August 17, 2022 | Ali Abbas
Estimated reading time: 6 minutes
Greenwashing won’t wash: FCA’s Dear CEO letter commits to all 3 pillars of ESG
Environmental, Social and Governance (ESG) were – in the not so distant past – considered mere charitable efforts to modernise financial services. Over the last few years, we’ve seen global regulators commit to tackling the three pillars of ESG, though most endeavours have thus far confronted the ‘E’ – climate change and the associated risk.
In a Dear CEO letter to alternative fund providers, published by the FCA, the regulator has firmly committed to moving forward on all three pillars of ESG, noting that the sector is “evolving as markets and investor needs change”.
The letter, which outlines the FCA’s view of “the main risks of harm” in the alternative investment space, focuses on three main supervisory priorities for the FCA:
- Putting consumers’ needs first
- Strengthening the UK’s position in global wholesale markets
- An ESG strategy for positive change
Among more traditional expectations of firms, the FCA has – for the first time in direct communications – confirmed that it will be turning its attention to the incorrect or underhand marketing of products as ‘sustainable’ or ‘ESG-related’ – more commonly known as ‘greenwashing.’
The FCA calls on alternative investment firms to take action in 6 specific areas:
1. Consider the suitability of investments offered to customers
Despite a ban on mass-marketing of speculative investments to retail clients, the FCA remains concerned by the “inappropriate distribution and marketing practices” of some firms towards mainstream investors.
This is not a new area of concern for the regulator, but an area which continues to see “informal governance processes compounded by poor due diligence and inadequate investor categorisation.” Such oversight can often see instances of consumers saddled with products or investments that do not suit their individual needs, attitudes to risk or affordability.
2. Manage conflicts of interest fairly
Managing conflicts of interest is a foundational tenet in financial regulation and one that the FCA is keen to see demonstrated within alternative funds. Poor management of conflicts, the FCA notes, “can encourage market manipulation or improper fund performance reporting, in turn producing poor consumer
firms bypass their own processes to make sales or increase assets under management. Moreover, it has seen occasions where “dominant shareholders make material decisions independent of the firms governance structure.” Both of these scenarios see harmful conflicts which can lead to poor investment outcomes.
This is a clear indication that the FCA is moving away from only the ‘E’ in ESG and instead is turning towards all three pillars. Conflicts of interest and corporate accountability point towards an increasing focus on the ‘G’ – governance.
3. Harness and manage risk, especially in times of stress
Alternative funds often carry significant or more turbulent investment risks. As such, the FCA says within the Dear CEO letter that it expects firms to have systems in place that are proportionate to the nature, scale and complexity of any associated risks. Where risk levels are higher, the FCA of course expects to see that firms have tailored their risk management systems to ensure they’re fit for purpose.
Instead, the FCA has “seen firms overestimate liquidity in the context of stressed or fast-moving markets” and fail to adapt when circumstances become more challenging. In situations of high stress, it is crucial that firms have a tight rein on their risk and liquidity management and are investing in technology and operationally resilient processes to assist these endeavours.
4. Improve corporate culture for consumer protection and world-leading markets
As above, the FCA is tackling the gamut of ESG, moving away from a primarily climate-risk focus and on governance and social factors. Diversity and inclusion form an important part of both the ‘S’ (social) and ‘G’, with the overarching aim that financial organisations should represent their customers.
Over the last few years, the FCA has narrowed its focus on corporate culture, taking the view that a healthy culture is “critical for consumer protection and our ambition for well-functioning and world-leading markets”. Culture is all-encompassing and includes diversity and inclusion, how staff are incentivised and remunerated, all the way through to how comfortable individual employees feel in “speaking up”.
The FCA will be tightening its grip on culture in the coming months and looking for evidence of healthy cultures, and how senior managers and firms’ policies are acting to influence culture.
5. Don’t greenwash…ensure that ESG-focussed funds are not misleading
The FCA has seen a growth in both Authorised Funds that have stated an intent to utilise Environmental, Social and Governance (ESG) within their communications, as well as an increase in the number of Alternative Investment Fund registrations that have stated a focus on ESG.
The FCA – alongside other global regulators – is acutely aware of the issues surrounding ESG-labelled products. Specifically, it is concerned to ensure that any fund linked to ESG is actually an ESG-related product and not just labelled as such for saleability.
The regulator asks that firms “ensure that documentation of such products are clear, not misleading, and that firms’ actions match the stated claims”. In effect, the FCA is turning its focus to greenwashing and will be clamping down on greenwashing activity, following in the footsteps of its European counterparts.
What does the Dear CEO letter tell firms to do next?
Within the 6-page Dear CEO Letter, the regulator sets out a number of steps that it expects alternative investment firms where relevant and appropriate. These include:
- Consider the appropriateness or suitability of investments offered to customers prior to engaging;
- Reduce risks to consumers with limited investment knowledge or risk appetite by conducting thorough investor assessments;
- Review existing processes to ensure they are effective, including checking that professional investors meet the tests required by COBS 3.5 (and COBS 4.12 in the event that firms market non-mainstream, pooled investments) ;
- Consider and prepare for the implementation of the FCA’s new Consumer Duty;
- Carefully review procedures to ensure conflicts of interest are avoided, managed or disclosed;
- Consider shareholder structures and the implications they may have on effective governance;
- Ensure UK Market Abuse Regulation (MAR) controls are tailored to suit individual business models;
- Boards should ensure risk functions are appropriately resourced, contemporaneous and commensurate with the level of market risk and risk being taken; and
- Take steps to “provide an environment where diverse talent can flourish and diversity of thought is encouraged”.
What to watch out for?
As well as actions to take, the FCA’s Dear CEO letter took the opportunity to announce a number of events that firms should look out for over the coming months and years:
- The FCA will publish a consultation paper on diversity and inclusion in the latter part of 2022, it will expect boards to consider all aspects of this across organisations.
- Firms offering ESG products should “expect to be subject to review”.
- Alternative Investment Fund Managers with assets under management of over $5bn should be taking steps to implement the Task Force on Climate-Related Financial Disclosures (TCFD) rules by 2023.
- PS22/10 rules, which serve to strengthen financial promotion rules for high-risk investments will come into force on 1 December 2022, with further provisions in force on 1 February 2023. Firms should prepare accordingly.
As the FCA acknowledges, “the sector is evolving as markets and investor needs change”. However the purpose of the sector, “to protect and grow the capital of its customers and to effectively oversee investments in the long term” remains the same.
With changing markets and investor needs comes regulatory change to manage new and emerging risk. If you’re struggling to keep up with the volume and velocity of change and map it across your business, CUBE can help.