Testing how Authorised Fund Managers are embedding the Guiding Principles in ESG and sustainable investment funds

Principle 1 of our Guiding Principles publication referred to the design of ESG and sustainable funds and the need for clear disclosure of key design elements in fund documentation.

Some funds did not have an explicit ESG or sustainability objective – or were inconsistently aligned with a stated ESG or sustainability objective and/or the ESG and sustainability approach stated in the investment policy.

There were inconsistent approaches by AFMs to setting specific ESG and sustainable investment objectives at the product design stage across the funds we reviewed. However, AFMs did set out their ESG and sustainability approach in varying degrees of detail in the investment policy.   

While we noted that AFMs were setting ESG investment policies and strategies, some did not set any specific ESG or sustainability objectives for funds with ESG or sustainability-related terms in their names, in addition to the financial objectives. In most cases, the financial objectives were supplemented by additional ESG and/or sustainability information and policies that were disclosed in the investment prospectus and wider firm-level documentation. Some AFMs explicitly set a wide range of ESG and sustainable outcomes in fund documentation, such as the fund prospectus, but only committed to achieving at least one of those outcomes.  

However, we also saw examples of AFMs including more explicit and detailed ESG and sustainability approaches within the prospectus for their funds. These approaches sought to achieve specific and defined investment aims, such as delivering a particular environmental or social impact or measurable improvement in the ESG and/or sustainability characteristics of a defined portfolio of investments.  

On their ESG and sustainable funds, AFMs should comply with COLL 4.2.5(3)(a)R[6] which requires investment objectives, the policy for achieving those objectives and any limitations on the policy, to be set out in the prospectus. The Guiding Principles also state that where a fund claims to pursue ESG and/or sustainability characteristics, themes or outcomes, such as in its name or marketing material, these should be appropriately reflected in the fund’s objectives and/or policy.  

AFMs should comply with the requirements in COBS 4.2.1R[7] to ensure communications and financial promotions are fair, clear and not misleading, as well as considering the implications of the consumer understanding rule[8] under the Consumer Duty, where relevant.

The design of AFMs’ stewardship approaches did not meet our expectations. 

Our review identified that AFMs can do more in their fund and firm-level disclosures to explain their stewardship approach. This includes how their approach enables them to deliver on a fund’s objectives, how they measure delivery of stewardship outcomes and any associated challenges.  

Among the AFMs we reviewed, many said they used stewardship as a tool to further their funds’ ESG and sustainable investment objectives. Our review identified that measuring impact on the operations of investee companies from stewardship activities may be an ongoing challenge for firms. Some AFMs were able to demonstrate longstanding, developed and transparent programmes of engagement with investee companies. However, it was often difficult to identify clear examples of progress resulting from this engagement. As a result, some firms appeared to rely heavily on stewardship activities without being able to demonstrate how they set, assessed and monitored outcomes, and how these linked to the investment objectives of funds.  

In many cases, it was difficult to identify the AFM’s stewardship approach and engagement activities from fund literature alone. Firm-level documents were also sometimes not accessible from, or cross-referenced to, fund-level documents. There were challenges in identifying how firm-wide stewardship activities related to fund-level objectives during our meetings and in disclosures to investors.  

Our Guiding Principles emphasise that AFMs should develop an engagement policy that complies with COBS 2.2B.6R[9] and clarify how stewardship contributes to meeting the fund’s intended ESG and sustainability aims. We remind AFMs to review their disclosures on stewardship and consider if they are sufficiently clear on how this activity contributes to achieving their funds’ ESG or sustainability objectives. This includes consistently linking these disclosures to relevant firm and fund documentation.

Good practice: Design

1. Developing and/or using appropriate ESG and sustainability scoring systems or using benchmarks that are suited to the AFM’s funds, with firms also demonstrating an understanding of their underlying methodologies and limitations, including of relevant third-party methodologies.
2. AFMs that demonstrated more effective stewardship approaches embedded their stewardship activity within investment teams, providing investment managers with ownership of engagement activity with the support of a central stewardship resource.
3. AFMs have active engagement policies and initiatives with investee companies to further their ESG and sustainability approach. Firms use voting as a means of influencing investee companies to pursue ESG and sustainability objectives.
4. AFMs make efforts to measure and record the outcomes of their stewardship activity with investee companies and how this furthers the ESG and sustainability objectives of their fund range.

