Unsustainable Proposals - ETicaNews · carbon exposure metric that the Taskforce on Climate-related...

Unsustainable Proposals A critical appraisal of the TEG Final Report on climate

benchmarks and benchmarks’ ESG disclosures and remedial proposals

February 2020

A Scientific Beta Publication

Table of Contents

We would like to thank Aditya Bhutra for excellent research assistance.Printed in France, February 2020. Copyright © 2020 Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document. The authors can be contacted at [email protected].

Introduction .................................................................................................................................................................. 7

1. The Proposals are Arguably Ultra Vires...........................................................................................................10

2. The Proposals have been Hijacked by Special Interests ...........................................................................13

3. The Proposals have Severe Flaws and Limitations ......................................................................................19

4. Remedies .................................................................................................................................................................48

Conclusion ...................................................................................................................................................................58

Appendix ......................................................................................................................................................................62

References ...................................................................................................................................................................62

About Scientific Beta ................................................................................................................................................67

Scientific Beta Publications ....................................................................................................................................69

2A Scientific Beta Publication — Unsustainable Proposals — February 2020Copyright © 2020 Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document.

The 2019 update of the European Benchmark Regulation (Regulation (EU) 2019/2089, hereafter the “Regulation”) creates labels for Benchmarks that are on a decarbonisation trajectory or are aligned with the Paris Agreement under the United Nations Framework Convention on Climate Change (hereafter “Climate Benchmarks”). The Regulation also introduces a requirement for the Benchmark methodology and statement to include explanations of how Environmental, Social and Governance (hereafter “ESG”) dimensions are reflected when a Benchmark pursues ESG objectives. The EU Climate Transition and EU Paris-aligned Benchmarks labels are meant to harmonise and improve transparency of the climate change index market at the EU level and to ensure a high level of investor protection by combatting misleading claims as to the environmental credentials of investments, or greenwashing. The introduction of disclosure requirements with respect to ESG incorporation into Benchmarks is intended to facilitate cross-border comparisons and help market participants make well-informed choices.

In this context, the legislator has empowered the European Commission to adopt delegated acts both to specify minimum standards in terms of asset selection and weighting and the determination of the decarbonisation trajectory and to lay out the minimum contents of explanations about ESG incorporation and their standard format. To assist in these matters, the European Commission has set up a Technical Expert Group, or TEG, on sustainable finance.

This white paper reviews the proposals of the TEG that are to be used in the preparation of the delegated acts, finds them wanting, and offers remedies.

The TEG proposals do not respect the spirit of the Regulation and are ultra viresWe observe that instead of specifying how explanations on the incorporation of ESG dimensions should be provided, the TEG proposals establish long lists of ESG indicators to be computed and disclosed as part of the Benchmark statement. If implemented, these disclosures would modify the nature of the Benchmark statement and entail considerable administrative and data acquisition costs for Benchmark administrators. As such, they would become an essential dimension of the Regulation, which would be inconsistent with the scope of the legislative delegation enjoyed by the European Commission. We thus contend that the TEG proposals are ultra vires.

The TEG proposals are unduly influenced by commercial interests and champion the interests of ESG data and services providers rather than sustainabilityWe show that the composition of the working group that prepared the proposals is marked by under-representation of the potential end-users of Benchmarks, which the Regulation aims to protect, and is skewed towards providers of ESG data and services, i.e. parties that stand to benefit from the proposals. We explain why Climate Benchmark anchoring on capitalisation-weighted indices, the adoption of an exotic metric for the assessment of decarbonisation and, most of all the introduction of extensive and onerous ESG disclosures of dubious relevance may be viewed as illustrations of a dismal failure of conflict-of-interest management on the part of the TEG. As per the spirit and the letter of the Regulation, ESG disclosures are only required of Benchmarks that pursue

Abstract

3A Scientific Beta Publication — Unsustainable Proposals — February 2020

Copyright © 2020 Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document.


ESG objectives. By making such disclosures especially onerous, the TEG proposals discourage the incorporation of ESG dimensions into Benchmarks, create a unique competitive disadvantage for Climate Benchmarks and other Benchmarks that pursue ESG objectives, and de-incentivise the voluntary adoption of these disclosures.

The TEG proposals are flawed, do little to discourage greenwashing in the financial industry or support decarbonisation efforts in the real economy, and fail to promote better decision-making around sustainabilityWe then review the TEG proposals in detail and discuss three severe flaws. First, we underline that anchoring Climate Benchmarks on broad-market benchmarks considerably reduces the scope of the Regulation and thus its ability to combat greenwashing and promote the reorientation of capital flows towards a more sustainable economy; we also explain how the proposals’ crude control of the sectoral dimension of index decarbonisation at best gives a false sense of security in regards to greenwashing and at worst, encourages it.

Then we question the relevance and adequacy of the exotic carbon exposure metric introduced by the TEG. We review basics of greenhouse gas emissions accounting and carbon metrics, observe that the recommendation of the TEG to deviate from the generally-accepted carbon exposure metric is neither supported by a literature review or a cost/benefit analysis. Last but not least, we expose biases of the TEG metric with respect to sectors and the cash position of companies and contend that the consequences of its volatility on the decarbonisation trajectory have not been thought through. We underline that its incorporation of data on indirect emissions through the value chain, which by the very admission of the TEG will not be fit for purpose of stock selection “for the foreseeable future”, may lead to disregarding the efforts made by companies in the mitigation of their greenhouse gas emissions. This final effect is a pathetic travesty of the design of the Regulation.

The third severe flaw is the dramatic failure of the proposals to enhance transparency and enable market participants to make well-informed choices in respect of the incorporation of ESG factors into Benchmarks. We indeed observe that the onerous ESG disclosures contained in the proposals have at best low informational value. This is primarily due to them being centred on metrics – ESG ratings – whose inherent divergence frustrates the possibility of meaningful comparisons across providers and that have serious theoretical limitations as indicators of ESG performance or risks. With rare exceptions, the rest of the recommended disclosures lack proper specification or standardisation to support meaningful uses by investors.

Against this backdrop, we make three series of remedial recommendations:

Promoting high decarbonisation across all index strategiesTo avoid narrowing the scope of the Regulation, we recommend that Climate Benchmarks retain full flexibility in respect of sector exposures while being required to achieve a high level of

Abstract

decarbonisation in a manner that controls for any sector effects (and show how this can be done). We also recommend that the respect of the decarbonisation target of an index strategy be assessed in relation to its non-decarbonised version rather than the market benchmark.

Adopting metrics that recognise the decarbonisation efforts of corporates and investors To respect the investments already made by concerned parties in the education of the public and the decarbonisation of Benchmarks and to incentivise companies to decarbonise their operations, we strongly recommend decarbonisation be primarily assessed using the generally accepted carbon exposure metric that the Taskforce on Climate-related Financial Disclosures (FSB, 2017) has recommended for reporting. The reduction of indirect emissions through the value chain should be promoted separately in a manner that is consistent with the granularity and other limitations of available data.

Avoiding misleading or irrelevant ESG disclosures and keeping ESG data costs under checkTo avoid de-incentivising the offering and adoption of Benchmarks that pursue ESG objectives and to promote well-informed decision-making in matters of sustainability, we recommend that, as per the letter of the Regulation, ESG disclosures remain focused on explaining how ESG dimensions are incorporated into such Benchmarks.

It is critical that ESG ratings not be given regulatory endorsement and that they remain excluded from minimum disclosures. To be informative, disclosures in respect of ESG factors beyond what is strictly required under the Regulation should be focused on exposure to desirable or controversial activities, precisely defined and highly standardised. The informational value of additional ESG disclosures should be sufficient to compensate for the administrative and data acquisition and redistribution costs that they entail and which will ultimately be borne by investors. To increase the informational value of disclosures and keep cost inflation in check, an administrative body should be tasked with maintaining a public list of compliant and non-compliant issuers.

Abstract

A Scientific Beta Publication — Unsustainable Proposals — February 2020Copyright © 2020 Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document.

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About the Authors

6A Scientific Beta Publication — Unsustainable Proposals — February 2020Copyright © 2020 Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document.6

Noël Amenc, PhD, is Professor of Finance and Associate Dean for Business Development at EDHEC Business School and the founding Chief Executive Officer of Scientific Beta. His concern for bridging the gap between university and industry has led him to pursue a double career in academe and business. Prior to joining EDHEC Business School as founding director of EDHEC-Risk Institute, he was the Director of Research of Misys Asset Management Systems, having previously created and developed a portfolio management software company. He has published numerous articles in finance journals as well as four books on quantitative equity management, portfolio management, performance analysis, and alternative investments. He is a member of the editorial board of the Journal of Portfolio Management, associate editor of the Journal of Alternative Investments, and member of the advisory board of the Journal of Index Investing. He is also a member of the Finance Research Council of the Monetary Authority of Singapore. He was formerly a member of the Consultative Working Group of the European Securities and Markets Authority (ESMA) Financial Innovation Standing Committee and of the Scientific Advisory Council of the AMF (French financial regulatory authority). He holds graduate degrees in economics, finance and management and a PhD in finance.

Frédéric Ducoulombier, CAIA, is ESG Director at Scientific Beta. From 2015 to 2019, he was in charge of risk and compliance for Scientific Beta having previously served EDHEC Business School’s risk and investment management research centre for 10 years as the founding Director of EDHEC-Risk Institute’s executive education arm and of EDHEC Risk Institute–Asia. At EDHEC Business School, he also taught economics and finance, managed graduate programmes and served as Deputy Associate Dean of Graduate Studies and Deputy Associate Dean of Research and Development. His research and advocacy work has focused on the purported risks of exchange traded funds, the governance and transparency of financial indices, non-financial risks in the fund management industry, smart beta and factor investing and the integration of environmental, social and governance criteria into investment. He was a member of the Consultative Working Group of the European Securities and Markets Authority (ESMA) Financial Innovation Standing Committee from February 2015 to January 2017. He holds a master’s in management from IESEG School of Management, a graduate certificate in East Asian Studies from a University of Montréal/McGill University program, and is a Chartered Alternative Investment Analyst® designee.

Introduction

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1 - The three objectives of the plan (COM/2018/097) are to: (i) reorientate capital flows towards sustainable investment to achieve sustainable and inclusive growth; (ii) manage financial risks stemming from climate change, environmental degradation and social issues; and (iii) foster transparency and long-termism in financial and economic activity2 - Understood as “a measurable, science-based and time-bound trajectory to reduce scope 1, 2 and 3 and carbon emissions towards the alignment with the long-term global warming target of the Paris Climate Agreement”.3 - For those benchmarks which are not pursuing ESG objectives, the amendment clarifies that it “shall be sufficient for benchmark administrators to clearly state in the benchmark statement that they do not pursue such objectives”.4 - For significant equity and bond benchmarks, as well as the CTBs/PABs, benchmark statements are also required to disclose whether or not and to what extent a degree of overall alignment with the target of reducing carbon emissions or the attainment of the objectives of the Paris Agreement is ensured. (Article 27 (2a)).

In March 2018, the European Commission adopted an action plan for financing sustainable growth1

which included establishing EU labels for green financial products to support the reorientation of capital flows towards a more sustainable economy. At end February 2019, European co-legislators agreed to amend the regulation applicable to index administrators and users (Regulation (EU) 2016/1011 on indices used as benchmarks, hereafter “Benchmark Regulation”) to create two labels for low carbon indices used as benchmarks and extend Environmental, Social and Governance (“ESG”) disclosure requirements for all benchmarks. The amendment was adopted on 27 November 2019 and came into force on 10 December 2019 (as Regulation (EU) 2019/2089).

As a growing number of investors pursue low carbon strategies, the legislators believe that the creation of labels for benchmarks that implement minimum standards of decarbonisation or are aligned with the Paris Climate Agreement (hereafter “Climate Benchmarks”) can contribute to better transparency and help prevent misleading claims as to the environmental credentials of investments, or greenwashing.

These labels are intended for benchmarks whose constituents are selected and weighted either so that the resulting benchmark portfolio is on a decarbonisation trajectory (“EU Climate Transition Benchmark” or “CTB”) or is aligned with the global warming target of the Paris Climate Agreement (“EU Paris-aligned Benchmark” or “PAB”). The commission is empowered by the amendment (Level I text) to adopt delegated acts to specify minimum standards in terms of asset selection and weighting and the determination of the decarbonisation trajectory, which should be published by 30 April 2020.2 By January 2022, administrators of significant benchmarks located in the EU are required to endeavour to provide at least one EU Climate Transition Benchmark (Article 19d).

The amendment to the Benchmark Regulation also requires benchmark methodologies and statements to include explanations of how indices reflect ESG factors3 and empowers the European Commission to specify the minimum contents of these explanations and their standard format (Articles 13 and 27).4

These disclosures are intended to facilitate cross-border comparisons and help market participants make well-informed choices.

