Regulation vital to ensure “transparency and rigour” of ESG benchmarks that play a key role in investors’ transition to net zero.
Institutional investors have welcomed the prospect of tougher regulatory oversight of ESG benchmark administrators, following a preliminary review by the UK Financial Conduct Authority (FCA) which found their overall quality of ESG-related disclosures was “poor” due to widespread failings.
“Passive products have recorded significant growth in recent years and can play an important role in the transition to a net zero economy. It’s essential to have access to high-quality ESG benchmarks to achieve this objective,” Marco Montanari, Global Head of ETF and Indexing Capability at HSBC Asset Management told ESG Investor.
“We welcome regulatory initiatives aimed at enhancing clarity for investors, harmonising the regulation concerning ESG benchmarks to the regulation of ETF/index fund managers, and aligning ESG related requirements across different jurisdictions.”
Last month, the FCA published a letter to ESG benchmark administrators outlining shortcomings identified in its preliminary review, including insufficient detail on the ESG factors considered in benchmark methodologies and a failure to fully implement ESG disclosure requirements.
The UK watchdog added that underlying methodologies for ESG data and ratings products used in benchmarks were not accessible, clearly presented and explained to users, pointing out that benchmark administrators had not implemented ESG benchmark methodologies correctly, using outdated data and ratings or failing to apply ESG exclusion criteria.
The FCA warned ESG benchmark providers to address the issues identified in its letter, with firms expected to explain their strategies “on request”.
“In a world where third-party ESG ratings have the ability to affect inclusion in benchmarks and the valuation of companies, it is high time the regulators ensure there is transparency and rigour in this area of the market,” Daisy Streatfield, Sustainability Director at global investment manager Ninety One, told ESG Investor.
“If we are to have an efficient market it is vital that benchmark objectives, construction and the methodologies that underpin appropriate and clear.”
The regulator told ESG benchmark providers that it will continue to monitor the quality of ESG-related disclosures and carry out additional work in this area to “address potential failings”.
It also said that it will use the “full range” of supervisory tools if relevant action is not taken to address the issues outlined in its preliminary review.
“We support the need for ESG benchmarks to evolve to reflect new ESG data availability and the developing regulatory environment in order to facilitate investor decision-making though greater transparency,” a spokesperson for BNP Paribas Asset Management told ESG Investor, albeit adding that the firm had not yet specifically reviewed the FCA’s position.
In 2021, assets in passively managed ESG funds represented around 40% of the total ESG fund market in the US (US$350 billion), according to a Morningstar report.
Joe Dabrowski, Deputy Director of Policy, PLSA, said: “We largely agree with the thrust of the FCA letter. The numerous approaches to ratings and scores used by index providers can lead to high degrees of variability, which is unhelpful to end-investors seeking to implement climate-aware investment strategies.
“As part of its Green Finance Strategy, the [UK] government has published a consultation on regulating ESG ratings providers to seek better outcomes for these products. This is a positive step. We also keenly await the outcomes of the industry-led working group that is developing an ESG Data and Ratings Code of Conduct to promote best practice in the market.”
Devil in the detail
In September 2022, the FCA outlined its expectations and highlighted the risk of poor ESG-related disclosures.
In a letter to providers, the FCA stressed the importance of high-quality ESG benchmarks to support trust in the market for ESG products and the transition to a net zero economy. It also noted the “subjective nature of ESG factors” give rise to an increased risk of inadequate disclosures in ESG benchmark statements.
The quality of the resulting benchmarks may not align with the expectations of their users and/or end-investors which may in turn impact the transition to a net zero economy, the FCA said in the letter.
Ninety One’s Streatfield noted that definition of ‘ESG’ remains unclear and ambiguous.
“Is it about reducing risk? Avoiding certain industries? Or having a positive impact? Different approaches to ESG assessment, ratings and benchmark construction will speak to different aspects of this,” she said. “Unfortunately, the devil is often in the detail.”
According to Streatfield, overall ESG data quality and evidence underpinning assessments is “often lacking”.
“Standards around data quality and transparency on quality should be a key area for the regulators to address,” she said. “In ensuring higher standards for rating and benchmarks, it is critical that regulators are mindful to avoid implying a single solution to an ‘ESG’ or ‘transition’ benchmark. This will not necessarily serve what consumers want or the planet needs.”
Most benchmarks used to reduce passive portfolio emissions are based on the two defined and regulated by the EU: Paris Aligned and Climate Transition.
EU lawmakers introduced criteria for Climate Transition Benchmarks (CTB) and Paris-aligned Benchmarks (PAB) into law in 2019, outlining a baseline standard for index providers designing tailored indexes and benchmarks for passive products to track.
Both are designed to keep to global warming to 1.5C above pre-industrial levels by 2050 by achieving emissions reductions year-on-year, but in practice may penalise investors and negatively impact the net zero transition, said Streatfield.
“If an investor wants to have the greatest contribution to delivering the Paris goals, arguably they should look to invest in higher carbon assets with potential to deliver net zero to support their transition in the short, medium and long term,” she said.
“A linear reduction can actually make it harder to invest in companies that will have the greatest positive impact on the transition over the long-term and will inevitably penalise investment in emerging markets where capital is most needed.”
PSLA’s Dabrowski added: “The PLSA has been calling on the Government for some while to progress and finalise the UK green taxonomy and to ensure climate reporting is embedded across the investment chain so there is a more consistent basis for asset owners to assess the ESG credentials of a given fund or equity.
“We look forward to engaging with the proposals when they emerge this autumn.”
An MSCI spokesperson said: “We are reviewing the FCA’s industry findings, and we will discuss with the FCA as part of our ongoing and regular engagement as an authorised benchmark administrator.
“MSCI supports a code of conduct that creates the foundations for ESG rating best practices, related to transparency and process, which protects the independence of ratings and methodologies.”
ESG Investor approached other ESG benchmark administrators for comment, including, S&P, ISS and FTSE Russell. All declined to comment.
Morningstar was unavailable to comment at the time of publication.
The FCA is conducting further work on ESG benchmark administrators and the quality of ESG-related disclosures but have not specified when it will publish its findings.
This article was updated to include additional comment from MSCI.