Principle 2 of our Guiding Principles referred to the delivery of ESG and sustainable investment funds and ongoing monitoring of holdings. The way a fund’s investment strategy is implemented, and the profile of its holdings, should be consistent with its disclosed objectives on an ongoing basis. 

Fund holdings that appeared inconsistent with a fund’s ESG or sustainability objectives.  

We reviewed funds that included holdings in the oil, gas, mining and manufacturing sectors. The documentation explained these holdings were included because the underlying companies were on a path to achieving net zero emissions. However, in some instances we found that, while the companies had set an ambition to achieve net zero emissions by 2050, they had not set any targets for Scope 3 emissions. The AFM did not explain the absence of a Scope 3 emissions target in the fund literature and the treatment of these holdings in the firm’s ESG and sustainable investment framework was not clear. 

Our Guiding Principles state that where holdings might appear contradictory to a fund’s ESG or sustainability investment strategy, the AFM should consider explaining this to investors.

We remind AFMs to consider how their fund communications and financial promotions comply with the requirement in COBS 4.2.1R to be fair, clear and not misleading, given that without a supporting explanation it may not be clear how some holdings align with the fund’s disclosed ESG and sustainability objectives and/or policies. AFMs should have a credible, defined and documented approach to the treatment of these holdings in their investment frameworks. Where applicable, AFMs should also consider the customer understanding outcome within the Consumer Duty and how their disclosures align with this.

Good practice: Delivery

1. A strong focus on investment research and due diligence for asset selection that is embedded in the AFM’s investment processes.
2. Due diligence is carried out on third party data providers whose inputs are used to inform the AFM’s external disclosures and reporting around delivery, focussed on gaining a clear understanding of the underlying methodologies, inputs and limitations of the data.
3. On an ongoing basis, we expect AFMs to maintain appropriate systems and controls to ensure data accuracy and compliance with underlying methodologies, as well as identifying and addressing any errors by third party data providers and assessing the ongoing appropriateness of ESG data for the delivery of the fund.

Principle 3 of our Guiding Principles stated that pre-contractual and ongoing periodic disclosures on ESG or sustainable investment funds should be easily available to investors and help them to make investment decisions.

Key ESG and sustainability information was often not explained or put into context in disclosures. 

We found that some AFMs failed to explain information about the key ESG and sustainability-related features of their funds. For example, some AFMs often chose to disclose carbon footprint data and carbon emissions metrics but omitted to explain that they excluded Scope 3 emissions, even though these are often the majority of a fund’s carbon footprint. We also saw examples of ongoing reporting on carbon emissions metrics that showed the emissions of ESG and sustainable investment funds were higher than non-ESG or sustainable funds, without any explanation given.

We know there may be difficulties in getting reliable data on Scope 3 emissions and that it is not currently mandatory for companies to disclose these emissions. However, we remind AFMs that they should explain any material data considerations or limitations in fund disclosures and include the necessary contextual information about the use of third-party ESG and sustainability methodologies.

Some AFMs also explained that their funds continue to invest in carbon-intensive sectors with a view to promoting the transition to net zero emissions. However, investors may not expect an ESG or sustainable fund to have greater emissions than a non-ESG or non-sustainable fund. The AFM’s approach should therefore be explained in disclosures, also with reference to any of the AFM’s relevant engagement activity, to ensure these are fair, clear and not misleading, in line with COBS 4.2.1R.

Firm-level disclosures are not easily reconcilable with fund-level disclosures.

It was common for the fund prospectus to have little detail on ESG and sustainability policy goals and instead investors were referred to firm-level policies that gave greater detail. We saw this particularly among AFMs who ran several funds with different ESG and sustainable investment characteristics, investment strategies and asset types.

