The European Union's ESG initiative - Part 2

Meeting the objectives outlined in the Paris Climate Agreement (COP 21) and the UN's 2030 Agenda and Sustainable Development Goals (UN SDGs) is a priority for many governments. As part of its efforts to achieve these goals, the European Commission (EC) unveiled its Action Plan on Sustainable Finance in May 2018, a proposal which will introduce a regulatory framework to support sustainable investment.

In addition to creating a taxonomy for Environmental, Social and Governance (ESG) investing principles and establishing meaningful buy-side ESG reporting standards, the EC's proposals will introduce significant changes to benchmarking practices. The EC hopes the rules will assist the single market with achieving its sustainability targets while also facilitating greater transparency for ESG investors using benchmarks.

New ESG benchmarks to help investors pursue sustainable strategies

The EC has confirmed it is looking to establish two categories of benchmarks. The first is a low-carbon benchmark, the constituents of which will be expected to have lower carbon emissions than the underlying assets on a standard investment index,¹ such as the FTSE 100 or S&P 500. The second index will be a positive carbon impact benchmark² composed of assets whose carbon emission savings exceed their overall carbon emissions.³

“While the low-carbon benchmark would be based on a standard 'decarbonizing' benchmark, the positive-carbon impact benchmark would allow an investment portfolio to be better aligned with the Paris Agreement objective of limiting global warming to below 2°C," according to a statement released by the UN Principles for Responsible Investment (UN PRI) in response to the EC's proposals.⁴ The EC said its Technical Expert Group will engage with relevant stakeholders on the design and methodology underpinning the two low carbon benchmarks, and a report will be published by mid- 2019.⁵

While the EC supports the development of a generally accepted market standard to measure a company's carbon footprint,⁶ the proposals are not advocating “a fully harmonized methodology."⁷ Nonetheless, the initiative will assist institutional investors to better monitor and compare the sustainability performance of their portfolio holdings.⁸

Adjusting existing ESG benchmarks to support investors' sustainability  agendas

Sustainable investing is being championed and encouraged by asset managers' end clients. According to a study conducted by Schroders in 2017, 78 percent of investors indicated that sustainable investing was more important to them now than five years ago.⁹ The same study found 64 percent of investors had increased their allocations into sustainable funds over the last five years,¹⁰ with AuM managed by responsible funds estimated to be at EUR 350 billion as of November 2017.¹¹

the initiative will assist institutional investors to better monitor and compare the sustainability performance of their portfolio holdings.

Index providers have responded to client demand by creating a number of ESG-linked benchmarks. FTSE, for example, has established the FTSE4Good Index Series, which is designed to measure ESG performance of companies to help firms create sustainable investment products.¹²

Agencies such as the UN PRI, however, have publicly stated that some ESG index providers are not wholly transparent about their methodologies, adding it could increase the risk of potential 'greenwashing'¹³ whereby a company purports to be green through advertising and public relations but has yet to implement meaningful solutions.¹⁴

The EC's proposals are likely to compel benchmark administrators into publishing how they factor ESG metrics into their sustainable benchmarks.¹⁵ Details about the precise nature of the disclosures are unclear, although more information is likely to be provided in the Delegated Acts. Enhanced transparency around ESG methodologies will be beneficial to end investors and the reputations of ESG benchmark providers.