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New sustainable benchmarks regulation: read the small print

By Jon Hay
26 Feb 2019

The EU’s first piece of sustainable finance legislation sets rules for green investment indices. That is all well and good, but more promising is a hint that all the ordinary indices may have to admit how un-green they are.

The European Union has produced the first concrete result of its Sustainable Finance Action Plan, launched to great acclaim last March — a regulation establishing a new official label for low carbon investment benchmarks (essentially, bond and equity indices).

The text was agreed by the European Parliament and the Council of Ministers’ negotiators on Monday night. It still has to be finally voted through the Council and Parliament, but if that happens, it will become law.

It may be one of the last achievements of the current EU administration, which will soon close down, ready for European elections in May. They will bring a new set of Parliamentarians and commissioners to Brussels. Whether the new leaders have as much enthusiasm for sustainable finance as the last is hard to predict, but with populists on the march across Europe, the auguries are not encouraging.

The benchmarks law is probably one of the easiest and least controversial parts of the Action Plan — though that does not mean it is easy or uncontroversial.

Its main purpose is to prevent greenwashing — marketing things as green that aren’t — which was widely perceived to be a risk with the proliferation of investment indices claiming to be green, sustainable, ethical and so on. With no one officially checking these claims, investors were liable to be confused, or even misled.

Accordingly, the main thrust of the law is to establish two new official labels, which index providers can claim if their indices meet the criteria. The labels are voluntary.

Supporters of strong action on climate change have managed to influence the design of the labels. Originally, the two categories proposed were “low carbon benchmarks” — those carrying companies whose emissions were lower than the general market — and “positive carbon impact indices”, listing firms whose net effect was to reduce emissions, such as wind turbine makers.

Taking into account suggestions from NGOs and others, the European Parliament pushed for these to be changed. The two bands will now be “climate transition benchmarks” and “Paris-aligned benchmarks”.

The latter comprise companies that can demonstrate they are aligned with the target, enshrined in the Paris Agreement, for global warming to be held to no more than 1.5C, according to a statement from the Commission. (The final text of the law is not available yet.) This is quite a high bar, since to get to 1.5C, human carbon emissions need to be reduced very deeply and quickly, officially to zero by 2050 but in reality probably faster than that.

The easier group will be climate transition benchmarks. These are meant to encourage and highlight companies that, while not yet compatible with a 1.5C future, have committed themselves to a transition that will get them there.

So far, so good. Of course, the labels remain voluntary. Index providers will still be allowed to market indices dubbed green, ethical or sustainable, without carrying the label. But at least there will be an official standard investors can look to, once technical experts have spent the next couple of years devising it.

Less good is that, especially in the early years after the benchmarks are introduced, they will remain a specialist set of indices covering a subset of companies that have made strong commitments to change their models. They will say nothing about the great mass of companies, especially in emerging markets, in many of which the social pressure to look green is much weaker.

Beyond the converted

For climate change to be warded off, however, the whole economy has to change, not just the green avant-garde.

The best approach to benchmarks, promoted by some green groups, would have been to require every equity and bond index, of any kind, to declare what kind of climatic future the companies in it are going to produce, from 1.5C to, say, 6C.

That way investors would have had to confront the reality, which in their hearts most understand, but very few will utter: that nearly all investment portfolios are now financing a future of catastrophic climate change.

This suggestion was blocked from going into the law. But there is still a chance that something of that kind could emerge from it. The environmentally progressive forces in the EU legislative process appear to have managed to introduce some stipulations that apply to all benchmarks.

According to GlobalCapital sources, in one of its clauses that has so far received less attention, the law will require providers of all indices (except those on interest rates and currencies) to make a statement of how their investment strategy aligns with carbon emissions targets and/or the goals of the Paris Agreement.

For “significant benchmarks”, which is thought to mean equity and bond indices of over €50bn market capitalisation, the benchmark administrator will have to make a “detailed statement” on “whether or not and to what extent an overall degree of alignment with the target of reducing carbon emissions is ensured”.

Much will depend on the precise final wording that is approved, and on how this is interpreted by the secondary legislation, known as delegated acts, which explains how to implement EU law.

But this could mean all mainstream indices have to carry a statement, at least somewhere in their small print, which discloses how well aligned they are with Paris. At the very least, they may have to satisfy this requirement by saying “we are not making an effort to be aligned”.

That will give pension funds and retail savers ammunition to ask asset managers why they are following benchmarks that are going to lead to destruction.

A small victory perhaps — but the principle that the Paris Agreement and carbon emissions are relevant even to mainstream indices has been established.

That is a notable official step along the road, which should be the aim of the whole Action Plan, and of sustainable finance in general: not just to make the green corner of finance greener, but to green the whole thing.

By Jon Hay
26 Feb 2019