Summary
The EU technical expert group on sustainable finance (TEG) has published its Final Report on Climate Benchmarks and Benchmarks' ESG Disclosures. The TEG report follows agreement by the European Parliament and Council in February of this year on the text of a draft Regulation which will amend the EU Benchmarks Regulation. The draft amending Regulation provides for (i) environmental, social and governance (ESG) disclosures applicable to all benchmarks (save for currency and interest rate benchmarks), (ii) 'Paris alignment' disclosures applicable to all benchmarks, and (iii) the creation of two new types of "climate benchmarks" - 'Paris-Aligned' Benchmarks (PABs) and Climate Transition Benchmarks (CTBs).
In its final report, the TEG made recommendations in respect of all three areas of the forthcoming amending regulation:
- ESG and 'Paris-aligned' required disclosures: the TEG suggested that ESG disclosures in relation to benchmark methodology and benchmark statements be based on underlying asset classes and the maturity of market understandings of how to integrate ESG disclosures into such classes, and that 'Paris-aligned' required disclosures should essentially follow from the PAB disclosures; and
- Climate benchmarks: the TEG proposed a set of minimum technical methodology requirements to be met by benchmarks in order for them to qualify as PABs or CTBs.
Background
Following a report of the High-Level Expert Group on Sustainable Finance in January 2018, the European Commission put forward a legislative proposal for the creation of two new categories of low-carbon benchmarks in March of that year. In parallel, the Commission also established the TEG to provide it with technical advice in relation to the proposed new legislation. In February 2019, the European Parliament and Council reached political agreement on the text of a draft Regulation which will amend the EU Benchmarks Regulation. In accordance with its mandate, in its final report the TEG has made recommendations in respect of the draft amending Regulation in relation to the required ESG and 'Paris-aligned' disclosures and the two new categories of climate benchmarks. The TEG's recommendations will inform the delegated acts to be prepared by the Commission under the draft amending Regulation.
There are currently hundreds of benchmarks which describe themselves as having ESG or 'low-carbon' objectives to reflect climate change considerations. However, in the view of the legislators, the market has been slow to adopt these benchmarks due to their lack of objective methodology and harmonisation, limited clarity and varying degrees of reporting. These issues hinder the comparability, reliability and general practicality of such benchmarks. The draft amending Regulation and accompanying delegated acts are an attempt to address these concerns, and generally to encourage the take-up of climate change benchmarks.
ESG and 'Paris alignment' disclosures
Under the draft amending Regulation, administrators of all benchmarks or families of benchmarks - save interest rate and currency benchmarks, and subject to an opt-out for those benchmarks not pursuing ESG objectives - must provide the following disclosures:
- ESG methodology disclosures: an explanation of how the key elements of the benchmark methodology reflect ESG factors;
- ESG benchmark statement disclosures: inclusion in the benchmark statement of an explanation of how ESG factors are reflected in each benchmark; and
- 'Paris alignment' disclosures: inclusion in the benchmark statement of information on the degree of alignment with the target of carbon emission reductions or attainment of the long-term global warming target of the Paris Climate Agreement.
The TEG recommends setting out these disclosure requirements based on the current market understandings of how ESG considerations can be integrated into the valuation of assets as part of a particular asset class, or across similar asset classes. These understandings are more mature in some asset classes - such as listed equities or corporate and supranational bonds - than in other asset classes - such as asset-backed or private debt - where the market is still trying and testing new approaches and no consensus on how to take ESG factors into account has been reached. Consequently, the TEG recommendations on minimum disclosures for the methodology document and specifications for the benchmarks statements vary based on the maturity of ESG data and the considerations applicable to a given asset class. A list of indicators to be used in determining minimum disclosure requirements by asset class has been set out by the TEG in the report.
The TEG has also outlined disclosure templates in Appendix D of the report and provided specifications for the publication of ESG information that benchmark administrators would need to follow. The TEG recommends that the ESG factors in benchmark statements should be updated at least annually.
With regard to the requirement in the draft amending Regulation for benchmarks to disclose the degree of their alignment to the Paris Climate Agreement, the TEG noted that no broadly accepted framework or standard has yet emerged for disclosing an investment portfolio's alignment to a temperature scenario. The TEG therefore focused on the new PAB benchmark, noting that benchmarks that qualify as PABs must disclose certain related information (for example, to which temperature scenario it is seeking to be aligned and related methodology), and those which do not so qualify may nevertheless disclose similar information.
Climate Benchmarks
According to the TEG, the main objectives of the new climate benchmarks are to (i) allow a significant level of comparability of climate benchmarks' methodologies while leaving administrators with an important level of flexibility in designing their methodologies; (ii) provide investors with an appropriate tool that is aligned with their investment strategy; (iii) increase transparency on investors’ impact, specifically with regard to climate change and the energy transition; and (iv) disincentivise 'greenwashing' – i.e. the promotion of low-carbon indices as being equally environmentally relevant despite having different characteristics.
The TEG says in its report that the two types of climate benchmarks have a similar objective but are different in terms of their levels of restrictiveness and ambition. PABs are designed for highly ambitious climate-related investment strategies and are characterised by stricter minimum requirements. The TEG expects that the main users of PABs will be institutional investors such as pension funds and (re)insurance companies seeking protection against climate related risks. CTBs allow for greater diversification than PABs, and the TEG understands that users will be primarily institutional investors seeking a more aggressive position towards client change.
The TEG recommends a set of minimum technical methodology requirements that a benchmark must meet to qualify as a PAB or a CTB, the key features of which can be broadly summarised as follows:
- CTBs have to show a substantial decrease in overall greenhouse gas (GHG) emissions intensity compared to their underlying investment universes or parent indices;
- CTBs must be sufficiently exposed to sectors fighting against climate change;
- CTBs must be capable of reducing their GHG emissions intensity on an annual basis;
- CTBs and PABs must exclude companies involved in controversial weapons and companies which have been found to be in violation of global norms or in controversies arising from significant harm of at least one of the six environmental objectives; and
- PABs must further exclude companies which derive a specified percentage of their revenues from oil or natural gas exploration or processing or electricity generation above a threshold GHG intensity.
The TEG also recommends that administrators of such climate benchmarks adopt a 'green to brown share ratio' target of at least equal for EU CTBs and at least quadruple for EU PABs.
Next steps
The European Commission will use the TEG report as a basis for drafting delegated acts under the Regulation amending the Benchmarks Regulation, which is scheduled to be adopted by the end of 2019. The delegated acts are expected to be adopted by mid-2020 following a formal public consultation.
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Authors: Andrii Fokin and Mike Logie
