21 May 2020
Investors increasingly demand ESG and low-carbon indices to benchmark their portfolio. But what are the potential pitfalls, and what are regulators doing about them, ask Gregory Campbell and Daniela Bunea
ESG is big business. Environmental, Social and Governance (ESG) and climate (or low-carbon) benchmarks offer a 'green' alternative to traditional benchmarks.
They aim to support sustainable investing and the transition to a low-carbon economy. Compared with traditional benchmarks, ESG benchmarks integrate ESG factors into their asset selection.
Sustainable investing is today a major consideration in investment strategy. Benchmark providers have been creating ESG-only benchmarks, which has helped them boost their revenues by catering to this sector. According to the Index Industry Association (IIA), ESG investing is the fastest growing area of benchmarks, with an increase of 60% and 14% in 2018 and 2019 respectively.
The availability of information via the internet has clearly facilitated the fast and affordable distribution of and access to ESG benchmarks. Harnessing the sentiment and interest, the administrators and index providers are also creating more supply with increasingly competitive ESG benchmarks through the use of technology. In the future, artificial intelligence and machine learning have the potential to expand access to such products. And finally EU institutions and regulators have recognised the need to focus on sustainability in the decade ahead.
What are the challenges (and solutions) for ESG benchmark providers?
ESG benchmark providers have faced several criticisms recently, mainly in relation to inconsistency and a lack of clarity and transparency around the ESG rating methodology.
There are increasing reports in the media on how ESG benchmarks have erroneously included impermissible companies within the index whose activities (such as dealing in arms, oil, gas etc.) is not compatible with the ESG objective and/or expected to contribute to a sustainable economy.
So how does it go wrong? Taking a step back, benchmark providers rely on ratings supplied by ESG rating agencies. These firms usually assess companies' performance and measure how they compare to peers. However, a common complaint has been that ESG rating providers and even the index providers themselves are not transparent enough.
That is due to the use of proprietary methodologies, which agencies prefer to keep secret for commercial reasons. Moreover, they can also have differing definitions of what constitutes ESG, as highlighted in an IOSCO report (see below).
All these lead to inconsistent and arguably opaque ratings, as flagged by the CFA Institute and other analysts.
The Global Sustainable Investment Alliance pointed out that sustainable investment professionals are generally unsatisfied with publicly-traded companies' climate-related disclosure, and they do not believe that markets are consistently and correctly pricing climate risks into company and sector valuations. In turn, the claimed inaccuracy of corporate data could result in an incorrect or high ESG rating given to a company that is not genuinely pursuing an ESG objective.
Plus, due to better reporting capabilities, large companies usually score better than smaller companies.
As the ESG landscape continues to evolve, ESG ratings agencies will need to continue expanding and refining their understanding of companies' activities and objectives. Some ratings agencies have also been requested by some of their large clients to deliver customised ratings (with a focus on e.g. human capital factors or gender factors) to meet specific needs. Recently, a professor of sustainable finance suggested the idea of creating a new climate rating system. In fact, the EU is currently exploring the possibility of a legislative initiative for an EU Green Bond Standard.
In recent years, there has been a significant increase of funds that track ESG benchmarks, such as ETFs. Once that benchmark tracker product is marketed to the public, the relevance, materiality and usability of the information presented is of paramount importance to investors and their financial advisers, because advisers and investors use that information to execute their due diligence in order to determine whether the product is suitable in terms of its risk and return profile, or whether other similar products are better suited.
So what are decision makers doing?
At global level, a number of ESG frameworks have emerged, particularly for issuers' disclosures on ESG matters. In its latest report on sustainable finance, IOSCO noted that many of these are high-level and voluntary in nature, without granular requirements, and purposefully allow issuers and asset managers the flexibility to tailor their disclosures. IOSCO warns that the lack of consistency and comparability across these frameworks could impair cross-border financial activities and raise investor protection concerns. However, we should not be surprised by this since we are just at the start of scrutinising ESG matters.
According to IOSCO, the range of ESG frameworks, investor confusion over terminology and the lack of a uniform taxonomy for sustainable activities could in fact make 'greenwashing' (that is to say making misleading low-carbon claims) worse.