It is in this context, that the European Commission set up a Technical Expert Group on sustainable finance (“TEG”) in July 2018 and requested its assistance in the definition of minimum technical requirements for Climate Benchmarks and ESG disclosures. The TEG produced a draft report in June 2019 (TEG, 2019a) and, following a Call for Feedback, handed its final report at end September 2019 (TEG, 2019c), which it complemented with a handbook aiming to provide clarifications on its recommendations and respond to frequently asked questions (TEG, 2019d).

Introduction

5 - TEG final report on Climate Benchmarks and benchmarks’ ESG disclosures, September 2019.

According to the executive summary of the final report, the main objectives of the Climate Benchmarks are to: (i) allow a significant level of comparability of Climate Benchmarks methodologies while leaving benchmarks’ administrators with an important level of flexibility in designing their methodologies;(ii) provide investors with an appropriate tool that is aligned with their investment strategy;(iii) increase transparency on investors’ impact, specifically with regard to climate change and the energy transition; and (iv) disincentivise greenwashing.5

Unfortunately, it appears that the proposals contained in the final report of the TEG not only exceed the scope of the mandate given to the European Commission and illustrate a lack of proper management of the conflicts of interest faced by the members of the Benchmarks Working Group who prepared the proposals, but also dramatically fail to deliver on the above objectives.

In the rest of this document we briefly explain why the proposals may be construed as ultra vires and unfaithful to the regulation they are supposed to detail; document how central elements of the recommendations benefit special interests while harming the ambition and relevance of the regulatory amendment; point out severe limitation and design flaws of the proposals and offer suggestions to remedy them.

Introduction


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1. The Proposals are Arguably Ultra Vires

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6 - Note that there is no doubt that exclusions themselves are permitted since, under Article 19a (2-a), the Commission is empowered to adopt delegated acts to specify “the criteria for the choice of the underlying assets, including, where applicable, any criteria for excluding assets”.7 - In the interest of disclosure, the Scientific Beta Low Carbon option, which was launched before the publication of the TEG interim report, includes core ESG exclusions in respect of both securities and activities (using the TEG terminology).8 - The final report also introduces ESG exclusions in respect of controversial weapons and societal norms, which may be viewed as falling under the delegation given by Article 19a (2-a).9 - They cover a) the definitions for all key terms; b) the rationale for adopting the benchmark methodology and procedures for its review; c) the criteria and procedures used to determine the benchmark; d) the controls and rules that govern any exercise of judgement or discretion; e) the procedures which govern the determination of the benchmark in periods of stress or periods where transaction data sources may be insufficient, inaccurate or unreliable and the potential limitations of the benchmark in such periods; f ) the procedures for dealing with errors in input data or benchmark determination; and g) the identification of potential limitations of the benchmark, including its operation in illiquid or fragmented markets and the possible concentration of inputs.

The amendment to the Benchmark Regulation (the “Level I text” or “Regulation”) empowers the European Commission to adopt delegated acts to:(i) specify minimum standards in respect of asset selection and weighting for both Climate Benchmarks plus decarbonisation trajectory for CTBs (as per added Article 19a) and (ii) specify the minimum contents and standard format of the explanations of ESG incorporation into any Benchmark methodology (as per revised Article 13) and Benchmark statement (as per revised Article 27).

As to minimum standards, we note that the proposal of the TEG introduces exclusions in respect of controversial weapons, violation of global norms and environmental controversies. These are “inspired by an ambition to not doing significant harm at ‘the security level’” (TEG, 2019c) although the basis for such exclusions6 in the Level I text is ambiguous: Recital 14 states that it is of particular importance that the Climate Benchmarks do not significantly harm other ESG objectives, but the articles themselves (Articles 3(1)-23b(c) and 19b(iv)) address the do no significant harm principle only in respect of activities, which is a distinct concept as underlined and implemented by the TEG.7 When exclusions are explicitly mentioned in the Level I text, it is to mandate the disclosure of any criteria used to exclude assets from the pool of eligible benchmark constituents owing to carbon footprint of fossil fuel reserves considerations (Annex III-1(c)).

With respect to ESG disclosures, the proposals go beyond specifying how explanations on the incorporation of ESG factors should be provided as they present long lists of ESG indicators to be computed and disclosed as part of the benchmark statement.8 These include portfolio-level exposure to controversial activities or companies; climate change metrics; and weighted average ESG ratings and E, S and G ratings; as well as ESG ratings for top 10 index constituents. Besides qualitative explanations, minimum disclosures for equity indices include no less than 25 data points on which to report: 15 portfolio metrics and 10 security-level ESG ratings.

The purpose of the Benchmark statement, as described in the Benchmark Regulation (Recital 43 of Regulation 2016/1011), is to provide (would-be) users with a description of what the Benchmark measures and how susceptible it is to manipulation. As provided by the Regulation, Benchmark statements should be of reasonable length and focus on providing the key information. The minimum disclosures in the Benchmark statement, as laid out in Article 2 paragraph 2 are strictly concerned with how a benchmark is constructed and managed; Benchmark performance – financial or otherwise – is not part of minimum disclosures.9 The amendment to this paragraph (Regulation (EU) 2019/2089) only requires that administrators explain, in the context of the minimum disclosures, how ESG factors are reflected (and this only when the Benchmark or family of Benchmarks purports to pursue ESG objectives). The delegation to the Commission is limited to the specification of how this should be done and to the standardisation of references to ESG factors in the context of compliance with Article 2 paragraph 2.


10 - In its feedback to the interim report, index provider S&P Dow Jones Indices LLC made such a case and noted: “The TEG report goes far beyond providing non-essential elements by suggesting a series of extremely detailed, costly, and onerous disclosure obligations that are not contained in the Level 1 text.” Other contributors insisted on the subjective choice of indicators, the absence of clear definitions for these indicators and the resulting lack of comparability, and the irrelevance of ESG ratings.

We thus trust a reasonable case can be made that the proposed ESG disclosure requirements not only exceed the scope of the delegation given by the Level I text, but also modify the nature of the Benchmark statement and entail considerable administrative and data acquisition costs for Benchmark administrators (and indirectly end-users). In the latter respect, the proposed disclosures would become an essential dimension of the Regulation, which would be inconsistent with the overall scope of the legislative delegation enjoyed by the European Commission. Indeed, under Article 290 (1) of the Treaty on the Functioning of the European Union, “the essential elements of an area shall be reserved for the legislative act and accordingly shall not be the subject of a delegation of power”.10

It should also be underlined that the Commission’s initial amendment proposal had taken into consideration feedback from the Commission’s Regulatory Scrutiny Board with respect to the risks of requiring Benchmark administrators to use the EU classification system for environmentally sustainable economic activities (hereafter “Taxonomy”) that was being developed as well as the need to pay heed to cost considerations for Benchmark administrators (which had not been properly addressed by the Commission’s earlier impact assessment study) and that a minimum standards approach had been preferred to maximum harmonisation so as to leave flexibility to benchmark administrators and limit compliance costs (COM(2018) 355 final).

It thus appears that the considerations that guided the drafting of the Level I text are contradicted by the overly prescriptive and onerous recommendations made by the TEG for the preparation of the Level II text,

We thus consider that the TEG proposals not only extend beyond the powers of the European Commission, but also that they contradict the Regulation and its key objectives. If the Regulation intends to promote the offering and adoption of Benchmarks that support the transition to a low-carbon and sustainable economy, then delegated acts that would create material administrative and data costs that cannot be justified as a legal obligation or by practical relevance would be counterproductive.



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2. The Proposals have been Hijacked by Special Interests

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11 - Arguably index administrator FTSE Russell was represented by its London Stock Exchange Group sister company Borsa Italiana.12 - Currently being acquired by the London Stock Exchange Group.

The reports of the TEG were prepared by the Benchmarks Working Group, a nine-member taskforce that lacked representativeness and was severely skewed towards providers of ESG data and services (see Table 1).

Indeed, potential end-users of Benchmarks, which the Benchmark Regulation aims to protect, were under-represented in this taskforce: a single asset owner contributed to the group and European pension funds were not represented at all (i.e. neither through one of their associations, nor through individual pension funds that have been leaders in addressing the challenges of Climate Change). In addition, index administrators, which bear the brunt of the regulation, had their representation limited to a single company, moreover one that is also a leading provider of ESG data/analytics.11 By contrast, four working group members represented organisations directly engaged in the provision of ESG data and analytics or belonging to financial groups engaging in such businesses and one of the two investment managers represented had co-developed an ESG analytical tool marketed by a fellow working group member.

Table 1: Composition of the Benchmarks Working Group

Organisation of which working group participant is a representative Nature of this organisation

Personal Capacity N.A. (Academic)

Allianz Global Investors Investment manager (global)

Borsa Italiana (London Stock Exchange Group)

Stock Market(Infrastructure, index, data/analytics group)

Carbone 4 Specialised consulting firm and data/analytics provider

Mirova Investment manager (sustainable investing)

MSCI Index and data/analytics provider

Refinitiv/Thomson Reuters12 Data/analytics and infrastructure provider

Swiss Re Ltd Reinsurance and insurance provider

European Securities Market Authority Regulator

Given the skewed composition of the Benchmarks Working Group, one would expect the TEG, if not the working group itself, to exercise particular care to avoid or mitigate conflicts of interests. The proposals contained in the interim and final report document show that, whatever conflict of interest management approach was adopted, it has dramatically failed. We provide three illustrations:

2.1. Adoption of Capitalisation-Weighting AnchoringThe proposal defines decarbonisation relative to the market capitalisation weighted index of the underlying universe and considers that decarbonisation of an index that focuses on few highly carbon intensive sectors (Oil and Gas, Utilities, Transportation) and/or only a few highly emitting constituents constitutes greenwashing. Against this backdrop, it requires investment in sectors “highly exposed to climate change issues” be no less than in the capitalisation-weighted representation of the underlying universe.


13 - In its reports, the TEG (2019a, 2019c) notes that Benchmark exposure to high climate impact sectors “cannot be less than the exposure of the investment universe to the same set of sectors” and then more often than not uses the plural when referring to exposure or allocation constraints (“exposure constraints”, “sector and activity allocation constraints”, “Activity allocation constrains (sic)”); it also notes that it has dismissed “sub-sector neutrality constraints”. This has led multiple parties to assume that constraining was at the level of each identified high climate impact sector. However, the handbook published by the TEG (2019d) clarifies that the exposure constraint should be understood to apply across high climate impact sectors and not sector per sector. Hence, the proposal of the TEG allows divestment from brown fossil fuels if it is compensated by over-investment into other high climate impact sectors.14 - The runner-up, FTSE Russell was represented by a sister company of the London Stock Exchange Group.

The organisations that promoted climate change awareness by championing fossil fuel divestment may be surprised to learn that their efforts of the last decade have in fact advanced greenwashing.

The rationale given by the TEG for this controversial stance is that “many solutions” necessary to a low-carbon economy “will come from highly emitting sectors”. While this premise may be viewed as highly ideological, at least outside the ranks of these highly emitting sectors, it is perfectly legitimate and very important to control for sector effects when assessing the effectiveness of a decarbonisation approach.13

Such control however does in no way require the adoption of allocation constraints that encourage alignment of the structure of investments with the (biased) reflection of economic structure given by public equity markets and its evolution over time (as a result of price evolution and changes to the set of listed companies). This alignment may be viewed as a missed opportunity to more aggressively reallocate funds towards the climate transition and a form of greenwashing if it leads to status quo investment into activities that must be phased-out or dramatically curtailed in the transition to a low-carbon economy. In addition, allocation constraints narrow the scope of index eligibility for the proposed Climate Benchmarks and reduce the flexibility that index administrators require to serve the varied needs of investors. In this regard, anchoring Climate Benchmarks on broad-equity market indices ignores the evolution of investor choice in respect of Benchmarks over the last 10 years. An ever growing number of institutional investors have indeed revisited their assumptions about capitalisation-weighting and adopted alternatively weighted indices (also known as smart beta indices). Academic studies have debunked the myth that capitalisation-weighting had strong theoretical justifications and was by nature superior for investment (for a discussion, refer to Goltz and Le Sourd, 2011). In addition, empirical studies – by practitioners and academics alike – have illustrated the inefficiency of capitalisation weighting and the relevance of both diversifying or controlling unrewarded risks and establishing exposure to rewarded risks beyond broad market risk.

It has also been shown that smart beta indices could be effectively and efficiently decarbonised to reconcile the search for higher efficiency of capital allocation with a concern for climate impact and the mitigation of climate risks.

