Scientific Beta has made a critical appraisal of the proposals of the TEG on climate benchmarks and benchmarks’ ESG disclosures. Our conclusions are that:
- they do not respect the spirit of the Regulation they are supposed to detail and exceed the scope of delegated acts;
- they have been overly influenced by commercial interests and champion the interests of a few ESG data and services providers rather than supporting genuine sustainability; and
- their flaws mean that they do little to discourage greenwashing or support decarbonisation efforts in the real economy, and fail to enhance decision-making on sustainability.
The report is both flawed and misguided
The 2019 update of the European Benchmark Regulation (Regulation (EU) 2019/2089) creates labels for benchmarks that are on a decarbonisation trajectory or are aligned with the Paris Agreement under the United Nations Framework Convention on Climate Change.
It also introduces a requirement for benchmark methodologies and statements to include explanations of how environmental, social and governance (ESG) dimensions are reflected when a benchmark pursues ESG objectives. These amendments are meant to harmonise and improve transparency in the market for sustainability benchmarks and ensure a high level of investor protection.
In this context, the legislator has empowered the European Commission to specify minimum standards in terms of asset selection and weighting and the determination of the decarbonisation trajectory and to lay out the minimum contents of explanations about ESG incorporation and its standard format. To assist in these matters, the European Commission has set up a Technical Expert Group, or TEG, on sustainable finance.
We have reviewed the proposals of the TEG that are to be used in the preparation of the Commission’s delegated acts, we find them wanting and we offer remedies.
1. The proposals of the TEG do not respect the spirit of the regulation and are out of scope
Instead of specifying how explanations on the incorporation of ESG dimensions should be provided, the TEG proposals establish long lists of ESG indicators – 25 for public equity benchmarks – to be computed and disclosed.
If implemented, these disclosures would modify the nature of the benchmark statement and entail considerable administrative and data acquisition costs. As such, they would become an essential dimension of the regulation, which would be inconsistent with the scope of the legislative delegation enjoyed by the European Commission.
We thus contend that the TEG proposals are ultra vires. It should be noted in this regard that the Commission has not undertaken any impact study on the costs and benefits of these proposals.
2. They are unduly influenced by commercial interests and champion the interests of a few select ESG data and service providers rather than sustainability
The composition of the working group that prepared the proposals is marked by a skew towards providers of ESG data and services and the under-representation of the potential end-users of benchmarks, especially pension funds, which are the main European institutional investors.
The regulation aims to protect the end-users, but the extensive ESG disclosures recommended by the proposals would primarily, and arguably almost exclusively, benefit providers of ESG data and services.
Ultimately, by making ESG disclosures especially onerous, the TEG proposals discourage the incorporation of ESG dimensions into benchmarks, create a unique competitive disadvantage for climate benchmarks and other benchmarks that pursue ESG objectives, and de-incentivise the voluntary adoption of these disclosures.
This is particularly worrying with regard to the need to fund the climate transition. Drowning indicators of climate impact and risk in a mass of metrics unrelated to the subject will make the benchmark statement confusing and the costs of these disclosures will bear on the economic efficiency of climate benchmarks.
3. They are flawed, do little to discourage greenwashing in the financial industry or support decarbonisation efforts in the real economy, and fail to promote better decision making around sustainability
The proposals contain three severe flaws.
- First, anchoring climate benchmarks on broad-market benchmarks considerably reduces the scope of the regulation by failing to take account of new forms of non-cap-weighted benchmarks, which, for many investors, are seen as more aligned with their fiduciary objectives, given the inefficiency of market indices, which has been widely documented in the financial literature. In relation to this, the crude control of the sectoral dimension of index decarbonisation at best gives a false sense of security in regards to greenwashing and at worst, encourages it.
- Secondly, the relevance and adequacy of the exotic carbon exposure metric introduced by the TEG has not been established. It is biased towards certain sectors and companies with large cash positions and the consequences of its volatility on the worthy index self-decarbonisation requirement suggested by the TEG have not been thought through. Last but not least, it mixes direct emissions and emissions from the purchase of electricity with indirect emissions throughout the value chain, even though the data in relation to the latter is too crude to support security selection, as the TEG itself readily admits. In this, it can lead to disregarding the efforts made by companies in the mitigation of their greenhouse gas emissions. This final effect is a pathetic travesty of the design of the regulation.
- The third severe flaw is the dramatic failure of the proposals to enhance transparency and enable market participants to make well-informed choices with respect to the incorporation of ESG dimensions into benchmarks. Indeed, the proposals give a central role to ESG ratings, which are by nature too heterogeneous to allow for meaningful comparisons and that can be easily manipulated, and fail to properly specify or standardise indicators that could have relevance for decision making, such as indicators of exposure to controversial or beneficial activities. Quite perversely, by requiring the disclosure of a list of indicators without guaranteeing their quality and by leaving benchmark administrators with a large degree of freedom in putting these disclosures in practice, the TEG proposals create a false sense of comfort with regard to the ESG quality of the benchmarks, and in this sense institutionalise ESG-washing.
Against this backdrop, we make three remedial recommendations:
1. Promoting high decarbonisation across all index strategies
To avoid narrowing the scope of the regulation, we recommend that climate benchmarks retain full flexibility with respect to sector exposures while being required to achieve a high level of decarbonisation in a manner that controls for any sector effects. The respect of the decarbonisation target of an index strategy should be assessed in relation to its non-decarbonised version rather than the market benchmark.
2. Adopting metrics that recognise the decarbonisation efforts of corporates and investors
We strongly recommend decarbonisation be primarily assessed using the generally accepted carbon exposure metric that the Taskforce on Climate-related Financial Disclosures has recommended for reporting (weighted average carbon intensity, where the carbon intensity of a corporate is the ratio of its direct and electricity purchase emissions to its revenues). The reduction of indirect emissions through the value chain should be promoted separately in a manner that is consistent with the granularity and other limitations of available data.
3. Avoiding misleading or irrelevant ESG disclosures and keeping ESDG data costs under check
ESG disclosures should remain focused on explaining how ESG dimensions are incorporated into such benchmarks. It is critical that ESG ratings not be given regulatory endorsement and that they remain excluded from minimum disclosures.
To be informative, disclosures in respect of ESG factors beyond what is strictly required under the regulation should be focused on exposure to desirable or controversial activities, precisely defined and highly standardised. The informational value of additional ESG disclosures should be sufficient to compensate for the administrative and data acquisition and redistribution costs that they entail and which will ultimately be borne by investors. To increase the informational value of disclosures and keep cost inflation in check, an administrative body should be tasked with maintaining a public list of compliant and non-compliant issuers.
Noël Amenc is chief executive of Scientific Beta and Associate Dean for Business Development, EDHEC Business School; and Frédéric Ducoulombier is ESG director at Scientific Beta.