UK SDR Has Finally Landed. Where Now For ESG?

The theory behind the UK SDR is clear, but what will it look like in practice? Will it usher in a new era of sustainable investing or simply create a best-in-class classification system?

Joshua McAlpine 6 June, 2024 | 4:18PM
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After years of guidance and extensive consultations, the long-awaited UK Sustainability Disclosure Requirements (UK SDR) – a country-specific regulation largely influenced by the European Union's SFDR – has come into force. Well, partially at least.

Understandably, financial market participants have many questions surrounding the new rules; from the impact it will have on industry attitudes to ESG, how capital is allocated, the practicalities of the classification system, and ultimately, what this means for end investors.

But before we interrogate the UK SDR's intentions, let's unpack the essentials.



What is the UK SDR?

Born from the Financial Conduct Authority's (FCA) Sustainability Disclosure Requirements and Investment Labels Policy Statement, the framework outlines four product labels that can be applied to investment vehicles, along with and product- and entity-level disclosures. An additional key objective of the SDR regulation is to minimise greenwashing through its anti-greenwashing rule.

Why is the UK SDR Important?

On a practical level, the regulations and disclosures outlined by SDR are mandatory, so financial market participants subject to these rules must be compliant.

On a deeper level, the FCA's decision to introduce these rules reflects a growing demand for ESG-focused funds. Increasingly, people want two things: positive returns and a positive impact. The rules and disclosures are intended to increase transparency around investment products – a benefit to end investors.

Where Does the UK SDR Cover?

Unsurprisingly, these rules span the United Kingdom, but the implications will travel much further, with guidance on overseas funds expected later in 2024. Interestingly, we're already seeing an impact, with the most recent SFDR consultation re-evaluating whether Article 8 & 9 funds should have clearer and stricter labels, in line with the UK SDR. 

Who Does the UK SDR Apply to?  

Quite a few people, according to the FCA's policy statement:

1. UK firms that manage investment funds.

2. UK firms that distribute investment products to UK-domiciled retail investors.

3. FCA-authorised firms (domiciled in the UK) that make sustainability claims in their marketing about their products and services (anti-greenwashing rule).

When does SDR Come into Force?  

There are three key dates for 2024, so mark your calendars.

• May 31 2024: Anti-greenwashing rules and guidance take effect;
• July 31 2024: Firms can start to apply the labels alongside disclosures;
• December 2 2024: Naming and marketing rules take effect.

How Will the UK SDR Work?

Here's where the questions crop up. Operationally, SDR will function via four voluntary labels that asset managers can apply to their investment products (from July 31 onwards), so consumers have greater transparency about different investment products.

But long-term, the future is less clear if we think about "work" in the context of impact – what the UK SDR intends to achieve.   

Some financial market participants are sceptical this new regime will drive more capital into sustainable investments. There is a general sentiment that the four labels are too narrow in scope, which will suppress asset managers from adopting them for their products, at least in the short term. According to research by Morningstar, an optimistic scenario would see about 300 UK open- and closed-end funds opting for a label by year-end. These labelled funds would represent 8% of funds domiciled in the UK, and less than 3% of all funds available for sale in the UK.

For asset managers, the criteria outlined by these labels will likely mean funds opt for the "Sustainability Focus" or "Sustainability Mixed Goals" labels, as opposed to the "Sustainability Impact" label, which would be the gold standard for ESG-focused clients.

Methodologically, how do asset managers measure the key performance indicators that distinguish one label from another? How can you sufficiently prove that a product meets its UK SDR label, especially for "Sustainability Impact?"

Distributors may also find these labels tricky to navigate, as confusion around labelled versus non-labelled ESG-related funds will be challenging. In response to shifting client preferences, distributors actively want to offer labelled funds on their platforms. However, with the anticipated low adoption rate of these labels, this will prove difficult in the short term, and it may take a while before more labelled funds are widely available. 

The counterargument posits that this high barrier to entry is not necessarily a negative. As with everything, it’s all about perspective. For many, the high standards outlined by the four labels demonstrate a long-term commitment to sustainable investing. As investor preferences shift, the FCA aims to enable the end investor to choose from best-in-class sustainable investment products. Therefore, this strict criterion will showcase the (few) products that meet the mark.

For end investors, these best-in-class products will, in theory, be more transparent, leaving them without any doubt about how their capital has been allocated, though this will be dependent on how managers report on their alignment with the labels.

This transparency is seen by many as the primary intention of the Sustainability Disclosure Requirements, which aims to combat greenwashing by creating a best-in-class overview of what makes a "good" sustainable investment. More broadly speaking, when it comes to attracting more capital inflows to sustainable investments, this is the primary scope of the EU's SFDR regulation. Depending on your jurisdiction and where a sustainable fund is marketed or registered, you will need to comply with one or both regulations.

Morningstar's Data-Powered Solutions

While all regulations, from SFDR and TCFD-aligned reporting to the UK SDR, have unique complexities, they are united by a singular fact: they all rely on high-quality data and the ability to report transparently and consistently under each of these disclosure regimes.

That’s where Morningstar comes in. Our cutting-edge suite of solutions is fit for the future demands of regulators and clients alike.

Trusted Data

High-quality ESG data at the company and fund level from Morningstar Sustainalytics, brings quality and consistency for creating, promoting and comparing sustainable products. Once available, Morningstar Data will also provide access to whole of market SDR labels, as well as consumer-facing and product-level documents. 

Superior Analysis & Reporting Solutions

Easily perform peer analysis across labelling regimes or assess performance of labelled and non-labelled products with Morningstar Direct, our flagship platform for professional investors. Our flexible reporting solutions support custom, timely reporting at product and entity levels.

ESG Expertise

Leverage Morningstar's ESG expertise to help you navigate KPI selection to meet labelling requirements or use Morningstar's independent analysis to compare a portfolio against stated intentionality and avoid the dangers of greenwashing.

To learn more about the UK SDR, how it will impact you and your clients, and how Morningstar can help you adapt and thrive, take a look at our UK SDR solutions.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Joshua McAlpine  Joshua McAlpine is content writer at Morningstar

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