Benchmark Regulation: adoption of ESG disclosure requirements and low-carbon benchmark criteria

On 17 July 2020, the European Commission adopted three delegated regulations (Regulations) under the EU Benchmark Regulation (Benchmark Regulation). The Regulations specify new disclosure rules for benchmark statements and benchmark methodologies, and prescribe minimum requirements for EU Climate-Transition Benchmarks (CTBs) and Paris-aligned Benchmarks (PABs). The Regulations follow draft regulations published in April 2020 (covered here) which were the subject of a brief consultation. Following the EU scrutiny period, the Regulations will be published in the Official Journal of the EU and will enter into force twenty days later.

Market participants have been obliged to comply with many of the rules set out in the Benchmark Regulation since 30 April 2020, but as the Regulations, which set out the detail of the rules, were not yet in force at that date, ESMA issued a "No-Action Letter" stating that national competent authorities should not prioritise supervisory or enforcement action until the Regulations were in place. Once the Regulations enter into force, market participants will be required to comply with the new rules, with limited exceptions for certain rules which do not apply immediately.

The three Regulations are summarised below.

Regulation on the explanation in benchmark statements of how ESG factors are reflected in benchmarks (the Benchmark Statement Regulation)

In the benchmark statement of each benchmark or family of benchmarks, the administrator must include an explanation of how ESG factors are reflected in that benchmark or benchmark family (Article 27 of the Benchmark Regulation). The Benchmark Statement Regulation prescribes the detailed disclosure requirements.

The disclosure requirements under the Benchmark Statement Regulation vary depending on the benchmark type (equity, fixed income, sovereign debt, commodity and other) and, within the benchmark type, are broken down further by reference to environmental, social and governance factors. Interest rate benchmarks and foreign exchange benchmarks are excluded as they do not have underlying assets that have an impact on climate change.

Where benchmarks blend different underlying assets, administrators must explain how ESG factors are reflected for each underlying asset. ESG factors are to be disclosed on an aggregated weighted average value basis at benchmark family or benchmark level, as applicable, rather than at benchmark constituent level. Additional information may be included where relevant, and where additional ESG factors are referenced under the Methodology Regulation (discussed below). Data sources and standards used must also be included.

For individual benchmarks, rather than populating the prescribed template, an administrator may choose instead to insert a hyperlink to a website that contains all the necessary information. The information needs to be easily available and accessible and must remain available for five years.

The information in the benchmark statement must be updated whenever there are significant changes to the ESG factors, and at least annually. Reasons for each update must be given.

Where a benchmark does not pursue ESG objectives, the template must be used nevertheless, but the administrator need only tick a "no" in the relevant box and the disclosure requirements will not apply.

Enhanced disclosure requirements apply for CTBs, PABs, significant bond benchmarks and equity benchmarks, including in relation to alignment with the objectives of the Paris Agreement . Similar disclosure is required in respect of other benchmarks and families of benchmarks, but, in line with the Benchmark Regulation, the rules do not apply to these benchmarks until 31 December 2021.

Regulation on the minimum content of the explanation of how ESG factors are reflected in a benchmark's methodology (the Methodology Regulation)

Administrators of benchmarks (except for interest rate, foreign exchange and commodity benchmarks) must provide an explanation of how the key elements of their benchmark methodologies reflect ESG factors (Article 12 of the Benchmark Regulation). The Methodology Regulation sets out the detail of the explanatory requirement.

As with the Benchmark Statement Regulation, the detailed disclosure rules in the Methodology Regulation vary between benchmark types (which are as set out in the Benchmark Statement Regulation). For benchmarks and families of benchmarks which are pursuing ESG objectives, the key requirement is to set out a list of ESG factors that are taken into account in the benchmark methodology, together with an explanation of how the factors are used for the selection, weighting or exclusion of underlying assets.

ESG factors must be disclosed on an aggregated weighted average value basis at the level of the family of benchmarks or the benchmark, as applicable. Additional ESG factors and related information may also be added where relevant. Data sources and relevant standards used must also be included.

For individual benchmarks, rather than populating the template, an administrator may choose instead to insert a hyperlink to a website that contains all the necessary information. The information needs to be easily available and accessible and must remain available for five years.

The explanation must be updated whenever there are changes to the benchmark methodology and at least annually. Reasons for each update must be given.

The Methodology Regulation also includes a standard form disclosure template. Where a benchmark does not pursue ESG objectives, the template must be used nevertheless, but the administrator need only tick a "no" in the relevant box and the disclosure requirements will not apply.