However, by affirming the pre-eminence of capitalisation weighting in the context of Climate Benchmarks, the TEG proposals put fiduciary obligations in the way of the fight against climate change (since capitalisation-weighting exposes investors to unrewarded as well as uncontrolled risks).

Anchoring Climate Benchmarks on the capitalisation-weighted indices of markets, however, is favourable to the companies that provide these indices and promote market capitalisation anchoring in their alternative and climate index offerings. The European and international leader in the field is American company MSCI, which was the only index provider with direct representation on the working group.14 The adoption of market capitalisation anchoring despite adverse consequences in terms of support to the transition to a low carbon economy, investment efficiency and flexibility may come across as a failure of conflict-of-interest management on the part of the TEG.



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15 - In the final report, sector/industry classification requirements are expressed in reference to the European implementation of the UN classification (ISIC, revision 4), commonly known as NACE (v2).16 - Instead, stakeholders have only been invited to share their experience and use of the Benchmark statement and to provide feedback on the supervision of the Climate Benchmarks.

The latter concern is buttressed by the interim TEG report which recommended implementing capitalisation-weighting anchored sector constraints in relation to an industry classification co-developed, owned and marketed by MSCI. As one of the participants in the Call for Feedback underlined in a measured tone: “The use of the use of [this classification] (…) is not market neutral, as [it] is a proprietary classification system and its use (…) requires the acceptance of license agreements and payment of fees.” (CDP, 2019). Naturally, the Commission could not have let such obvious favouritism be written into law and the reference was dropped in the final report of the TEG, but we find the incident telling.15

Also troubling is the launch by MSCI of indices designed to be eligible as EU CTB/PAB benchmarks a mere five weeks after the publication of the final report of the TEG. While one may wonder at the astonishing efficiency of the provider’s data collection and verification, research and development, and index production processes, one may also wonder about the extent to which the proposals of the TEG have been dictated by the commercial projects of MSCI. Interestingly, the MSCI Provisional Climate Change EU CTB/PAB indices are constructed from the MSCI Climate Change indices that were launched at end June 2019, less than two weeks after the publication of the TEG interim report. No less troubling is the fact that the launch, which predates the publication of the final delegated acts, also demonstrates the provider’s confidence that the final CTB/PAB requirements will “not materially diverge from the recommendation included in the TEG’s Final Report”. While one may wonder at the boldness of risk-taking on the part of the index provider, one may also wonder about the extent to which the index provider will influence further legislative work.

As for this legislative work, the amendment to the Benchmark Regulation underlines that it is “of particular importance that the Commission carry out appropriate open and public consultations during its preparatory work on each of [the] delegated acts, including at expert level, and that those consultations be conducted in accordance with the principles laid down in the Inter-institutional Agreement of 13 April 2016 on Better Law-Making”. These principles notably require the Commission to carry out impact assessments of its delegated acts which are expected to have significant economic, environmental or social impacts (Article 13). During the process, the Commission is expected to consult as widely as possible.

The final results of the impact assessment must be made available to the European Parliament, the Council and national Parliaments, and be made public along with the opinion of the Commission’s Regulatory Scrutiny Board, which is required to carry out “an objective quality check” of impact assessments. In addition, under these principles, the Commission “commits to gathering, prior to the adoption of delegated acts, all necessary expertise, including through the consultation of Member States’ experts and through public consultations” (Article 28).

We note that the Commission has conducted a public consultation on the review of the Benchmark Regulation. However, this consultation by questionnaire launched on 11 October 2019 did not give stakeholders an opportunity to discuss the substantive elements in the TEG proposals.16


17 - Enterprise value is defined as “the sum of the market capitalization of common stock at fiscal year end, the market capitalization of preferred equity at fiscal year-end, and the book values of total debt and minorities’ interests minus the cash and cash equivalents held by the enterprise”.18 - The interim report had recommended the use of Total Capital, an accounting-based version of Enterprise Value that disregarded adjustments for cash or pension liabilities, which the TEG then considered irrelevant for scaling emissions. A majority of the respondents in the Call for feedback rejected this metric.19 - Note that there is significant basis to criticise the use of any form of WACI given the (decarbonisation trajectory) wording and (carbon footprint) objectives of the Level 1 text, but if the choice is made to adopt a form of WACI in the proposal, it is natural to opt for the most consensus version.

More than the appearance of conflict of interest created by the composition of the Benchmarks Working Group, we regret that the TEG proposals lead to narrowing the scope of application of the Regulation. By reducing the diversity and attractiveness of index strategies that can be offered as Climate Benchmarks, delegated acts based on the TEG proposals could reduce demand for and capital flows towards strategies tracking Climate Benchmarks.

2.2. Adoption of a Non-Consensus Carbon Exposure MetricThe proposal in the final report of the TEG (2019c) introduces a measure of Weighted Average Carbon Intensity, or WACI, that uses Enterprise Value as denominator.17 This metric is not widely accepted in the industry and it is at odds with the recommendations of the Taskforce on Climate-related Financial Disclosures (2017), which have been guiding companies and institutional investors in considering and reporting on climate-related risks.

This metric however corresponds to that used by the Carbon Impact Analytics tool (2015) developed by two members of the Working Group which thus appear in a position to benefit from the TEG proposals although the metric is fortunately not proprietary.

In putting forward this metric, the TEG remained deaf to the advice of participants in the Call for Feedback who underlined the relevance of retaining commonly employed metrics (in the absence of any scientific demonstration of the superiority of a new metric and lacking a cost/benefit analysis). 18

As we shall see in the next section, the justification for adopting this metric in lieu of the widely used version of WACI (which is in addition recommended by the Taskforce on Climate-related Financial Disclosures or TCFD) is flimsy. The metric is handicapped by significant flaws and is used in a manner that creates entirely avoidable risks for the integrity and reputation of the Climate Benchmarks.19

It would be regrettable if the desire of some members of the Benchmarks Working Group to showcase their own offerings and burnish their credentials led to the adoption of an exotic carbon exposure metric by delegated acts. While this would afford the interested parties a privileged position in relation to the implementation of the Regulation, reliance on a non-consensus metric would create unjustified costs for other stakeholders and reduce the influence of the Regulation, which we assume is not the objective of the legislator.

2.3. Introduction of Extensive ESG Disclosures with Limited Value for UsersThe final TEG proposal introduces extensive ESG disclosures for Benchmark administrators that entail significant wealth transfers to the benefit of ESG data providers and harm competition in the already highly concentrated index administration industry by directly and indirectly benefiting companies with integrated ESG data and analytics businesses. As discussed in the previous section, the recommendations go well beyond what would be required to simply describe how ESG factors



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20 - These disclosures include global ESG rating disclosures for top 10 holdings. Traditionally, data providers have barred index providers from disclosing security-level information to the public at large so as to protect their intellectual property. Interestingly, in November 2019, MSCI made the global ESG rating component of its ESG ratings publicly available, a highly disruptive move in the ESG data provision industry, in particular against the backdrop of the TEG proposals. For the avoidance of doubt, publicly available should not be equated with free of intellectual property protection or free of charge – the move should not be viewed as philanthropy but as a clever ploy that aims to establish the MSCI ESG Ratings as a natural reference in an area characterised by a high degree of heterogeneity of offering and difficulty for users to assess quality. MSCI terms of use explicitly state that: “Reproduction, redistribution or any other form of copying or transmission of the ESG Data without MSCI's prior written consent is strictly prohibited. Without limiting the generality of the foregoing, the ESG Data and other MSCI intellectual property you access via the MSCI web site may not, without MSCI's prior written permission, be used as a basis for any financial instruments or products (including, without limitation, passively managed funds and index-linked derivative securities) or other products or services, or used to verify or correct data in any other compilation of data or index, or used to create any other data or index (custom or otherwise), or used to create any derivative works, or used for any other commercial purposes.” Parties accessing the public MSCI ESG data acknowledge that it constitutes “copyrighted, trade secret and/or proprietary information of substantial value to MSCI”, that they “receive no proprietary rights whatsoever in or to the ESG Data” and that “title and ownership rights in and to the ESG Data and all the rights therein and legal protections with respect thereto remain exclusively with MSCI”.

are incorporated into index design and management, as stated by the Level I text or to demonstrate that Climate Benchmark assets do not significantly harm other ESG objectives. Instead multiple disclosures of ESG metrics are mandated that, for the most, are in respect of data that cannot be freely and simply availed but instead need to be licensed from specialised providers.20

To add insult to injury, the overall informational potential of the “minimum” disclosures is low, which makes it unlikely that they might lead to improved decision making with respect to current or future ESG and/or financial performance. A first issue is the lack of proper definitions of terms and concepts by the TEG that opens the door to subjectivity even when it comes to indicators that could be standardised. Another issue is the inclusion of indicators, which, being derived from heterogeneous data and idiosyncratic methodologies, may diverge significantly from one data provider to another. A related issue is the consideration given to indicators that may be widely used but are conceptually unfit to inform on ESG performance, notably portfolio-level ESG and E/S/G ratings.

This overload of poor quality and onerous ESG disclosures was maintained in the face of relevant and informed input from diverse stakeholders received on the occasion of the Call for Feedback.

While the danger of including ESG ratings in mandated disclosures was mentioned by a wide cross-section of contributors, multiple respondents also explained that the issue was more general:Index provider S&P Dow Jones Indices concluded that the TEG had “prescribed a maximalist, disproportionate, and inappropriate set of granular disclosures that would provide very little actual value to index users” (SPDJI, 2019).

In more diplomatic language, the European Fund and Asset Management Association noted: “We also wish to draw the Commission’s attention to the fact that the list of ESG factors to be considered per asset class covers a wide scope and for a lot of them there is an absence of agreed definitions and clear guidance (…) The TEG also calls for ESG scores to be shown for sustainable benchmarks, but there is currently a wide disparity on third party rating agencies on ESG scoring, a lack of transparency in this area. This absence of common understanding and definitions will necessarily lead to overreliance to the third party ESG data and ESG ratings providers, which would still be subjective and also present other risks for conflicts of interest, lack of transparency and competition issues” (EFAMA, 2019).

While the user relevance of the avalanche of ESG disclosures recommended by the TEG is very much in question, there is little doubt that the proposal is most beneficial to providers of ESG data, analytics and consulting services and will result in significant wealth transfers towards ESG data providers; for this reason, the lack of diversity in the TEG Benchmark Working Group and its marked skew towards direct and indirect representatives of data providers naturally raises concerns of regulatory capture.


3. The Proposals have Severe Flaws and Limitations

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21 - By 2021, a delegated act must identify which sectors should be excluded from PABs due to a lack of measurable emissions reduction targets aligned with the Paris Agreement (Article 19c). By end 2022, the constituents of CTBs must be restricted to securities issued by companies that follow a decarbonisation trajectory (which requires disclosure of (a) measurable carbon emission reduction targets to be achieved within specific timeframes; (b) a reduction in carbon emissions which is disaggregated down to the level of relevant operating subsidiaries; and (c) annual information on progress made towards those targets) and whose activities do not significantly harm other ESG objectives (Article 19b). Why a phase-in approach is included in respect of the latter criterion for CTBs whereas PABs must comply from day one is not immediately obvious. 22 - We assume the reference to an average of 7% is meant to define the ceiling for the carbon metric of reference based on the number of years since inception. 23 - This adjustment is dramatically more stringent than that for which the TEG sought feedback; indeed, the inflation adjustment in the interim report was only meant to “reflect the potential effects of inflation on the financial denominator of carbon intensity”. In any case, one would assume that inflation should be interpreted to mean change, otherwise the volatility in the denominator chosen by the TEG, as experienced historically, is bound to cause the violation of the year-on-year decarbonisation constraint and the demise of the benchmarks. However, nothing in the language of the TEG reports and handbook suggests that the correction should be applied in the case of deflation.24 - In the handbook (TEG, 2019d), the adjustment factor is different as it relies on a subset of the investable universe: “The enterprise value inflation adjustment factor is computed by dividing the average enterprise value of the index constituents at the end of calendar year by the average enterprise value of the index constituents at the end of the previous calendar year.” This is one of multiple inconsistencies in the work of the TEG.

The adopted amendment to the Benchmark Regulation requires that the constituents of the Climate Benchmarks be selected and weighted so that PAB portfolio carbon emissions are aligned with the objectives of the Paris Agreement and CTB portfolios are on a decarbonisation trajectory, i.e. a measurable, science-based and time-bound emissions reduction path towards alignment with the objectives of the Paris Agreement. Both types of Climate Benchmarks have to respect the minimum standards to be stated in delegated acts and the activities of PAB constituents must not do significantly harm to other ESG objectives (Article 3(1)-23a/23b).