The EU is leading the way with the launch of the European Green Deal - a roadmap for making the EU's economy sustainable. The EU Low-Carbon Benchmark Regulation, published in December 2019, aims to improve transparency and comparability of ESG benchmarks, reallocate capital towards climate-friendly investments, and prevent administrators from greenwashing.
The regulation distinguishes between EU Climate Transition Benchmarks and EU Paris-aligned Benchmarks by developing minimum standards for each of these categories. In addition, the regulation also requires benchmark administrators to make ESG disclosure by type of benchmark (equity, foreign currency, commodity, etc), and to explain how the key elements of their methodology reflect ESG factors for each benchmark or family of benchmarks.
On 9 April 2020, the European Commission published for consultation three draft Delegated Acts (Level 2 legislation) for the purpose of specifying more detailed requirements under this regulation. The timing of entry into force of Level 1 rules (30 April 2020) compared to the still undefined Level 2 rules could lead to significant divergence in implementation across EU Member States. Acknowledging that, ESMA sent a no action letter to EU national authorities, only the day before, asking them to not prioritise supervisory or enforcement action against administrators regarding Level 1 requirements until the Delegated Acts apply, and suggested to the European Commission to not delay the adoption of the Acts.
Meanwhile, the European Supervisory Authorities issued a joint consultation on technical standards for ESG disclosures on 23 April 2020. The purpose of the draft standards is to ensure that financial market participants and financial advisers provide the necessary information on the adverse impacts of investment decisions and financial advice to help investors to make informed investment decisions.
The key takeaway from these rules is that, from now on, benchmark administrators need to be much more rigorous in claiming and proving (on an ongoing basis) that they are only including the correct and appropriate constituents in their climate benchmarks.
What should an index provider be doing?
Benchmark and index providers have already been heavily hit by increasing regulation. The IIA has its own set of standards for members; IOSCO issued the (now) well known and adopted Principles for Financial Benchmarks, and local benchmark regulations are creeping in all around the world (not least the broad and far-reaching EU Benchmarks Regulation).
Choosing to administer and provide ESG and climate change benchmarks creates another layer to consider:
- design or differentiate between 'EU climate transition' and 'EU Paris-aligned' benchmarks according to these minimum standards, and then label their existing ESG benchmarks accordingly;
- identify proprietary ESG factors from the list of ESG factors included in the Level 2 text;
- explain which of the ESG factors have been taken into account when designing the benchmark methodology, and how those factors are reflected in the key elements of that methodology; and
- explain how ESG factors are reflected in each benchmark or family of benchmarks.
It remains to be seen whether administrators will find it easy to understand and make use of the different ESG factors. We believe that more guidance is necessary for each factor. Alternatively, this report by the Technical Expert Group on Sustainable Finance, which contains a more detailed description of each factor, could be of more help.
So, what lies ahead of us?
Undoubtedly, ESG benchmarks will not stop growing for some time to come, as more people are becoming aware of the impact of climate change and will want to reorient their investments towards more sustainable projects. We should not be surprised if ESG benchmarks achieve mainstream acceptance imminently. But with that expected future reality will come more scrutiny from regulators.
"All players, companies and index providers alike, will have to meet more rigorous and comparable standards and become highly transparent"
All players, companies and index providers alike, will have to meet more rigorous and comparable standards and become highly transparent.
It remains to be seen how the COVID-19 pandemic will affect the ESG segment. Preliminary data for Q1 2020 from various reports seems to reveal that ESG indices and ESG companies have outperformed other indices and non-ESG companies. Could that be a sign that ESG stocks are more resilient to crises? Only the future will show.
Notwithstanding COVID-19, it is still easier and less costly to get it right from the start, so you should invest the time and resources now to prepare for the increased regulatory scrutiny and investor expectations.
Get expert support where necessary. And don't forget that becoming best in class brings competitive advantage.
Gregory Campbell is a director at PwC UK and Daniela Bunea is a senior associate in the PwC UK regulatory insights team.