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.
The legislator has told the European Commission to specify minimum standards in terms of asset selection and weighting and the determination of the decarbonisation trajectory. We find the proposals of the Technical Expert Group (TEG) set up by the EC wanting.
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 entail considerable administrative and data acquisition costs. The EC has not undertaken any impact study on the costs and benefits of these proposals.
The working group that prepared the proposals is skewed towards providers of ESG data and services and under-represented by potential end-users of benchmarks, especially pension funds. 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 and other ESG benchmarks, and de-incentivise voluntary adoption of disclosure. Drowning indicators of climate impact and risk in a mass of metrics unrelated to the subject will make the benchmark statement confusing.
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.
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. This can disregard companies’ efforts in mitigating their greenhouse gas emissions. This 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 which can be easily manipulated. 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 and institutionalise ESG-washing.
We make three recommendations. Climate benchmarks should 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.
We strongly recommend decarbonisation be primarily assessed using the carbon exposure metric the Taskforce on Climate-related Financial Disclosures recommends 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). ESG disclosures should remain focused on explaining how ESG dimensions are incorporated into such benchmarks.
It is critical that ESG ratings are given regulatory endorsement and that they remain excluded from minimum disclosures. To be informative, ESG disclosures beyond what is strictly required under the regulation should be focused on exposure to defined desirable or controversial activities.