On 20 March 2023, the FCA published a Dear CEO letter to benchmark administrators setting out the findings of its preliminary review into ESG benchmarks. The review covered: (i) the quality of disclosures made by a sample of UK benchmark administrators; and (ii) the robustness and reliability of ESG benchmarks themselves. The FCA's key finding was that the overall quality of ESG-related disclosures made by benchmark administrators is currently "poor". In particular, the FCA considered that certain administrators have adopted the following unsatisfactory practices:
- Providing insufficient detail on the ESG factors considered in benchmark methodologies.
- Not ensuring that the underlying methodologies for ESG data and ratings products used in benchmarks are accessible, clearly presented and explained to users.
- Not fully implementing ESG disclosure requirements as set out in the UK version of the Low Carbon Benchmarks Regulation.
- Failing to implement their ESG benchmarks' methodologies correctly (e.g., by using outdated data and ratings or failing to apply ESG exclusion criteria).
Although these findings will be of direct relevance to UK benchmark administrators, they will also be of key interest to asset managers and other firms that incorporate ESG benchmarks into their investment decisions in some way, or that seek to measure performance of financial products in reliance on ESG benchmarks.
How do ESG benchmarks work?
ESG benchmarks may be used to determine the performance and the ESG credentials of various investment products (e.g., investment funds). Benchmark administrators are responsible for implementing the methodologies and calculations that define the ESG performance of the relevant products. Various market participants rely on such benchmarks to make investment decisions and the FCA is therefore keen to ensure accuracy in this space for investors.
Benchmark administrators provide indices that are used in:
- Financial instruments traded on trading venues or via systematic internalisers in the UK
- Mortgage or consumer credit contracts
- Investment funds
Often, practitioners find it difficult to discern the difference between an index and a benchmark. Both are defined in Article 3 of the retained EU law version of the Benchmarks Regulation (UK BMR). An index is a broader term which is used to describe any figure that is published and regularly determined. An index has the ability to become a benchmark when a figure is used to determine the financial return or value of a financial instrument. Benchmarks are best understood as analytical tools that help track the return of an investment fund, define asset allocation or compute performance fees. Thus, the role of a benchmark administrator is to use benchmarks as an analytical tool to demonstrate the ESG credentials of distinct investment products.
Risks, issues and action points for administrators
The Dear CEO Letter sets out the FCA's assessment of the risks observed and the issues identified in the preliminary review, along with action points for benchmark administrators to take in response to the concerns raised:
|Regulatory duty||Risks and issues identified||Action points for benchmark administrators|
|Benchmark statements|| |
Administrators must publish a benchmark statement for each benchmark, or, where applicable, for each family of benchmarks that may be used in the UK.
A template for ESG disclosures for benchmark statements can be found in the UK version of the Commission Delegated Regulation (EU) 2020/1816.
Administrators must provide explanations of how ESG factors are reflected against each of the requirements referred to in paragraph 2 of Article 27 of the UK BMR.
|All benchmark administrators in the FCA's review failed to provide sufficient explanations in their benchmark statements on how ESG factors are reflected against each of the requirements referred to in the UK BMR.|| |
Refer to ESG factors in explaining the rationale for benchmark methodology. In particular, ESG factors should be listed out, with an indication of whether they are being used for selection, weighting or exclusion.
Provide specific information on how key elements of the methodology reflect ESG factors for each benchmark or family of benchmarks, considering the underlying assets on which the benchmark is based.
|Benchmark methodologies|| |
Benchmark administrators must provide good-quality disclosures so that users and end-investors can assess the benchmark's ESG claims.
The minimum content of ESG methodology explanations is set out in the UK version of Commission Delegated Regulation (EU) 2020/1817.
The FCA found a lack of detail in benchmark methodologies. In some instances, benchmark methodologies did not clearly describe why certain ESG factors were applied.
Provide adequate disclosures so that users and end-investors can assess the benchmark's ESG claims.
Where a benchmark purports to have climate objectives only, but uses broader ESG metrics in its methodology, the benchmark administrator should clearly explain why the broader ESG metrics are appropriate, given that they also factor in social and governance factors.
|Low Carbon Benchmark Regulation|| |
Benchmark administrators must also provide specific information on how key elements of the methodology reflect ESG factors for each benchmark or family of benchmarks, considering the underlying assets on which the benchmark is based.
The minimum content of these explanations is set out in the UK version of Commission Delegated Regulation (EU) 2020/1816. Mandatory ESG factors for which scores must be provided based on underlying assets are detailed in Annex II of the same regulation.
The FCA found most disclosures omitted key information set out in the templates. Whilst this information was often contained in other documents, this was not clearly signposted.
All benchmark administrators in the FCA sample failed to provide sufficient information on the data and standards used to calculate the weighted average scores for their ESG factors. Descriptions of the data sources and the extent to which they are estimated or reported were particularly poor.
Several firms were not disclosing average weighted scores against all of the mandatory ESG factors.
|Provide specific information on how the ESG factors are reflected in each benchmark or family of benchmarks. These disclosures should display the corresponding score of the relevant ESG factors at an aggregated weighted average value. Provide sufficient information on the data and standards used to calculate the weighted average scores for their ESG factors.|
|Robust and reliability of ESG benchmarks||Benchmark administrators are required to use a "robust and reliable" methodology for determining a benchmark under Article 12 of the UK BMR.|| |
The FCA found several instances where benchmarks had been miscalculated due to the incorrect application of ESG factors.
The FCA found administrators had assessed constituents against outdated ESG ratings and data or failed to apply their ESG exclusion criteria when rebalancing.
The FCA observed that some administrators did not have adequate controls in place to verify that ESG factors had been correctly applied in their ESG benchmarks.
|Implement sufficient systems and controls to ensure compliance with regulatory duties. Disclose how data used in benchmark methodologies is verified and its quality assured, as well as which international standards it adheres to (e.g., the TCFD). Ensure that all these requirements are met each time the methodology is implemented, and the benchmark is determined.|
Benchmark administrators, and their senior leadership, should carefully consider the risks, issues and action points identified by the FCA, and have appropriate strategies to address them. The FCA expects administrators to be prepared to explain these strategies at the regulator's request. Given the importance of ESG benchmarks and initial findings from the review, the FCA plans to holistically consider the risks of harm related to ESG benchmarks across the value chain.
There are a number of other recent developments and initiatives relating to ESG regulation and data. The FCA supports the regulation of ESG ratings and is working with the government, which is expected to consult shortly on whether and how to extend the FCA's perimeter to include ESG ratings providers. However, adoption of the legislative measures necessary to achieve this will take some time – to that end, the FCA has formed a working group to develop a voluntary code of conduct for ESG data and ratings providers (for further detail, see our related client alert).