The FCA’s reforms to the ESG labelling regime: Litigation funders could see a spike in enquiries

Litigation funders could see a spike in enquiries resulting from the Financial Conduct Authority’s (FCA) planned reform of the ESG sector, which are aimed at clamping down on firms engaging in ‘greenwashing’ when labelling their financial products. ‘Greenwashing’ is the practice by which misleading, inaccurate or over-stated claims are made (or even implied) in order to boost a business’s ESG credentials, with insufficient or no basis.

The FCA has put forward a raft of proposed regulatory changes for the ESG fund sector, and in doing so made clear its determination to ‘clean up’ the space by targeting funds which market themselves as ‘ESG-friendly’ but, in practice, do not adhere to ESG standards. In doing so, the FCA may open the door for claims from dissatisfied investors.

The FCA’s proposals reflect a worldwide increase in ESG and climate change reporting requirements, as changing public and investor attitudes to global warming lead to mounting pressure on politicians and regulators. As such, companies and their directors are facing increased risk of legal claims brought in relation to climate-related disclosure (or non-disclosure) and breach of fiduciary duty. These actions may take the form of significant group litigation on behalf of investors who (for example) made investments on the basis of false or misleading eco-statements which, when exposed, create losses for the fund, the company and – in turn – investors.

In response to the FCA’s plans, a cross-party Treasury Committee urged the regulator not to penalise investors in funds which make false sustainability claims, adding further pressure on fund managers to curb ‘greenwashing’. Members of the committee called on the FCA to protect investors, and to ensure that they do not have to pay to transfer their investments into funds which are labelled as ‘sustainable’, and properly so.

ESG Funds & the FCA’s Proposals

2022 saw UK investment into ESG funds reach a record £91 billion, up from £56 billion just two years earlier. However, the sector has seen a rise in ESG funds which seek to benefit from the popularity that comes with sustainable environmental credentials, but do not uphold the standards associated with the ESG label.

Under the new rules, only ‘true’ ESG funds will be allowed to brand themselves as such, so that investors are not duped by greenwashing.

Under the FCA’s proposed reforms, the ‘one size fits all’ ESG tag will be replaced by three more specific terms for funds to deploy:

  • Sustainable focus funds will need to invest at least 70% of capital in companies or government bonds that meet a ‘credible’ threshold of environmental and/or social sustainability.

  • Sustainable improver funds will have to clearly state in which areas they will and will not invest, and also outline their policies to influence for the better companies in which they own stock.

  • Sustainable impact funds will be required to ‘articulate a theory of change’, and regularly keep investors informed about their performance in helping to drive such progress.

With these changes, the FCA hopes to deliver sought-after clarity to investors, with many admitting to being confused and / or sceptical when surveyed about the current system.

Under the new rules, any fund with investments that deviate from its own stated ESG aims or credentials would be automatically excluded. Critics maintain that the regulations are too strict, risking exclusion of an estimated 60-70% of funds currently active in the sector. By contrast, supporters argue that the FCA is acting entirely in line with both moral and environmental norms: investors will be better shielded from misleading marketing by fund managers, and funds will be obliged to make good on their ESG promises if they want to continue to attract the ESG investor market.

What does this mean for ESG disputes in the UK?

These regulatory reforms will put funds’ public statements and fund managers’ investment decisions under a more powerful microscope by regulators and investors alike.

Firms are advised to take note of the heightened risk of regulatory non-compliance and legal action, and to scrutinise their own ESG statements and underlying activities. By way of example, one need only look at the recent filings with the US securities regulator in which Shell was accused of misrepresenting its renewable energy investment claims, thereby purportedly misleading investors. The complaint saw Shell’s name added to a growing list of major firms accused of greenwashing, including Nestlé, Exxon Mobil, and Coca Cola, as activists and investors call on companies not to overstate their ESG credentials and to keep their ESG promises.

As rules tighten across the ESG spectrum and the costs associated with meeting increasingly stringent compliance requirements rise, there will be plenty of funds who, having assessed the increased risk, decide to exit the sector. Further, rising insurance premiums linked to potential adverse legal actions by investors will put off many existing and potential operators in this market.

However, for those who remain active in the space, regulatory scrutiny will increase and become more difficult to avoid. The FCA’s new measures are just one of many reforms the sector will undergo as the climate challenge heats up. In the meantime, companies active in the sector must ensure: (1) their underlying operations align with public statements regarding their ESG credentials, to avoid claims they have misled investors; and (2) compliance with the new FCA regulations if they wish to continue using and benefitting from ESG branding and recognition.

Written by Kate Gee and Alasdair Marshall of Signature Litigation.