The Commission is explicitly empowered to specify minimum standards of constituent selection and weighting criteria as well as decarbonisation trajectory requirements (Article 19a(2)). Providers of CTBs/PABs need to comply with applicable rules by end April 2020.21

There is no consensus yet on how to determine whether a portfolio is aligned with the Paris Agreement. One family of approaches assesses the alignment of processes and products of portfolio companies with the technological requirements of a reference decarbonisation pathway. Another considers whether emissions associated with the portfolio are consistent with those of a reference decarbonisation pathway.

The TEG adopted the latter approach and, in reference to the average rate of decrease in absolute emissions in the Intergovernmental Panel on Climate Change (IPCC) 1.5 degree Celsius with no or limited overshoot scenario, set a year-on-year decarbonisation requirement of 7% on average22

(intertemporal constraint) for both types of Climate Benchmarks. Under penalty of disqualification, the trajectory implied by this requirement cannot be missed two years in a row or more than three times over a 10-year period. In addition, it imposed a minimum decarbonisation relative to the market-capitalisation-weighted benchmark of the underlying universe of 30% for CTBs and 50% for PABs (cross-sectional constraint). If the decarbonisation of these Benchmarks translates into equivalent reductions in associated emissions, then the decarbonisation constraints of the TEG proposal are consistent with the ambitions of the Paris Agreement. Indeed, the Emissions Gap Report 2019 (UNEP, 2019) documents that a year-on-year fall in emissions of 7.6% is required between 2020 and 2030 for alignment with the 1.5 Celsius scenario of the Paris Agreement.

While the carbon metric selected by the TEG is a weighted average of the normalised emissions of portfolio constituents, the year-on-year reduction requirement is adjusted for “inflation” in the average value of the normalisation factor in the “investable universe” (as per the final report).23,24 Assuming that the rate of inflation of the normalisation factor applicable to the benchmark is the same as in the investable universe, then the observed change in the carbon metric of the benchmark can be attributed to differences in weighted constituent emissions. Under this assumption, a reduction in


25 - Note that these constituents change over time and that, from a portfolio metric reduction point of view, the assets whose normalisation factors have increased the most year-on-year relative to the average in the investable universe will be most attractive, other things equal. 26 - These objectives are: 1) climate change mitigation; 2) climate change adaptation; 3) sustainable use and protection of water and marine resources; 4) transition to a circular economy, waste prevention and recycling; 5) pollution prevention and control; 6) protection of healthy ecosystems. A political comprise on the EU Taxonomy was reached on 5 December 2019 and endorsed by Member States on 18 December 2019.27 - In the NACE classification these are: (i) Agriculture, forestry and fishing; (ii) Mining and quarrying; (iii) Manufacturing; (iv) Electricity, gas, steam and air conditioning supply; (v) Water supply; sewerage, waste management and remediation activities; (vi) Construction; (vii) Wholesale and retail trade; repair of motor vehicles and motorcycles; (viii) Transportation and storage and (ix) Real estate activities.

the normalised carbon metric of the portfolio indeed requires a reduction of the absolute emissions associated with its constituents.25

Besides decarbonisation, the TEG has put forward minimum standards in respect of constituent selection and weighting – including ESG issues – which are summarised in Table 2 below.

Table 2: Minimum Standards for EU Climate Benchmarks in the final TEG report

Minimum standards EU CTB EU PAB

Risk orientated minimum standards

Minimum Scope 1+2(+3)11 carbon intensity reduction compared to investable universe

30% 50%

Scope 3 phase-in • Immediate for energy and mining (reserves may be used)• Two years for transportation, construction, buildings, materials, industrial activities

• Four years for all other activities

Baseline Exclusions • Controversial Weapons• Violators of United Nations Global Compact or OECD Guidelines for Multinational Enterprises

• Issuers in controversies owing to harm to one or several of the six environmental objectives of the EU Taxonomy26

Activity Exclusions No • Coal exploration or processing (1%+ revenues)• Oil exploration or processing (10%+ revenues)

• Natural Gas exploration or processing (50%+ revenues)• Electricity producers with carbon intensity of lifecycle greenhouse gas

emissions higher than 100gCO2e/kWh (50%+ revenues)

Opportunity orientated minimum standards

Year-on-year self-decarbonisation of the benchmark

At least 7% on average per annum

Minimum green share / brown share ratio compared to investable universe (Voluntary)

At least equivalent Significantly larger (factor 4)

Exposure constraints Minimum exposure to nine sectors highly exposed to climate change issues27 is at least equal to equity market benchmark value

Corporate Target Setting Weight increase shall be considered for companies which set evidence-based targets under strict conditions to avoid greenwashing

Disqualification from label if two consecutive years of misalignments with trajectory

Immediate

Relevance orientated minimum standards

Review Frequency Minimum requirements shall be reviewed every three years to recognise market development as well as technological and methodological progress

The adopted amendment to the Benchmark Regulation requires all index administrators to explain how their benchmarks “reflect ESG factors” (amended Article 13 requires this in respect of the “key elements” of methodologies while amended Article 27 imposes a disclosure at the level of the benchmark statement or a mention that no ESG objectives are pursued). The Commission is empowered to specify the information to be provided in the benchmark statement and the standard format to be used for references to ESG factors “to enable market participants to make well-informed choices”.



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28 - In Appendix C of the final TEG report, this is reduced to the Fossil Fuel Sector exposure.29 - What the TEG calls Carbon intensity is a class of metrics where the portfolio metric is computed as the index-weighted average of constituent level total emissions normalised by a financial metric. There is an extent of confusion with respect to which financial metrics may be acceptable to the TEG (as the references in Sections 3.3.2.; 5.3.3. and 5.12. are inconsistent).

In this regard, the TEG proposed methodology and Benchmark templates for the purpose of reflecting the incorporation of ESG factors into indices but went beyond qualitative requirements and suggested extensive quantitative ESG disclosures; Table 3 lists the latter disclosures for equity indices.

Table 3: Minimum ESG Disclosures for Equity Indices used as Benchmarks in the final TEG report

ESG themes Disclosures

Overall ESG • Average ESG rating (relative to securities covered by ESG research) • Overall ESG ratings of top 10 index constituents by weighting in index• Total weighting of index constituents not meeting the principles of the UN Global Compact (conduct-related controversy screen)

Environmental • Average Environmental rating of index (E component of ESG rating) (relative to securities covered by ESG research) • High emitting sector exposure (% of total weighting)28 • Carbon intensity29

• Reported vs estimated emissions (%)• Portfolio exposure to green economy as measured by % of green revenues or Capex• Exposure to climate-related physical risks

Social • Average Social rating of index (S component of ESG rating) (relative to securities covered by ESG research) • Total weighting of index constituents in controversial weapon sector or tobacco • Controversial weapons definition • Tobacco % • Tobacco definition• Number of companies in the index involved in social violations

Governance • Governance rating of index (G component of ESG rating) (relative to securities covered by ESG research) • Average degree (%) of board independence• Average degree (%) of board diversity

In matters of decarbonisation, we favour the idea of combining a cross-sectional approach with an intertemporal approach as it allows the Climate Benchmarks to show immediate, benchmark-relative, decarbonisation (as is commonly offered on the low carbon index market) and promote absolute decarbonisation over time (which is currently less common). However, we have major reservations with the proposal of the TEG when it comes to minimum standards of index construction, which concern Climate Benchmarks, and ESG disclosures, which concern all Benchmarks. Notably, we find that, with respect to Climate Benchmarks, the proposal unnecessarily: (i) restricts the scope of the amended Regulation by anchoring Climate Benchmarks on broad market capitalisation weighted indices; and (ii) substitutes a non-standard and biased carbon exposure metric for the adequate indicator that is widely used in the market; and that, for all Benchmarks, it (iii) introduces quantitative reporting requirements in respect of ESG issues where qualitative disclosures would have sufficed, which promises added costs for investors at best without commensurate gains for informed decision making owing to a lack of precise definitions or relevant indicators.


3.1. The Proposal Dramatically Reduces the Scope of the Regulation

Benchmarking decarbonisation against the market capitalisation-weighted representation of the underlying universe disqualifies progressive indices with high exposure to high carbon intensity assetsBy setting a decarbonisation target relative to the market capitalisation-weighted index of the universe, the proposal restricts the scope of the amended Regulation, which required index constituents to be “selected, weighted or excluded in such a manner that the resulting benchmark portfolio is on a decarbonisation trajectory.”

Figure 1: Weighted Average Carbon Intensity by Sector, Developed Markets, 10-year average

Weighted Average Carbon Intensity of companies per economic sector (as per the Thomson Reuters Business Classification) in the Scientific Beta Developed Universe; 10-year average at end 2018. Companies are capitalisation-weighted. Emissions data are provided by Institutional Shareholder Services. Weighted Average Carbon intensity is expressed in tons of CO2 equivalent per USD million of revenues.

Due to the material differences in carbon intensity that exist across sectors and activities (as illustrated on Figure 1), constraining the minimum relative decarbonisation vis-à-vis the broad universe benchmark makes it very difficult for index administrators to offer as Climate Benchmarks any climate-progressive versions of index strategies that consist of investment in high climate impact sectors or activities or result in benchmark-relative overweighting of such sectors or activities.

While broad-market capitalisation-weighted indices still occupy a central place in the portfolios of investors, sector, smart-beta and factor indices have become widely used by institutional investors seeking to control their risk exposures and improve their long-term returns. This is even true of indices accessed via ETFs as illustrated by Figure 2.



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Figure 2: Use of ETFs for broad market exposure vs. specific sub-segmentsThis exhibit indicates the frequency of respondents using ETFs for each of the purposes mentioned. Respondents were asked to rate their usage frequency from 1 to 6. The “frequent” category displayed here includes ratings from 4 to 6. The percentages are based on the results of the EDHEC ETF, Smart Beta and Factor Investing surveys from 2009 to 2019.

While sector indices have long been a mainstream (tactical) allocation tool, in particular for tactical allocation, the use of vehicles, including indices, that address the limitations of broad-market capitalisation-weighting in terms of exposure to unrewarded risks (insufficient diversification notably) and rewarded risks (suboptimal exposure to risk factors) has become increasingly common for strategic and tactical allocation (as illustrated by Figure 3).

Figure 3: Use of Smart Beta and Factor Investing SolutionsThis exhibit indicates the percentage of respondents that reported using smart beta and factor investing solutions. Non-responses are excluded. The percentages are based on the results of the EDHEC ETF, Smart Beta and Factor Investing surveys from 2013 to 2019.

Against this backdrop, climate-progressive versions of sector funds or smart beta and factor investment strategies could however offer materially improved carbon intensity and climate change profile relative to their traditional versions and thus significantly contribute to reallocating funds towards the transition to a low-carbon economy. In the fight against climate change, indices focused on


30 - In the interest of disclosure, Scientific Beta already offers Low Carbon versions of its flagship multifactor indices that have historically produced WACI reduction relative to the market benchmark that exceeds the minimum put forward by the TEG.31 - The key concern of the amended Regulation seems to improve transparency of and prevent greenwashing in the market for low carbon indices so as to “protect investors from confusion and ambiguity about the aims and level of ambition underpinning different categories of so-called low-carbon indices used as benchmarks”; however, its Recital 6 mentions that one of the objective of the European Commission’s action plan for financing sustainable growth is to reorientate capital flows towards sustainable investment.

solutions necessary to the energy transition could also be an interesting tool for investors seeking high impact (and if the TEG is to be believed, these solutions mostly lie in high climate impact/high carbon intensity sectors). Unfortunately, broad market-capitalisation anchoring for relative decarbonisation assessment means that most climate-progressive indices focused on high carbon intensity sectors and activities and many climate-progressive smart beta and factor indices will be disqualified as Climate Benchmarks by the requirements proposed for the Level II text, including when they are ahead of the decarbonisation trajectory objectives that the Level I text mentions.

Index-based investment strategies used by institutional investors have diversified considerably and we feel strongly that for the Climate Benchmarks to have wide relevance, this should be properly reflected by the Level II text.30

Setting a crude sector exposure constraint fails to satisfyingly address greenwashing concerns and unnecessarily restricts index administrator flexibility and investor choiceHaving expressed its relative decarbonisation target in relation to the broad market capitalisation-weighted benchmark, the TEG notes its concern that the requirement could be achieved merely “by simply divesting from greenhouse gas intensive sectors and reallocating to sectors with very little greenhouse gas intensities” which it qualifies as “greenwashing risk” for the Climate Benchmarks. The TEG addresses this risk by constraining allocations to nine sectors (see Table 4 below) that it identifies as having “high climate impact” to be no less than those of the benchmark. In its handbook, the TEG (2019d) clarifies that this constraint is to be understood in respect of the total allocation to these sectors rather than sector by sector.

