Investment products and the EU’s new Sustainability Strategy

Plans for ESG Benchmark Label and tightening of SFDR category 8 rules

The European Commission has announced plans to develop an ESG Benchmark label, and will tighten requirements for Article 8 funds under the Sustainable Finance Disclosure Regulation (SFDR) as part of its ‘renewed’ sustainable finance strategy.

Such a benchmark would be similar to the existing Paris-aligned and Climate Transition benchmarks, but would cover a wider range of sustainability and ESG factors. 

The Commission said that it will assess the possibility of creating an ESG Benchmark label, “taking into account the evolving nature of sustainability indicators and the methods used to measure them”.

Consequently, the Commission will carry out a study of existing ESG-related benchmarks, best practices and shortcomings, as well as minimum standards for EU ESG Benchmarks.

A separate review will be carried out of the minimum standards for both EU Climate Transition Benchmarks and EU Paris-aligned Benchmarks, to ensure that the underlying assets are compliant with the EU’s Green Taxonomy. 

European investors have already shifted significant amounts of money into indices aligned with the two climate benchmark methodologies. In May, Handelsbanken Fonder reallocated €12.5bn to funds aligned with the Paris-Aligned Benchmarks and AP2 moved SEK8bn (€790m) from its global equities and bonds portfolios into indices which apply the Paris-Aligned Benchmark methodology last year. Germany has also announced plans to shift €9bn of public pension money into two indices  based on Climate Transition Benchmark methodology.

In the UK, FTSE Russell has launched a series of Paris-aligned benchmarks in collaboration with Brunel, the local government pension pool. The series of equity indices cover a broad range of developed and emerging equity markets. They tilt both towards and away from constituents based on ‘exposure objectives’ including fossil fuel reserves and green revenues, and all aim to achieve a 50% emissions reduction over a ten-year period.

One investor, who didn’t want to be named, said that creating an ESG Benchmark Label “is going to be much more difficult for the EU to get right than it was for Carbon Benchmarks”.

“As we all know, unlike carbon, ESG scores are all over the place. So if the EU is going to come up with an ESG benchmark they are presumably also going to have to prescribe an ESG scoring framework as well, which requires the equivalent of an ESG taxonomy”.

 “They could say you can use any ESG scoring framework, as long as the ESG benchmark is, for example,  50% better than the standard market cap equivalent. But that means ESG benchmarks based on different providers' datasets and scoring frameworks will have dramatically different compositions – and it will be possible to game the system quite easily. For example an asset manager could come up with their own ESG scores”.

On SFDR, the Commission also plans to introduce minimum sustainability criteria for funds which fall under Article 8. It said that implementing the standards would both guarantee sustainability performance, and “incentivise transitional efforts”.

A Morningstar survey of around 6000 Luxembourg domiciled funds at the end of March found that 18% were classified as Article 8 funds, with Article 8 and 9 funds accounting for assets of €768bn. Amundi and BNP Paribas alone had 839 Article 8 and 9 funds between them.

In further attempts to combat greenwashing, green, social and sustainable securities may also be subject to targeted prospectus disclosures from 2022. The Commission said that this would enhance the “comparability, transparency and harmonisation” of information provided.

The UK’s Financial Conduct Authority is also moving forward with plans to regulate the labelling of ESG-oriented funds. An announcement is expected this month on a set of principles for ESG and sustainability fund designs and disclosures, and the Treasury announced plans to introduce a sustainable fund mark last week. 

In another ESG regulatory development elsewhere, the Hong Kong Securities and Futures Commission (SFC) introduced increased disclosure rules for ESG funds last week. From January 2022, funds domiciled in Hong Kong will have to disclose ESG information including engagement policies and ESG investment strategies, as well as report annually on engagement and whether the fund “attained its ESG focus”.  The new rules are less strict than the EU’s SFDR, but a HSBC report said the bank expects “the SFC to further tighten the criteria to avoid another round of ‘greenwashing’”.