and it explicitly tried to be different.”

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