Table 4: Sectors identified by the TEG as High Climate Impact sectors

European Classification of Economic Activities (NACE) Sections

Agriculture, forestry and fishing

Mining and quarrying

Manufacturing

Electricity, gas, steam and air conditioning supply,

Water supply; sewerage, waste management and remediation activities

Construction

Wholesale and retail trade; repair of motor vehicles and motorcycles

Transportation and storage

Real estate activities

The TEG affirms that “one of the key objectives” of the amended Regulation is to “shift capital from greenhouse gas intensive assets towards solutions necessary to the energy transition” and therefore that Climate Benchmarks “should not allow for a simple divestment from sectors key to this transition.”31 Under the assumption that “many solutions will come from highly emitting sectors” and that “most of the solutions necessary to a low-carbon economy” lie in these sectors, the TEG recommends that Climate Benchmarks should not allow for underweighting of the designated high climate impact sectors.



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32 - The only justification is provided in the handbook (TEG, 2019d) and is as follows: “Since equity investors rarely directly contribute cash to the companies, they can contribute to the transition through (i) engagement and voting and (ii) providing a decarbonization example for other investors.”33 - To understand how, assume an investment in a public equity climate benchmark and that the solutions are only or primarily accessible through private equity or infrastructure investment. In this case, imposing a sector restriction on the benchmark reduces the ability of the investor to free up funds to invest in solutions.

For reasons undisclosed in the TEG reports (2019a, 2019c) this allocation restriction applies only to equity benchmarks – apparently, the risks of gaming the TEG decarbonisation constraints and of depriving of funds sectors that are key to the climate transition are non-existent in other asset classes.32

We agree that it is key to control for sector effects when assessing decarbonisation to avoid illegitimate claims regarding the climate progressive nature of indices and could also see relevance in qualifying the award of the climate benchmark labels to distinguish indices with high exposure to key transition sectors. That said, we view the position of the TEG as highly ideological, unnecessarily restrictive of the ambitions of the Level I text and potentially counterproductive33 and must also underline that its implementation encourages the very type of target ‘gaming’ about which it complains.

The interim proposal of the TEG had been specified in a more granular manner that notably identified Oil, Gas & Consumable Fuels as a distinct sector. With respect to the exposure constraint so defined, CDP (2019), the not-for-profit organisation that has been running the global environmental impact disclosure system for more than 15 years wrote in its feedback: “The constraint is counter-intuitive and contradictory. One would say that it leads to lock in the old economy and that it is far from market consensus. Why do investors still need to invest in Coal, Oil and Gas or infrastructure that lock us down in a carbon intensive economy in a Paris-aligned benchmark?”

In the same spirit our feedback had underlined that the proposal would come across as institutionalising greenwashing by mandating continued or increased support to sectors, notably the Oil and Gas industry, which need to be phased out or radically reduced in any realistic transition scenario. We had also stressed that some sectors had been defined in a manner that allowed for in-sector reallocation from high to low carbon-intensity activities analogous to those denounced by the TEG as greenwashing.

Based on the clarification with respect to sector constraining provided in the handbook (TEG, 2019d), these assessments need to be revisited. On the bright side, the TEG proposal does not require maintaining or increasing support to the Oil and Gas industry (captured by Mining and Quarrying in the final proposal) or any other High Climate Impact sector as long as the overall exposure across the nine sectors is maintained or upped. On the downside, the proposal allows both intra-sector and inter-sector reallocation, which does little to address the type of greenwashing criticised by the TEG. Indeed, the cross-sectional decarbonisation can be achieved by underweighting the sectors with the highest carbon intensities within the group of High Climate Impact sectors, e.g. Electricity, Gas, Steam and Air Conditioning Supply, and the inter-temporal decarbonisation can be achieved by further reallocations within the group towards sectors with lower carbon intensities in relative terms.

In the proposal of the TEG, the sectoral dimension of decarbonisation is not controlled beyond what is afforded by the global exposure constraint. This means that there is no mechanism to incentivise and reward decarbonisation achievements within each of the High Climate Impact sectors.


Additionally, there is no guarantee that the decarbonisation reported by a Climate Benchmark will amount to more than inter-sector reallocation within the High Climate Impact group. Hence, the required decarbonisation may be achieved by simply underweighting the highest carbon intensity sectors without modifying the relative weights of issuers within these sectors.

Given the wide dispersion of carbon intensities across sectors and the severity of the inter-temporal decarbonisation requirement, the risk of seeing the decarbonisation constraints being gamed by inter-sector reallocation should be considered material. Note that further underweighting of the highest carbon intensity sectors would provide budget to increase the (absolute and) relative weights of issuers from other High Climate Impact sectors that may lag in terms of decarbonisation efforts in respect of their sector peers but may be attractive for other reasons.

It is thus obvious that Climate Benchmarks so defined cannot be considered as tools to send clear signals to companies regarding the necessity of decarbonising their operations, electricity supplies and overall value chains. It is also clear that many a strange animal from a sustainability viewpoint could qualify as an EU Climate Benchmark, with obvious risks to the value of these official labels for the various stakeholders involved (benchmark administrators, asset managers, investment advisors, investors) and to the credibility of European policy in matters of sustainable finance.

Overall, imposing a group-level exposure constraint on top of a minimum required reduction in the weighted averaged carbon intensity of the benchmark promotes inter-sector (as well as intra-sector) reallocation that may reduce the targeted carbon metric of Climate Benchmarks without necessarily promoting relevant changes from a climate-change perspective. At best, these constraints give a false sense of security in regards to the greenwashing risks highlighted by the TEG; at worst, they encourage these shenanigans.

In addition, requiring Climate Benchmarks to have exposure in respect of multiple sectors (nine out of 21 in the reference classification) that matches or exceeds that of the market-capitalisation weighted index of the underlying universe makes sector indices ineligible and narrows the spectrum of index strategies that index administrators may offer as Climate Benchmarks.

Smart beta and factor indices were developed to address important limitations of broad-market capitalisation-weighted indices with respect to exposure to unrewarded and rewarded risks. In the pursuit of their financial objectives, these alternatively weighted indices may naturally incur significant sector deviations relative to the cap-weighted representation of the universe. Imposing market-capitalisation weighting constraints on such alternatively weighted indices entails costs for investors in the form of reduced investment options and reduced optimality of available options (relative to the set of strategies that could be offered in the absence of sector constraining).

Note that optimality costs are not limited to alternatively-weighted indices because, whatever the type of index, the inter- and intra-sector reallocations encouraged by the proposal may lead to excessive sector, sub-sector and security-level concentration, which will expose investors to unrewarded risks.



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34 - While different benchmarks could cater to different objectives and as such have different (sub) sectoral exposures, they would all be consistent with the promotion of decarbonisation within each (sub) sector.

In ConclusionBy first proposing to benchmark the relative decarbonisation of Climate Benchmarks against the capitalisation-weighted index of the broad-market, the TEG disqualifies indices that are on a decarbonisation trajectory or aligned with the Paris Agreement but focus on or significantly overweight high carbon intensity sectors and activities. Adopting this specification as part of the Level II text would deprive investors of the opportunity to implement such strategies within the confines and protections of the amended Regulation.

By then imposing an exposure constraint in respect of High Climate Impact sectors as a way to address concerns of greenwashing, the TEG further narrows the range of index strategies that may be offered as Climate Benchmarks and provides additional support to the anchoring of the Climate Benchmarks to the economic structure reflected by the market-capitalisation weighted representation of the underlying market. As this structure may be – and typically is – at odds with the needs of the climate transition, this could create understandable greenwashing concerns. However, in the latter respect, the main issue is the representation that the exposure constraint set forth by the TEG is an effective and efficient manner to prevent the gaming of the decarbonisation target by reallocation from relatively higher to lower carbon intensity assets.

Indeed, the constraint authorises reallocation from higher to lower carbon intensity sectors within the large and diverse group of High Climate Impact sectors as well as in-sector reallocations from higher to lower carbon intensity sub-sectors whether or not such reallocations are relevant from a climate change mitigation perspective. In the absence of proper and granular control of sectoral effects, the cross-sectional and inter-temporal decarbonisation targets set forth by the TEG can be achieved by weight adjustments that fail to provide any clear signal to issuers with respect to the urgency of decarbonising.

Under these conditions, Climate Benchmarks as a class34 need not reflect and incentivise progress towards what could constitute a self-sufficient low carbon economy, i.e. an economy that would include companies from all required sectors and sub-sectors that are required in a low carbon world (or an average of competing versions of such an economy). On the contrary, the specifications of the TEG create the conditions for greenwashing of a particularly perverse and dangerous kind since they are marketed as preventing greenwashing.

We thus conclude that the sector exposure constraint as proposed by the TEG not only includes significant drawbacks in terms of restricting administrator flexibility and related investor choice but also fails to address the very risks for which it was put forward. In the final section of this paper, we will explain how allocation-related greenwashing concerns can be addressed not only effectively but also efficiently, i.e. how one can promote transition towards a low carbon economy without unduly restricting the variety and quality of index strategies available to investors.


3.2. The Proposal Introduces a Non-Consensus and Questionable Carbon Exposure Metric

Basics of greenhouse gas emissions accounting and carbon metricsThe Greenhouse Gas (GHG) Protocol Corporate Standard, developed by World Resources Institute and the World Business Council on Sustainable Development, first published in 2001, is the international standard for corporate and organisational GHG inventory. The Corporate Standard covers the accounting and reporting of the seven greenhouse gases covered by the Kyoto Protocol and its amendment and distinguishes three scopes of emissions as detailed in Table 5 below.

Table 5: Scopes of Greenhouse Gas Emissions

Scope 1 emissions GHG emissions from sources that are owned and/or controlled by the company.

Scope 2 emissions GHG emissions from the generation of electricity, steam, heating or cooling purchased/consumed by the company.

Scope 3 emissions All other indirect greenhouse gas emissions that occur in the value chain of the company (i.e. emissions that result from upstream activities such as the production of purchased raw material, as well as emissions from downstream activities, such as the distribution and use of the company’s products).

Carbon footprinting entails allocating to the portfolio a share of the greenhouse gas emissions of each company in proportion to the share of its capital that is controlled by the portfolio. Carbon footprinting metrics thus represent the indirect responsibility of a portfolio’s investor in respect of emissions. Carbon footprinting measures respect the ownership (or economic interest) principle in the Greenhouse Gas Protocol, whereby corporate emissions are proportionally allocated “per share” to the investor and portfolio level aggregation is based on the respective ownership of each holding. These measures do not measure exposure to climate risk directly but are proxies that allow investors to detect potential issues.

Carbon exposure metrics that do not rely on the ownership approach to allocate emissions cannot directly inform on an investor’s contribution to climate change but can be useful as measures of exposure to the risks linked to a transition to a low-carbon economy. WACI averages corporate-level Carbon Intensities, i.e. company emissions normalised by a financial aggregate – normally company revenues – according to portfolio weights. It is often used as a proxy of overall portfolio exposure to carbon-intensive companies and by extension to the risks of the transition towards a low carbon economy.

Investors use various metrics to report the carbon footprints and carbon exposures of their portfolios. The TCFD, set up by the Financial Stability Board (FSB, 2017) established a list of five commonly used metrics which asset owners and managers should consider reporting.

Among these, the WACI, defined as the weighted average of constituent ratio of Level 1 and 2 corporate emissions to corporate revenues, is identified as the recommended metric for reporting by asset managers and asset owners.



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35 - Recital 20 calls for the disclosure of the “total carbon footprint” of climate change benchmarks and Annex III requires the CTB methodology to give information about “the total carbon emissions of the index portfolio”.36 - Carbon Intensity is a carbon footprinting metric also known as financed emissions to financed revenues.37 - While the use of Enterprise Value is clearly required by the TEG for the purpose of assessing decarbonisation, the TEG might be less restrictive in matters of reporting as the following appears in the disclosure section of the report: “intensity - while presenting challenges in the presence of revenues or total capital growth, if chosen as denominators – has the advantage of allowing comparability between indices.” Such flexibility in reporting would obviously be a source of confusion.

Choice of a non-standard exposure metric by the TEGWhile the amendment to the Benchmark Regulation mentions climate-change mitigation as the objective of the Climate Benchmarks and suggests a requirement to disclose the carbon footprint of benchmarks,35 the TEG chooses to target reduction in exposure to climate risks and fittingly adopts an exposure metric. The term carbon footprinting being sometimes used in a loose manner and the Level I having failed to appropriately define terms, it is possible that the choice of the TEG is indeed aligned with the intention of the Level I text. Nevertheless, the TEG notes that to increase transparency on investors’ impact is one of the main objectives of the new Climate Benchmarks, so it is disputable that the focus on an exposure metric rather than an impact metric is most appropriate.