Regulation setting minimum standards for EU Climate Transition Benchmarks and EU Paris-aligned Benchmarks (the CTB and PAB Regulation)

The CTB and PAB Regulation sets out the minimum requirements to be met in order for a benchmark to be labelled a CTB or a PAB, and can be summarised as follows:

• Reference Temperature Scenario: the methodologies used to construct CTBs and PABs must use the 1.5°C temperature reference scenario referred to in the IPCC's Special Report on Global Warming of 1.5°C, with no or limited overshoot.
• Equity Allocation Constraints: the exposure to certain sectors (including transportation, construction, real estate and manufacturing) of CTBs or PABs based on equity securities admitted to a public market (in the EU or otherwise) must be at least equivalent to the corresponding aggregated exposure of the underlying "investable universe" .
• Calculation of Greenhouse Gas: administrators of CTBs and PABs must calculate the greenhouse gas intensity or, where applicable, the absolute GHG emissions of these benchmarks using the same currency for all of their underlying assets, and must recalculate the greenhouse gas intensity and the absolute greenhouse gas emissions of those benchmarks annually.
• Scope 3 (GHG) emissions data: administrators are required to include Scope 3 GHG emissions data in CTB and PAB methodologies, but the requirement is being phased in as follows:
  
  • data relating to the energy and mining sectors must be included from the date on which the rules start to apply; 
  • data relating to additional prescribed sectors (including the transportation and construction sectors) must be included within two years from the introduction of the rules; and 
  • data relating to all other relevant sectors must be included within four years from introduction of the rules. 
  
  Between the date of its application and 31 December 2021, CTB and PAB administrators may use fossil fuel reserves where they demonstrate that they can neither calculate nor estimate Scope 3 GHG emissions data.

• Weight increase of companies that set and publish GHG emission reduction targets: administrators of CTBs and PABs may only increase the benchmark weight of issuers of constituent securities that set and publish GHG emission reduction targets where those issuers:
  
  • consistently and accurately publish their Scope 1, 2 and 3 GHG emissions; and
  • have reduced their GHG intensity or, where applicable, their absolute GHG emissions, including Scope 1, 2 and 3 GHG emissions, by an average of at least 7% per annum for at least three consecutive years.
• Decarbonisation trajectory: the decarbonisation trajectory target of CTBs and PABs must be at least, on average, an annual 7% reduction of GHG intensity or absolute GHG emissions. Administrators must disclose the decarbonisation trajectory targets and, if the targets are not met, the reasons for that failure and the steps that they will take to reach the adjusted compensating target referred to below.
• Loss of label: if a target is missed, the administrator must upwardly adjust the following year's targets in compensation. If a target is missed in a given year and this is not compensated in the following year, or a target is missed three times in any consecutive 10-year period, the administrator may no longer label the benchmark as a CTB or PAB. Thereafter, the benchmark may be relabelled as a CTB or PAB if it meets its decarbonisation trajectory target for two consecutive years, provided that it has not already lost the label twice.
• Baseline reduction of GHG intensity or absolute GHG emissions: for CTBs, the GHG intensity or the absolute GHG emissions must be at least 30% lower than the combined GHG intensity or absolute GHG emissions of all of the investable instruments in the asset class in question. For PABs, this figure is higher, at 50%.
• Excluded companies: administrators of CTBs must initially disclose in their methodologies only whether and how they exclude companies. By 31 December 2022, they will be required to exclude certain types of company, including companies involved in weapons-related activities and companies which are considered to significantly harm any of the six environmental objectives set out in the EU Taxonomy Regulation .

PABs may not reference any companies which:

• are involved in any activities related to controversial weapons;

• are involved in the cultivation and production of tobacco;

• are in violation of the United Nations Global Compact principles or the Organisation for Economic Co-operation and Development Guidelines for Multinational Enterprises;

• derive 1% or more of their revenues from exploration, mining, extraction, distribution or refining of hard coal and lignite;

• derive 10% or more of their revenues from the exploration, extraction, distribution or refining oil fuels;
• derive 50% or more of their revenues from the exploration, extraction, manufacturing or distribution gaseous fuels;
• derive 50% or more of their revenues from electricity generation with a GHG intensity of more than 100 g CO2 e/kWh; or
• significantly harm one or more of the environmental objectives referred to in the EU Taxonomy Regulation.

Conclusion

The timing of the Regulations (and the ESMA No-Action Letter) was sub-optimal for benchmark administrators, who were keen to have a smooth transition to the new requirements. However, when the Regulations enter into force later this year, there will be more certainty over benchmark methodology requirements. The minimum standards for CTBs and PABs should also mean we can begin to see the first of these types of benchmarks entering into the market. For the European Commission, this is a big step forward towards achieving some of the objectives set out in its Action Plan on Financing Sustainable Growth.

Authors: Lorraine Johnston, Mike Logie and Kirsty McAllister-Jones