We often found the contribution of an individual fund to firm-wide ESG and sustainability goals was not disclosed and, therefore, the nature and extent of ESG and sustainability outcomes a fund aimed to deliver was unclear. Individual funds often varied in their alignment to the firm-wide ESG or sustainability policy, even though the firm policy was described as a minimum standard.

AFMs should review and consider how they can improve and reconcile fund and firm-level disclosures in line with COBS 4.2.1R to ensure they are appropriately aligned and provide a clear indication of the ESG and sustainability goals the product aims to achieve. AFMs should consider the impact of the Consumer Duty on their funds, as relevant. We also remind AFMs that our climate-related disclosure rules[10] include requirements to disclose material differences between fund and firm-level approaches, where relevant.

Key ESG and sustainability information was often not presented coherently and accessibly.

Documents, and cross-references in documents, were often not linked together in a clear and coherent way. This may make it challenging for investors to understand key features of the fund and its ESG or sustainability-related performance.

Fund factsheets were the most common medium used by AFMs for ongoing reporting on the ESG and sustainability characteristics of their funds and were usually displayed on the AFM and third-party websites, including platform providers. However, some AFMs included further ESG and sustainability-related information in supplementary reports that were not displayed as prominently as the factsheet. In some cases, we found it difficult to navigate documents as key information was not where we would expect it to be and/or it was necessary to cross-refer between several documents to find it. We also identified some cases where the cross-references within the fund disclosures were out of date or no longer available. In some instances, AFMs did not provide any ongoing non-financial reporting or way of tracking the sustainability performance of their funds.

AFMs should review the quality and accuracy of cross-references in their disclosures and consider whether they are accessible for investors and presented in a clear, succinct and comprehensible way, in line with the Guiding Principles. We also remind AFMs to consider the impact of the Consumer Duty on their disclosures, where relevant.

Good practice: Disclosure

1. AFMs provide disclosures that are clear about the ESG and sustainability features of a fund, what it is designed to offer and how they measure performance on an ongoing basis.
2. AFMs, in explaining their use of benchmarks in the fund's prospectus and other consumer-facing communications, should ensure that the methodology, limitations and ESG data, including for ESG benchmarks, are made clear so that consumers can make informed and effective decisions.
3. AFMs test how information about the fund’s ESG and sustainability features are understood by investors. They also gather data about investors’ use of ESG and sustainability information on their website and use it to inform ongoing disclosures.
4. Links are used effectively in regulatory documents and factsheets to direct investors towards additional explanatory material around the AFM’s sustainability approach and its impact.

Overall, we found that AFMs need to refine their existing oversight and controls. We observed that AFMs’ governance arrangements had generally evolved over time and were adapting to maturing ESG and sustainability regulation. We saw AFMs encounter specific challenges in their oversight for older funds, including those that had been adjusted to incorporate ESG and sustainable objectives and policies post-launch. Governance records and management information were often lacking, which made evidencing key decisions, the rationale for those decisions and challenge required by our principles and rules, more difficult.

Effective oversight should mean that firms identify and appropriately manage risks of harm from practices that are inconsistent with existing regulatory requirements and the Guiding Principles. This is particularly important in light of the Consumer Duty.

Firms must act to deliver good outcomes for retail customers who hold, or are looking to invest in, ESG and sustainable funds. AFMs have a key role to play in this and should ensure that their strategies and intent are matched with appropriate oversight and control frameworks that are able to identify, monitor and manage the risk of poor outcomes, particularly from unclear ESG and sustainability disclosures.

Good practice: Governance

1. A strong product governance structure is in place around the AFM’s ESG and sustainable investment fund range. Risks relating to ESG are identified, monitored and reported through the governance structure.
2. Firms monitor ongoing adherence to the fund investment objective and policy, with exceptions reported to the relevant committee and overseen by the Board.
3. Management information relating to ESG and sustainability objectives and aims are monitored in the product governance structure.
4. Embedded investment policies and processes exist for ESG and sustainable investment funds, with relevant staff aware of them and involved in their delivery.