This notwithstanding, the use of exposure metrics for the decarbonisation of portfolios and reporting has always been a popular option with investors and the recommendations of the TCFD have contributed to establishing WACI as the default metric. Hence the choice of an exposure metric over an impact metric by the TEG, while unsubstantiated, is not dissonant vis-a-vis mainstream practices.

However, the specific exposure metric suggested by the TEG is at the least rather exotic. Misleadingly termed carbon intensity36, it is a variation of WACI that takes into account Level 1 to 3 carbon emissions and uses Enterprise Value as denominator.37

This metric is not part of the list of commonly used metrics prepared by the TCFD and is at odds with the version of the WACI that the TCFD recommends for reporting by asset managers and asset owners.

This proposal also flies in the face of the advice given by stakeholders who participated in the Call for Feedback. The majority of these respondents rejected the interim report suggestion of a non-standard exposure metric and multiple stakeholders underlined the relevance of using the standard version of WACI:• CDP (2019): “We would like to bring to the TEG’s attention the fact that introducing Total Capital as the denominator in the calculation of carbon intensity is not aligned with the recommendations of the Task Force on Climate-Related Disclosures. The TCFD recommends asset owners and asset managers report to their beneficiaries and clients the weighted average carbon intensity of their portfolios expressed in tons CO2e / $M revenue.”• Swiss Sustainable Finance (SSF, 2019): “We would recommend to align the disclosure requirements with such metrics as used by widely accepted methodologies.”• Federation of European Securities Exchanges (FESE, 2019): “We do not think that changing the current market standard (million USD of revenue) would be beneficial. To the contrary, such change would cause large-scale inefficiencies.”• Eumedion (2019), an organisation representing 65 institutional investors in matters of corporate governance and sustainability: “Revenues as a measure should work quite well for most companies.”• Scientific Beta (2019): “If the objective is to find an indicator that is applicable to both equity and fixed income investments and extremely simple, then WACI does all this and is the metric recommended


38 - TEG also burdens administrators with computation of carbon intensities on the basis of average weights on a semi-annual basis to avoid the risk of window dressing at the reporting stage where the administrator would choose “a certain date during the year (likely end of December) to calculate carbon intensity, while performing the same calculation using average weights over the year would result in greater carbon intensity”. The indices eligible for use as benchmarks are systematic strategies and they typically rebalance at low frequency (which may nonetheless be different from the half-yearly frequency that is common at MSCI and FTSE-Russell). In any case, it makes no sense to use index weights averaged over six months with greenhouse gas emissions that may only be current at the end of the period, all the more so if the index is rebalanced over the period to adjust to changes in greenhouse gas emissions data. Averaging index-level metrics computed using point-in-time data although more onerous would at least make sense. To ensure that reported metrics are faithful and current, it would typically suffice to require that computations be performed on the basis of index weights at the latest rebalancing of the index or the latest date on which the index could have rebalanced, whichever the most recent and using data that can be regarded as current at the time. In the interest of comparability across indices, standard dates for reporting could be set with a periodicity that is aligned with that of possible rebalancing, e.g. at end of quarter for indices that can rebalance quarterly.39 - In the final report, the TEG writes: “Total capital could be an interesting measure for within sector point-in-time comparisons but it is not conducive for comparisons across sectors (e.g. it is biased against tech firms whose intangible assets are normally not accounted for in their book values).”40 - One may correctly note that revenues are influenced by pricing power, and this may depend on sector as well as idiosyncratic factors.41 - However, the TEG is less shy when it comes to alignment with the Paris Agreement since its activity thresholds virtually wipe out from the PABs not only coal companies but also oil and gas companies.42 - Professor Damadoran maintains data on enterprise value multiples by sectors: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/vebitda.html

by the TCFD for reporting by asset managers and asset owners. In addition, changes in the market values of securities do not affect the WACI beyond what is reflected in constituent weights.”

In the absence of any scientific demonstration of the superiority of a new metric and lacking a cost/benefit analysis, we see no basis to upend widely accepted practices.38

In this regard, it is interesting to note that the TEG admitted that its previous untested proposal of a novel WACI metric would have introduced serious biases39 as we and other stakeholders had pointed out on the occasion of the Call for Feedback. It is unfortunate however that the TEG remains so bold about its ability to put forward a new metric whose superiority would justify the costs of substituting it for a widely accepted metric which has also been recommended by the TCFD.

Limitations and flaws of the TEG carbon exposure metric

The metric creates sector biases on the basis of revenue multiplesThe TEG claims that its new metric “does not bias for or against any particular sector” although its choice is guided by the very fact that the enterprise value of coal industry companies is a low multiple of revenues as it candidly admits: “The TEG believes that using revenues as denominator in the reporting of the carbon intensity allows for the within sector point-in-time comparisons of the ability of corporations to decarbonize their business, generating less GHG emissions per unit of revenue. However, revenue multiples are not comparable across sectors. In particular, sectors such as coal which are exposed to potentially discontinued assets – often referred to as ‘stranded assets’ – tend to benefit from revenue as a denominator compared to market valuation based alternatives.”

Using revenue multiple-sensitive enterprise value rather than revenues40 to normalise emissions will ensure that the coal industry has a disproportionate impact on the benchmark total WACI in regards of its importance in terms of revenues. By introducing a novel carbon intensity metric admittedly meant to provide a high incentive for coal divestment without explicitly imposing it, the TEG is able to state that “No activity and ultimately no asset or company can be considered completely incompatible with a transition to a low-carbon economy at a point in time”.41

Interestingly, the TEG suggests that the use of the standard version of WACI by the industry – and we have to assume the Financial Stability Board Taskforce on Climate-related Financial Disclosures – is a form of “greenwashing in favour of polluting sectors.” Since we like a conspiracy theory as much as anyone else, we underline in the same anecdotal fashion as the TEG that some high-impact activities such as real estate development or online retailing have very high revenues multiples42.



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43 - Let the index be such that market capitalisation is initially half the enterprise value of the average company, then a 25% fall in stock-market prices over a year, other things equal, results in a 14.3% increase in the new intensity metric put forward by the TEG. Even if emissions fall 7% year on year, the metric still rises 6.3%. For the self-decarbonisation constraint to be respected in these stock market conditions, emissions have to fall 19%!44 - Admittedly, the same issue would arise with revenue, albeit with lower severity, given that the volatility of revenues is materially lower, even in the benign market environment of the last decade.

As such, they will be favoured by the proposed TEG metric when one could reasonably argue that it would be particularly relevant to ensure the promotion of high decarbonisation standards for buildings with long useful lives or support carbon efficiency improvements in a booming online retailing industry that may encourage wasteful consumer behaviour. In this we do not mean to suggest that the proposal of the TEG has been dictated by powerful real estate development or online retailing interests. Rather, we underline that departing from the consensus metric that affords equal importance across sectors to emissions normalised by revenues so as tilt decarbonisation against a specific priority sector may come with unintended and undesirable consequences in respect of other sectors. More generally speaking, it introduces opportunities for gaming the metric by exploiting differences of multiples across activities, which could be seen as a form of greenwashing.

In addition, we must strongly underline that (climate-impact and/or stranding risk hedging motivated) coal divestment is already a standard feature of institutional decarbonisation programmes, independently of the metric selected to report carbon intensity at the portfolio level. It follows that, by changing the reference metric to increase its sensitivity to the coal industry, the TEG reduces the difficulty of achieving the portfolio-level targeted intensity reduction given coal divestment. Put differently, an unneeded subsidy is given to coal divestment which allows less ambitious decarbonisation programmes to meet the requirements for qualification as Climate Benchmarks.

The metric is volatile and may render the self-decarbonisation requirement unworkableThe new carbon intensity metric put forward by the TEG imports stock market variability into measurement via the inclusion of market values for common and preferred equity. This brings drawbacks that the TEG had identified in its interim report and had led it to rely on accounting data in its earlier proposal: “The TEG explicitly uses the book values instead of market values (…) as market effects can significantly affect this indicator and create misleading results. As an example, if the valuation of a company changes significantly, leading its market values to rise, this would result in significantly lower GHG intensity even with no particular change regarding its absolute GHG emissions.” (TEG, 2019a) The reverse is also true.

This affects the relative attractiveness of securities from the point of view of index decarbonisation and thus the composition of the Climate Benchmarks over the years.

In addition if the inflation adjustment of the year-on-year self-decarbonisation target does not cover deflation – and there is nothing suggesting it does in the reports and handbook prepared by the TEG (2019a, 2019c, 2019d), then historically reasonable negative stock market variations in the short and medium term could lead to relevant decarbonisation strategies losing their Climate Benchmark qualifications despite continued progress on emissions reduction. This is because such drops in the general level of stock prices would need to be offset by unreasonably high cuts in emissions to keep a Climate Benchmark on the year-on-year decarbonisation trajectory.43,44 Naturally, Climate Benchmarks whose decarbonisation is based on allocation shenanigans of the type described above


45 - Amongst the top companies by cash held (https://www.gfmag.com/magazine/september-2018/global-finance-cash-25-2018), Cisco, Microsoft, Oracle, Amgen, Alphabet would see their economic footprint measured by book assets close to halved by a cash adjustment and Facebook would benefit from a one-third reduction. Since the new metric uses market rather than book values for equity, the effect would not be as strong for this group of companies as they benefit from high market to book multiples.46 - While negative revenues can also arise, there were only 120 such occurrences in the same population at the time of writing of these 91,369 (0.13%).47 - When pressed on the question, the Benchmark Working Group recommends that concerned benchmark administrators use of an alternative metric “excluding cash and especially cash equivalents” (TEG, 2019c, page 11). So it appears the TEG insists on the use of a single metric and then does not.48 - This was notably the historical position of ISS whose Scope 3 estimation methodology relies on 800 subsector specific models.

would be best positioned to survive such episodes of market volatility. The absence of adjustment for deflation rewards the methodologies that are least relevant from a climate transition standpoint by endowing them with a higher survival rate. This very feature naturally incentivises their adoption in the first place. Hence the proposed regulatory parameters promote low relevance decarbonisation strategies within the pool of Climate Benchmarks at onset and over time.

The metric is influenced by the cash position of companies and can become negativeEnterprise value is a metric that is used to determine the amount required to take over a company and for this reason includes a deduction for the cash and cash equivalents held by the company.

In this regard, we can only agree with the interim report of the TEG (2019a) that noted “adjustments for cash or pension liabilities appear irrelevant to the task of scaling GHG emissions”.

The adjustment means that, other things equal, a company that holds more cash (equivalents) will have a lower enterprise value and, as long as the latter remains positive, a higher carbon intensity.For this reason, the adjustment could be construed as a carbon tax on cash-rich companies (e.g. US based technology companies), which has no obvious economic or environmental justification and may be viewed as carrying problematic political overtones.45

In addition, enterprise value can become negative, typically when a company combines deep undervaluation with a strong cash position. This occurrence is not extremely rare and, at the time of writing, 1.3% of companies with active trading status on Bloomberg had negative enterprise value (1,196 out of 91,369 primary securities).46,47 Naturally, the behaviour of the enterprise-value version of carbon intensity when enterprise value hovers around zero requires that the affected securities be excluded least index construction and/or reporting be contaminated.

The metric does not do justice to issuer-level climate change effortsScope 3 emissions occur from multiple upstream and downstream sources not owned or controlled by the reporting company and as such may be challenging to estimate; they also entail a significant risk of double counting arising from reporting companies taking different views on the boundaries of their activities for emissions measurement. At this stage, reporting of Scope 3 emissions is not a requirement in most jurisdictions and very few companies report Scope 3 emissions across their 15 sub-categories. As a result, self-reported Scope 3 emissions data is too scarce and lacking in quality and consistency to support portfolio decision making. The limitations of self-reported data contribute to making estimation of Scope 3 emissions by third party more imprecise, which leads responsible data providers48 to caution against their use for security-level decisions!

These limitations are frankly acknowledged by the TEG (2019c), which states: “Given the current state of corporate Scope 3 GHG reporting, administrators (…) or their data providers will likely have to estimate Scope 3 data for the foreseeable future, using alternative methods focused on products (downstream) and supply chain (upstream). Using these alternative methods implies that less firm



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49 - It is correct to remark that the TEG had to address the question of Scope 3 emissions as they were mentioned in the Level I text. However, the said text only mentions Scope 1/2/3 emissions to require benchmark administrator to disclose what type and source of data they use to determine the decarbonisation trajectory in respect of these emissions. It does not require uniform treatment of emissions of all scopes (as the incremental inclusion of Scope 3 emissions proposed by the TEG demonstrates).50 - The TEG indeed writes: “Practically, this means that the benchmark administrator will calculate the GHG intensity of its benchmark on the first year and will have to calculate the benchmark’s emission intensity trajectory the index shall be compliant with to qualify for the EU PAB or EU CTB label.”

specific information is included in Scope 3 GHG estimations than in Scope 1 or 2 estimations. Hence, variations between similar firms will largely result from variations in the products and activities they trade in.”

