What are the new minimum ESG standards for benchmarks?

Commission Delegated Regulation (EU) 2020/1818

Background

Undertakings for collective investment (“UCIs”) promoting environmental and/or social characteristics, having a sustainable investment objective or more specifically a CO₂ emissions reduction objective will make extensive use of benchmarks to measure and disclose their environmental, climate and social performance.

The Delegated Acts¹ required by theLow Carbon Benchmark Regulation² have been published in the Official Journal of the European Union on 3 December 2020 and entered into force on 23 December 2020. They set out the environmental, social and governance disclosure requirements for benchmarks provided in accordance with the EU Benchmark Regulation³ as well as the minimum standards for EU Climate Transition Benchmarks (“EU CTB”) and Paris-Aligned Benchmarks (“EU PAB”).

Primary Change

Regulation (EU) 2020/1816 provides templates to be used by benchmark administrators to explain how environmental, social and governance (“ESG”) factors are reflected in each benchmark they provide.  Regulation (EU) 2020/1817 defines the minimum content of the explanation on how ESG factors are reflected in the benchmark methodology.

Regulation (EU) 2020/1818 requires implementation of common methodologies for (1) calculation of greenhouse gas (GHG) intensity or absolute emissions and changes in those indicators, (2) overweighting of companies setting and publishing GHG emission targets, and (3) setting a decarbonization trajectory for both EU CTB and EU PAB.

Regulation (EU) 2020/1818 also introduces an equity allocation constraint and disclosure requirements for the decarbonization trajectory, estimations and accuracy of the data sources used.

The thresholds for baseline reduction of GHG intensity or absolute emissions and exclusion criteria are stricter for EU PABs which are promising a greater impact on climate change in comparison to EU CTBs.

Key Points

1. Factoring ESG in benchmarks

Statements of benchmarks other than interest rate and foreign exchange benchmarks should explain, using the template provided in Annex I of Regulation (EU) 2020/1816  how ESG factors listed in Annex II of the same regulation are considered including:

• The score of ESG factors for the corresponding benchmark and family of benchmarks at an aggregated weighted average value
• How ESG factors are reflected for each of the underlying assets
• References to the sources of data and standards used for the ESG factors disclosed
• The scores of any additional ESG factors
• The additional disclosures applicable to CTBs and PABs, as required in sections 2 and 3 of Annex I

For individual benchmarks, administrators may replace the above information by a hyperlink to a website that contains all required information.

2. Factoring ESG in benchmark methodologies

With the exception of commodity benchmarks, administrators should explain which factors referred to in Annex II of Regulation (EU) 2020/1816 have been taken into account in their methodology and how they are reflected in the key elements of the methodology, including the selection of underlying assets, weighting factors, metrics and proxies. Commission Delegated Regulations (EU) 2020/1816, 2020/1817 and 2020/1818 of 17 July 2020.

Where a benchmark blends different types of underlying assets, the administrator should explain how ESG factors are reflected for each of the relevant assets.

Administrators should clearly state whether benchmarks do or do not pursue ESG objectives. Information about the methodology provided should be updated at least annually or whenever the methodology is changed and state the reasons for the update.

Information should be included on the type of data used (reported, modelled or sourced internally or externally), the third-party data provider, where applicable, and the processes implemented to assess data quality. International standards used in the methodology should also be described.

3. Common standards for Climate Transition Benchmarks and Paris-Aligned Benchmarks

• Reference temperature scenario

Benchmark administrators are required to use the 1.5°C scenario, with no or limited overshoot, referred to in the Special Report on Global Warming of 1.5°C from the Intergovernmental Panel on Climate Change, as the reference scenario to design the methodology to construct CTBs and PABs.

• Equity allocation constraint

The aggregated exposures of equity-based benchmarks to the sectors which contribute the most to climate change, including oil, gas, mining and transportation, must be at least equivalent to the aggregated exposure of all investable equities (“investable universe”) to those sectors in order to ensure that equity investors maintain their influence via engagement and voting. Those sectors correspond to the activities included in the draft technical standards of the taxonomy regulation⁴.

• Calculation of GHG intensity or absolute GHG emissions and annual change

The GHG intensity is defined as the absolute GHG emissions (tonnes of CO₂ equivalent) divided by millions of euros in enterprise value including cash (“EVIC” which is the sum of the market capitalization of ordinary and preferred shares and the book value of total debt and non-controlling interests without deduction of cash or cash equivalents).

GHG intensity should be the main parameter to calculate the decarbonization strategy since it ensures comparability and is not biased for or against a particular sector. Where benchmarks apply to fixed-income instruments of companies whose equity securities are not listed, administrators are allowed to use GHG emissions on an absolute basis.

The calculation should be performed on a yearly basis and use the same currency for all underlying assets.

Annual change should be calculated as a percentage between data at the end of year n and data at the end of year n-1. A new base year should be used whenever significant changes are applied to the calculation methodology.

