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How the European Commission’s green benchmarks could transform capital markets

Elena Philipova
Elena Philipova
Director, Sustainable Finance, Data & Analytics, London Stock Exchange Group
Delphine Dirat
Delphine Dirat
Senior Manager, Industry and Government Affairs Sustainable Finance, LSEG

Of all the tasks that the European Commission’s technical expert group (TEG) on sustainable finance has undertaken in the past few years, its mission to develop investment green benchmarks could be the most significant yet.

  1. The green benchmarks are designed foremost to help investors assess investment opportunities according to a slate of climate-based factors.
  2. They will join up with the European Commission’s wider sustainable finance strategy.
  3. Some investors are split on the simplicity of the benchmark guidelines, and the degree to which they allow for ‘greenwashing’.

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After lengthy work on the TEG’s part – which since July 2018 has been building a framework, consulting lawmakers and affected parties, and proposing legislation – a draft delegated act was published in April 2020 for public consideration.

On 17 July 2020, the European Commission officially adopted the technical regulations. They set out the minimum technical requirements for the methodology that will govern ‘EU Climate Transition’, ‘EU Paris-aligned’ benchmarks and sustainability-related disclosure.

The technical regulations were then entered into application on 23 December 2020, and will join up with the EU’s wider sustainable finance strategy once the other pillars (taxonomy, green bonds and disclosure) of it fall into place.

And, as seen in a recent FTSE Russell study, these regulations can readily allow for the construction of indices that can achieve the TEG’s objectives and remain flexible for any future tweaks that may be necessary.

Discover more about the FTSE EU Climate Benchmark Indexes

What are the green benchmarks for?

The green benchmarks are designed foremost to help investors judge investment opportunities according to a slate of climate-minded factors. It is also hoped they will address the risk of greenwashing – the practice where financial products are marketed as ‘green’ or ‘sustainable’ despite not meeting basic standards.

They also come in two flavours to allow benchmark providers to offer EU Climate Transition-compliant benchmarks (EU CTBs), as well as those that are focused on the provisions outlined in the Paris Agreement at COP 21 (EU PABs).

It means that, in short, benchmarks compiled by third parties will have to adhere to several rules in order to be labelled as EU Climate benchmarks.

Foremost among them is a need to balance any allocations to sectors or firms that contribute highly to climate change – think oil extractives firms, or utilities that are powered by fossil fuels or similarly polluting substances – against the rest of their portfolios.

Benchmarks that wish to bear the EU’s designation will also have to exclude assets that “significantly harm” wider ESG objectives. There is a great deal of granular detail about what this entails in the technical standards, but in short means that anything named a “climate benchmark” must screen for tobacco firms, controversial weapons makers, and any companies that violate the UN Global Compact.

They must also report on a swathe of other ESG factors, including gender balance of workforces, boards and management teams, due diligence practices, anti-corruption efforts and good corporate governance policies.

Greenhouse gas emission disclosures must include Scope 1, 2 and 3 data and must be at least 30 per cent lower – or 50 per cent for stricter PABs – than the emissions of the investable universe. A ‘green to brown share ratio’ that tracks how assets are decarbonised for eligible holdings is another tool which may be brought into the rules.

What will it mean for investors?

The Commission maintains that by using these metrics – greenhouse gas intensity and market capitalisation (the main metrics for screening assets) – it ensures uniformity across sectors and does not discriminate against particular industries.

A FTSE Russell study analyses an EU PAB (FTSE All-World Paris-aligned Benchmark) as laid out by the TEG, using the FTSE Target Exposure framework over the 10-year period from 2009-2019.

It found that the resulting FTSE All-World PAB Index achieved a carbon emissions reduction of 50 per cent when compared with the FTSE All-World Index, while emissions at the end of 2019 were half their 2009 level, meeting the EU’s requirement to cut year-on-year carbon emissions by 7 per cent.

Other benefits of the FTSE All-World PAB index include a doubling of the proportion of green revenue compared with the FTSE All-World index; an ability to incorporate forward-looking assessments of the climate risks ahead of companies; and the capacity to extend the approach to meet CTB requirements, as also set out in the TEG report.

Yang Wang, the report’s lead author, wrote that the created index “is able to achieve all the required objectives specified in the TEG report and examine the sources of outperformance over the period”.

But some investors say that a blunt approach to some aspects, particularly how the framework proposes for market capitalisation-weighted indices regarding decarbonisation and its sector-agnostic approach. Others say that it could go further, and call for emissions trajectories to take real economic outputs into consideration in line with other leading initiatives.

As a release from State Street Global Advisors put it, implementing the TEG’s technical regulations “will likely result in some disruption”.

“For investors without any form of climate risk management currently, this will be even greater,” SSGA’s report adds. “Furthermore, the objective to meet the new climate benchmark requirements will also… likely make portfolio construction and investment strategy more complicated”.

Next steps for green benchmarks

That has not stopped other asset managers integrating the recommendations into their own climate transition plans.

One such example is Lombard Odier Investment Managers (LOIM), whose new green equity strategy has been informed by the Commission’s work on climate benchmarks and the green taxonomy.

Hubert Keller, managing partner of LOIM, said: “It represents one of several important steps we are taking across the firm to align all portfolios and capture the investment opportunities arising from climate transition.”

Since July 2020, a number of providers are already offering EU-aligned benchmarks.

FTSE Russell launched its PAB indices on 31 May. The index series is designed to reflect the performance of global, regional and domestic equity market indices, where constituents are alternatively weighted to seek to align with the goals of the 2015 Paris Climate Agreement.

Understanding the requirements of the benchmarks is of paramount importance in order to make sensible – and meaningful – investment decisions, and requires a deeper examination of portfolios on a granular level in order to align with the EU’s technical regulations.

There are still likely to be refinements as a few last kinks, concerns about how decarbonisation is measured, for example, and more oversights that may enable greenwashing on some scale.

Discover more about the FTSE EU Climate Benchmark Indexes