This is particularly of the essence as Scope 3 emissions are larger than the sum of Scope 1 and 2 emissions by an order of magnitude – hence the joint consideration of Scope 1-3 emissions in index construction will drown out any corporate-level signal present in Scope 1-2 emissions in a sea of product and activity based Scope 3 noise.

In spite of this damning assessment, the TEG, opts to recommend an extremely rapid phase-in of Scope 3 emissions in climate benchmark construction methodology.49

The TEG correctly observes that this cannot do justice to the efforts made by issuers and puts the onus of improving this sorry state of affairs on Benchmark administrators and investors: “Consequently, the effectiveness and efficiency of corporate decision making with respect to upstream and downstream Scope 3 emissions and consequential intensity reductions may only gradually find their way into Climate Benchmarks, as administrators of EU Climate Transition and of EU Paris-aligned Benchmarks and other investors engage firms to substantially increase the volume and quality of its Scope 3 GHG emissions reporting.”

We would find it unacceptable that a tool that is part and parcel of the European Commission’s action plan to support the reorientation of capital flows towards a more sustainable economy (so cynically) disregard the efforts made by companies in the mitigation of their greenhouse gas emissions. We consider that mandating the construction of EU Climate Benchmarks upon unreliable data constitutes institutionalisation of illegitimate claims about the climate impact of these Benchmarks.

It should also be remarked that the 7% intertemporal decarbonisation requirement provides incentive to set decarbonisation in the reference year to the minimum acceptable under the cross-sectional requirement, e.g. 30% or 50%, so as to manage the risk of disqualification in later years.50 The wisdom of incentivising the highest possible “carbon intensity” at onset is not obvious from a climate change perspective and it is also a relative disadvantage for the most carbon efficient companies at onset. Also note that where the index administrator ports the 7% requirement to the individual security level – which it is not required to do – companies that have already achieved high efficiency due to past efforts are disadvantaged.

For fairness, it should be observed that the TEG has suggested that weight increase be considered for companies that set evidence-based targets; however, even if voluntarily adopted by the index administrator, this is likely to be of little weight relative to the cross-sectional and inter-temporal decarbonisation requirements.


51 - European investors complain over soaring cost of data - Funds say exchanges are jacking up fees to offset weaker revenues from trading, 4 April 2019, Financial Times. 52 - The bulk of the inflation has been via changes to licensing conditions.53 - While legislation in force in Europe requires such data to be provided “on a reasonable commercial basis”, it is ineffective.54 - Note that US exchanges have a statutory obligation to demonstrate that their fees are fair and reasonable and not unreasonably discriminatory and that the SEC ruled (on 16 October 2018) that NYSE Arca, Inc. and Nasdaq Stock Market LLC had failed to do so in respect of certain market data fees.55 - Looking at the revenues of ICE/NYSE, NASDAQ & CBOE over the past eight years, Tabb (2018) observes that non-transactional revenues have grown on a compound annual growth rate of 8.5%, mostly on the back of an 11.7% growth rate for data. While exchange-based market data and connectivity grew at 6.1%, non-exchange data, technology and services grew more than three times faster (at a rate of 18.7%). Market Data Revenue Analysis, Larry Tabb, SEC Market Data Roundtable, Washington, DC, 25-26 October, 2018.

In ConclusionThe adoption of an exotic carbon exposure metric that suffers from multiple flaws and limitations can only slow down the formation of a consensus on a matter that is critical for the transition to a low carbon economy. Indeed, the reduction in the carbon exposure of an index does not directly affect the contribution to climate change or accelerate the transition. The transmission channel is the pressure – including the price pressure – exerted by the exclusion or underweighting of certain assets in institutional portfolios tracking decarbonised indices. This pressure provides issuers with incentives to adapt the production of their products and services to the requirements of decarbonised portfolios.

Should the delegated acts promote a metric that is different from that around which a consensus has formed, the European Commission would contribute to a cacophony where loud and clear signals would be required for effective dialogue with issuers. Indeed, what will be the attitude of the senior management of companies that have a key role to play in the transition when faced with different and possibly divergent metrics and therefore demands from the investment management industry? Naturally, with the proposed inclusion of Scope 3 emissions, insult is added to injury; how could disdaining corporate efforts with respect to emissions mitigation foster a constructive dialogue?

3.3. The Proposal Introduces Costly ESG Disclosures that do Little to Support Informed Decision-Making

Proposed ESG disclosures would increase direct and indirect costs for investors Index administrators (and asset managers alike) are facing remarkable inflation in data provision costs, both in absolute and relative terms. According to Burton-Taylor International Consulting (part of TP ICAP), data revenues of exchanges have seen a compound annual growth rate of almost 13% over 2012-18 to total some USD6bn.51 Sales of data now account for a fifth of exchange revenues according to the same source and the contribution to profits is larger. Fast rising charges for market data licensing52 have created unease on both sides of the Atlantic and led to accusations of abuse of market power and calls for regulatory action53, including via regulation of access and simplification of fee structure and capping of revenues (see for example Copenhagen Economics, 2018).

The cost of technology underlying market data determination and distribution is understood to have fallen, making hikes in charges hard to justify. Market data is by nature central to a broad spectrum of financial market participants and trading venues have a natural monopoly on the prices determined on their platforms, so the competitive conditions in which these data are provided receive maximum, albeit insufficient, regulatory scrutiny.54 Exchanges and other data providers enjoy (even) more leeway with respect to the pricing of other financial data and extra-financial data and revenues for such data have grown even more briskly.55



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56 - LSEG’s Schwimmer Defends Refinitiv Deal, 25 September 2019, MarketMedia and Why the London Stock Exchange is keeping its eyes on the Refinitiv prize, 26 September 2019, NS Banking.57 - As noted in Eccles and Stroehle (2018), EIRIS was created in 1983, five years earlier than Kinder, Lydenberg & Domini (now part of MSCI).58 - The deadline was pushed to 31 December 2021 in 2019 for critical and third country benchmarks.

Tellingly, there has been considerable consolidation in the data provision market and data providers, and ESG data providers in particular, have increasingly been the targets of mergers and acquisitions. In 2019 shareholders of the London Stock Exchange Group approved an USD37bn takeover of infrastructure and data provider Refinitiv. Commenting on the deal, the LSEG CEO noted the increasing importance of data and data analytics and cited attractive synergies between the index business of LSEG and Refinitiv’s ESG database.56 Less than a year before that acquisition was announced, Refinitiv was valued at USD20bn in the hands of the consortium (led by Blackstone) which had completed a LBO of the company from Thomson Reuters. 2019 also saw significant transactions that transferred foremost European ESG data providers into the hands of American groups with Moody’s Investors Service taking control of ESG research pioneer57 Vigeo Eiris and S&P Global, already the owner of climate specialist Trucost, announcing plans to acquire the ESG ratings business of RobecoSAM. More targeted transactions saw index and data provision groups further consolidate their control over ESG data with purchases of boutique providers; illustrations include LSEG acquiring fixed income ESG rating specialist Beyond Ratings and MSCI acquiring climate change scenario analysis Carbon Delta AG.

While the costs of acquiring ESG data for portfolio construction are already significant and positioned to rise as a result of industry consolidation, the minimum ESG disclosures put forward by the TEG would further strengthen the ability of data providers to extract value from index administrators as they would render it illegal for the latter to offer Benchmarks pursuing ESG objectives without providing extensive disclosures in respect of ESG themes for which they will need to secure licenses from the former – including for usages that have traditionally attracted high costs due to their sensitivity in respect of intellectual property protection, i.e. security-level disclosures. It is also the wish of the TEG to strongly encourage voluntary disclosure in respect of indices that do not pursue ESG objectives by framing non-disclosure as “a last resort option”.

The governance-focused requirements of compliance with the Benchmark Regulation ahead of the initial58 deadline for authorisation of 1 January 2020 have imposed administrative costs upon index administrators. This is to the advantage of large providers (as the impact of costs of a fixed nature diminishes with size) and has contributed to additional barriers to entry into an industry which historically has been very concentrated. Increased index administration costs, when passed down the investment management value chain, contribute to higher direct costs for end-investors. Meanwhile, reduced competition in the index provision industry indirectly impacts end-investors by reducing their bargaining power and limiting innovation. In this regard, the ESG disclosures that the TEG recommends would entail both further administrative costs and new and material data costs for Benchmark administrators, which could eventually be borne by end-investors. Interestingly, while the TEG acknowledges the former and underlines that the update of its disclosure templates can be automated to reduce disclosure preparation costs, it does not appear overly concerned with the costs of procuring the data, which should be expected to be much more significant. As previously mentioned, the domination of the Benchmark Working


59 - Note that the integration of exchange, data and index activities in itself is a source of conflicts of interests that require adequate management if benchmark integrity is to be preserved.60 - While we understand the Directorate-General for Competition European Commission has been reviewing competition in the data and indexing industry, we are not aware of any enforcement action.

Group by parties that provide ESG data services raises natural questions on the quality of conflict of interest management on the part of the TEG.

As for indirect costs, it should be underlined that the conditions for fair and non-discriminatory access to ESG data by all Benchmark administrators, even at increased prices, cannot be met. The market is increasingly dominated by ESG data providers that are integrated with, or sister organisation of, the big three index providers controlling more than two-thirds of the market, namely US data and index powerhouses MSCI and S&P Global and British-based stock exchange and financial information company LSEG (owner of index and ESG data provider FTSE Russell).59

Requiring non-discriminatory and proportionate access to ESG data and services would provide mostly theoretical protection as the concentration and integration of the industry makes it difficult for parties that are harmed by unfair practices to come forward. For example, an index provider that has integrated in its products the business classifications and/or security universes and/or risk modelling tools provided by a major financial group may not be comfortable raising an issue in relation to access to ESG data knowing this may impact its access to other services. That is assuming this provider has not been denied access to these services in the first place because it was seen as competing with the said financial group in the index administration space.60

Imposing or promoting ESG disclosures for Benchmarks not only results in direct costs and the associated transfer of wealth to ESG data suppliers which, as an industry, are guaranteed more business and gain in pricing power through regulatory-mandated disclosures. It also involves higher indirect costs for investors by favouring the large index providers that have acquired ESG data capabilities. A serious cost and benefit analysis of these mandated ESG disclosures, which has yet to be attempted by the European Commission, would need to account for both direct costs and the costs of reduced competition in the Benchmark administration industry.

Also note that, by forcing additional and material disclosure costs on Climate Benchmarks (and other benchmarks pursuing ESG objectives), the regulator would create a disincentive for the offering and adoption of these Benchmarks. This is hard to justify given the urgent need to support the climate transition (and the overall political objective to favour sustainable finance). This sorry outcome is largely the making of the TEG – but it can still be avoided.

Meaningless and gaming-prone indicators dominate mandated ESG disclosuresThe majority of the quantitative disclosures recommended by the TEG concern ESG ratings: out of the 25 indicators that would need to be reported, four are portfolio-level ESG ratings (a global ESG rating plus a rating on E, S and G pillars) and 10 are security-level ESG ratings (one global rating for each of the top-10 constituents).

Even if it were not associated with material and distinctive costs as previously mentioned, this domination of the disclosures by ESG ratings would still be particularly damaging.



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61 - For illustration, Vigeo-Eiris recognises six ESG domains: Human Rights, Business Behaviour, Environment, Community Involvement, Corporate Governance and Human Resources.62 - For the avoidance of doubt, a straight line with a slope of 45 degrees would signal perfect alignment of rankings based on ratings.63 - Similar comparisons have been performed for global companies; for example, in a 2015 study CSRHub finds a (weak) correlation of 0.32 between MSCI’s and Sustainalytics’ ratings for companies in the S&P Global 1200 index (ACCF, 2018).64 - The TEG (2019c) writes: “Feedback from stakeholders has highlighted the limited use of this KPI, given the variety of methodologies used for the calculation of ESG scores. However transparency regarding the methodologies used (…) should provide investors with clarity around the meaning and interpretation of the scores.”65 - Even if they had, the comparison-relevant data that could be extracted from largely disparate ratings would be extremely limited and the relevance of such data would still depend on the validity of the underlying assessments, which as we shall see are very much at doubt.