• Phasing-in of Scope 3 GHG emissions data in the benchmark methodology

Due to insufficient quality of Scope 3⁵ GHG emissions are indirect emissions of upstream and downstream activities that occur in the value chain of a reporting company GHG emissions data, their inclusion in the calculation is phased in according to the sector:

- As of 23 December 2020 for the energy and mining sector (until 31 December 2021, benchmark administrators may use fossil fuel reserves where they demonstrate they cannot calculate or estimate Scope 3 GHG emission data)

- As of 23 December 2022 for the transportation, construction, buildings, material and industrial sectors

- As of 23 December 2024 for all other sectors

• Companies setting and publishing GHG emission reduction targets

The weight of issuers of the constituent securities that set and publish GHG emission reduction targets can be increased in the benchmark if:

-The issuers publish consistently and accurately the Scope 1, 2 and 3 GHG emissions and

-The issuers have reduced their GHG intensity or, where applicable, their absolute GHG emissions by an average of at least 7 % per annum for at least three consecutive years

• Setting a decarbonization strategy

The following targets⁶ apply:

For each year in which these targets are not achieved, the missed target should be compensated by adjusting upwards the targets for the following year.

Where the missed target is not compensated in the following year or the targets are not achieved on three occasions in any consecutive ten-year period, the administrator can no longer use the EU low carbon benchmark labels until the target is reached for two consecutive years following the loss of label, provided that the benchmark did not loose the label twice in which case the label is lost permanently.

4. Specific criteria for Climate Transition Benchmarks and Paris-Aligned Benchmarks

• Baseline reduction requirements

• Exclusion criteria

Any additional exclusion criteria based on climate-related, other environmental, social and governance factor should be disclosed in the benchmark methodology.

5.Transparency and accuracy

Administrators of low carbon benchmarks should formalize, document and make public:

•  the methodology upon which estimations of GHG emissions and significant harm of environmental objectives are based, including the approach and research methodology, the main assumptions and precautionary principles underlying those estimations
•  where external data sets are used, the name and contact details of the data providers, the methodology used and the main assumptions and precautionary principles, where available, as well as a hyperlink to the website of the data provider and to the relevant methodology used, where available.

The decarbonization strategy of the benchmarks should be formalized, documented and disclosed, including the base year and where the targets are not met, the reasons for the failure and the remediations steps to be taken to reach the next year’s adjusted target.

Data on Scope 1, 2 and 3 GHG emissions should be accurate and consistent with global or European standards such as:

• the Product Environmental Footprint, the Organisation Environmental Footprint methods
• the Corporate Value Chain (Scope 3) Accounting and Reporting Standard⁹
• the EN ISO 14064 or EN ISO 14069

The standard used should be disclosed in the methodology.

Practical considerations

Light green and dark green UCIs designating an index as a reference benchmark will make extensive use of benchmark statements to fulfil their own disclosure requirements under the SFDR¹⁰. Therefore, UCIs should examine carefully the new benchmark required disclosures and should map them with their own disclosures where appropriate.

According to SFDR¹¹ draft delegated technical standards, such UCIs should explain in their precontractual disclosures:

• how the reference benchmark is continuously aligned with each environmental and/or social characteristic or the sustainable investment objective and the investment strategy
• where an index is designated as a reference benchmark consistent with each environmental and/or social characteristics promoted or the sustainable investment objective, how that index differs from a broad market index

Where the index methodology is not aligned with environmental and/or social characteristics or the sustainable investment objective, UCIs should include a prominent statement that the reference benchmark is not consistent with those environmental and/or social characteristics or the sustainable investment objective.

Such UCIs will also need to publish on their websites some information on the benchmark’s input data, the methodologies used to select that data, the rebalancing methodologies, the underlying components, how the index is calculated and the effect of leverage within the index. Alternatively a hyperlink to the benchmark administrator website may be included.

For financial years starting after 1 January 2022, such UCIs will also need to include in their periodic reports an explanation of how the index designated as a reference benchmark differs from a broad market index, including at least the performance during the reference period of the sustainability indicators deemed relevant by the UCI to determine the alignment of the index with the sustainable investment objective and the sustainability factors referred to in the benchmark statement of the benchmark administrator.

UCIs with a CO₂ emissions reduction objective should include in their precontractual documents and websites a statement that the reference benchmark qualifies as a EU CTB/PAB benchmark.

Their periodic report should include a description of the contribution of the product to achieving the long-term global warming objectives of the Paris Agreement, including, in respect of a EU CTB/PAB Benchmark, the ESG factors and criteria considered by the benchmark administrator.

For more information, please read: Link to Regulation (EU) 2020/1816

For more information, please read: Link to Regulation (EU) 2020/1817

For more information, please read: Link to Regulation (EU) 2020/1818 

¹Commission Delegated Regulations (EU) 2020/1816, 2020/1817 and 2020/1818 of 17 July 2020

²Regulation (EU) 2019/2089

³Regulation (EU) 2016/1011

⁴Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment

⁵Scope 3 emissions are indirect emissions of upstream and downstream activities that occur in the value chain of a reporting company

⁶Such targets should be calculated geometrically and EVIC of the constituent securities should be adjusted where necessary

⁷As referred to in international treaties and conventions, United Nation principles and, where applicable, national legislation

⁸Referred to in Article 9 of Regulation (EU) 2020/852: Climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, protection and restoration of biodiversity and ecosystems

⁹Supplement to the GHG Protocol Corporate Accounting and Reporting Standard

¹⁰Regulation (EU) 2019/2088 on sustainability related disclosures in the financial sector

¹¹See the Final Report on SFDR draft Regulatory Technical Standards from European Supervisory Authorities. This section’s considerations are based upon this draft delegated act and subject to change