First, as we have underlined, there is no accepted ESG rating standard and ESG ratings are highly divergent across providers. For a start, there is not even a consensus on the number of ESG pillars. While most providers allocate ESG issues to three pillars, others, including foremost providers, prefer a more granular approach.61

Casual comparisons of ratings by practitioners, such as that made by the Government Pension Investment Fund of Japan (GPIF, 2017) which looked at the coherence of rankings from overall ESG ratings and whose results appear on Figure 462, illustrate that there is little consistency in ratings prepared by different data providers.63

Figure 4: Comparison of rankings for 430 Japanese companies commonly surveyed by MSCI and FTSE (as at July 2016)

Source: GPIF (2017), x coordinate is for MSCI and y coordinate for FTSE, from 1 (best) to 430 (worst)

This divergence of ESG ratings originates from divergences of objectives (what), methodologies (how) and assessments. Ratings could (and do) diverge because they relate to fundamentally different concepts, such as measurement of the ESG impact or performance of a company vs measurement of the financial materiality of ESG issues for a company. They also diverge on the choice and weighting of criteria (as a result of divergences of focus or disagreements with respect to the proper manner in which to approach the same issue), and/or because of differences in data sources and treatment, including arising from subjectivity.

It is very optimistic to assume that users would be able to identify and appreciate differences of objectives and methodologies across providers of ESG ratings so as to determine when it might be reasonable to attempt the comparison of indices for which reporting is produced using rating data from different providers. It is completely unrealistic to assume, as the TEG does,64 that users would have the wherewithal to adjust reported ratings for these differences so as to make them comparable.65 What is to be expected is that users will fail to appreciate these differences and rely on nonsensical comparisons between indicators produced by disparate methodologies to take into account sustainability in their investment decisions.


66 - Hence even if users were able to appreciate how the variability of approaches impacts ratings (as the TEG appears to assume), they would not be able to extract relevant information from these divergent ratings.67 - In this regard, note that both casual comparisons and scientific research point to size (large vs small companies receive higher ratings), country (companies in countries with higher reporting requirements receive higher ratings), sector, industry biases in ESG scores.68 - For the avoidance of doubt, the same variability is observed at the pillar level. For illustration, on the environmental dimension, Semenova and Hassel (2015) find that ratings provided by MSCI KLD, Thomson Reuters Asset4 and Global Engagement Services (now part of Sustainalytics) do not converge.69 - The KLD dataset does not contain an aggregate rating – such a rating is created in most academic studies by summing all strengths and subtracting all weaknesses across the seven dimensions covered by the dataset.70 - The other sources studied are scope divergence, i.e. the selection of different sets of categories and weight divergence, i.e. the relative importance of categories in the computation of the aggregate ESG score.

Second and as rarely discussed, the class of methodologies that dominate the market for ESG ratings would produce little relevant information for decision making at the level of granularity mandated for the disclosures even in a perfect world in which convergent ratings for homogeneous constructs would be available. Indeed academic research establishes that even in a world in which different raters agree on a definition of ESG performance as well as on a set and weighting of evaluation criteria, variability in assessment would still be sufficiently material to frustrate meaningful comparisons.

Chatterji et al. (2016) assess the agreement of six prominent ESG ratings (MSCI KLD and Innovest, Thomson Reuters Asset4, FTSE4Good, DJSI, and Calvert) and find low convergence in raters’ assessments of corporate social responsibility. The authors explain that this lack of agreement is not only attributable to stated differences of approaches (which are found to be very stark) but also that all or almost all of the ratings have low validity (relative to their idiosyncratic definitions).66 They conclude that these metrics cannot guide issuers and that, in the worst-case scenarios, well-intended managerial attention to social metrics could reduce social welfare. Likewise, they note that investment on the basis of these invalid metrics will fail to direct capital toward the most responsible firms.67 Finally, they observe that the lack of validity or the inconsistence of ESG ratings should cast doubt on the validity of rating-based academic research on the effects of ESG on performance.68

Berg et al. (2019) find an average correlation of 0.61 (and a range of 0.42 to 0.73) between ratings provided by MSCI KLD69, Sustainalytics, Vigeo-Eiris, Thomson Reuters Asset4, and RobecoSAM (to become part of S&P Global); for comparison, they compute the correlation of credit ratings from Moody’s and Standard & Poor’s to be 0.994. They observe that this has consequences for asset pricing (i.e. even if a large fraction of investors have a preference for ESG performance, ratings divergence disperses the effect on asset prices), corporate incentives (due to the sending of mixed signals) and empirical research (whose results risk being unreliable) and conclude: “Taken together, the ambiguity around ESG ratings is an impediment to prudent decision-making that would contribute to an environmentally sustainable and socially just economy.” Consistent with Chatterji et al. (2016), the authors find that more than half the divergence observed is explained by differences in assessment.70

They also observe that assessment in individual ESG categories seems to be influenced by the rating agency’s view of the analysed company as a whole.

In light of the above, it is particularly disheartening to see the TEG put ESG ratings at the centre of a proposal that is supposed to improve decision making on matters of sustainability.

In this respect, it must be underlined that the danger of including ESG ratings into mandated disclosure had been underlined by a diverse cross-section of respondents to the Call for Feedback. Among those:• Think-tank 2° Investing Initiative tersely stated: “ESG ratings do not correlate across providers so individual ratings will be misleading.”• Due diligence specialist Reprisk (2019), commenting on the overall impact of ESG disclosures in terms of benefits to investors, ESG and business conduct risk, noted that benefits were unclear



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71 - See for example Drempetic et al. (2019) for firm-size bias and Breedt et al. (2019) for geography bias.72 - The NGO also objected to the relative nature of most ESG ratings, which leads to distinguishing sustainable companies within non-sustainable sectors.

and that disclosures could even be “harmful as they focus on company-self reporting and random metrics such as ESG ratings”.• Electric utility Iberdrola explained that rating agencies contact issuers directly to obtain ESG information due to the perceived low quality of public databases and observed that these providers do not have uniform and consistent methodologies. The utility concluded that due to a lack of trustful data, limitations of rating methodologies and lack of investors’ expertise, the time had not come to make ESG ratings a mandatory element for Benchmarks. The utility noted that it perceived “the influence of the ESG industry in the wording” of the proposal.

It should also be observed that, in spite of their idiosyncrasies, ESG ratings as a group have been shown to suffer from biases with respect to company size, geography and industry.71 Requiring their use in the context of wide-audience Benchmarks could have unintended consequences in terms of financing if such biases were not controlled.

An issue that has received less attention but must be mentioned is that ESG ratings may contribute to greenwashing:

At the issuer or index constituent level, ESG ratings are typically averages of indicators of corporate strengths and weaknesses over multiple criteria. The relevance of aggregating strengths and weaknesses is disputable as investors could value these very differently, in both non-financial and financial senses, as we explain further below. Averaging strengths and weaknesses across multiple criteria also allows certain issuers to achieve strong ratings despite association with material ESG issues and provide rich opportunities for astute and well-endowed companies to take a “strategic” approach to ratings by orientating ESG investments and reporting towards “low-hanging fruits.” This may come across as greenwashing and leads to some questioning the very relevance of ESG ratings.

As an illustration, NGO WWF noted in its contribution to the Call for Feedback that it was not convinced that ESG ratings were very robust. Their consideration of secondary ESG issues (what it called “nice to have”) could lead to overlooking critical ESG issues (what it called “strategic core business issues”) and a focus on process indicators (“tick boxing”) could lead to overlooking impact indicators. For these reasons,72 the NGO noted that it was not certain that publishing ESG ratings would be the most relevant thing at this state.

At the portfolio level, the averaging of constituent-level ESG ratings which is mandated by the TEG, allows for compensation of ESG ratings across companies and thus makes it possible for example to show a neutral or improved portfolio rating while increasing the representation of poorly rated companies in the portfolio (as long as the impact thereof is offset by increased relative allocation to highly rated companies), which may be viewed as greenwashing. In the absence of theoretical or empirical justifications, computing a portfolio-level ESG score as a weighted average of constituent ratings is anything but conservative in terms of downside risk management if ESG ratings are to be considered as risk proxies (see Box 1 for more on these considerations).


73 - By way of disclosure, Scientific Beta refrains from using portfolio averages for ESG filtering and limits the reporting of portfolio averages to cases where they are grounded in physical and/or financial realities or correspond to industry standards. The ESG screens implemented by Scientific Beta impose the same minimum ESG standards on all constituents and respect the hierarchy of ESG performance when selecting companies relative to their industry peers. Concerns about the average ESG performance at the portfolio level (or other factors) are not permitted to distract from the removal of securities with low ESG performance.

Box 1: Rejecting average indicators of ESG performanceThe investment performance of a portfolio, expressed in dollar terms, is the arithmetic sum of the constituent-level performance, expressed in the same unit. The distribution of gains and losses across constituents may provide different utilities to different investors. However, we need not rely on subjective utility to compute the portfolio-level investment performance as we have an objective exchange value for the performance of each constituent. In the absence of such a numeraire for non-financial performance, we need to question the relevance of averaging constituent performance to represent portfolio performance for a variety of agents.

With respect to the assumption of linearity that supports averaging, let us note that high ESG performance at the corporate level rarely attracts as much attention or elicits as much passion as poor ESG performance. Companies that are known to be failing basic standards of corporate responsibility receive disproportionately more coverage than companies that greatly exceed standards (and the effects of irresponsibility on firm performance are more enduring than the effects of positive initiatives as observed by Price and Sun, 2017) . Likewise, consumers have traditionally been found to consider the ESG performance of companies as a hygiene factor rather than a motivator (Meijer and Schuyt, 2005).

Hence, for the average investor with progressive ESG motivations, it is unlikely that the non-financial impact of holding a company facing a critical controversy could be neutralised by an investment of the same amount in a company that has earned a corporate sustainability award; and for investors following a deontological approach, the suggestion is obscene. Even for a business-as-usual investor, the mere assumption of controversy risk aversion invalidates the possibility of a linear relationship between ESG performance and its utility that would support the use of an average of performance as an average of utility at the investor level.73

Investors may wish to rely on ESG performance indicators to proxy for “ESG risks” with potential financial materiality. By assuming that the impact of these risks is meant to be assessed financially, we avoid retracing the subjective utility issues described above. In this context, the use of an average indicator is consistent with the risk contribution of each constituent being given by the weight of the constituent (exposure) times the constituent-level ESG metric serving as a proxy for the product of frequency by severity expressed in dollars terms.

Whatever the nature of risk, we are to accept that there is an exact linear relationship between the ESG performance at the constituent level and the expected value of the financial impact of the risk realisation. These high-bar assumptions are required to give relevance to the reporting of portfolio-averages of ESG scores as risk proxies and to portfolio construction approaches that rely on averages of ESG indicators across assets as objectives (e.g. maximise weighted average ESG score or portfolio subject to financial constraints) or constraints (e.g. optimise traditional financial function subject to a minimum weighted average ESG score).

While such assumptions may be convenient, they cannot be regarded as conservative, especially for downside risk management. Supportive of this cautious approach is the work of Oikonomou et al. (2012) that finds that ESG strengths are negatively but insignificantly associated with systematic firm risk – including downside risk measures – while ESG weaknesses are significantly positively related to these measures; the association is particularly strong for socially

irresponsible actions.



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74 - We also note that the minimum disclosures (identified in Section 3.3.2. and Appendix C of the report) do not fully cover the index construction requirements (listed at Sections 5.11. and 5.12. of the same report).

ESG indicators with potential relevance are not sufficiently specified to support informed decision-makingThe legislator has delegated to the Commission the specification of minimum disclosure obligations with respect to the incorporation of ESG factors into Benchmarks with a view to enhancing transparency and enabling market participants to make well-informed choices.

We have already argued that the proposals of the TEG far exceed the scope of the delegation enjoyed by the Commission. We also find that, irrespective of the legal applicability of the proposal, the ESG indicators put forward by the TEG do little to advance well-informed choice.

While this is evident in the case of inherently flawed ESG ratings, this is unfortunately also true of indicators that could be reasonably expected to have relevance as they relate to normalised greenhouse gas emissions or to cumulated weight of index constituents that comply or fail to comply with norms or are associated with controversial or desirable activities. Indeed the comparability of these indicators is materially reduced by excessive leeway extended to index administrators with respect to choice or definition of metric, and/or insufficient precision of the concepts and terms used by the TEG, and/or implicit reliance on a rating approach that suffers from some of the same flaws as ESG ratings.74

In Table 6, we list some key comparability issues for the minimum disclosures listed in Section 3.3.2. of the final TEG report (TEG, 2019c).

Table 6: Minimum ESG Disclosures for Equity Indices and related Comparability Issues

ESG themes Disclosures Comparability issues

Overall ESG Average ESG rating (relative to securities covered by ESG research)

Heterogeneous ratingsLow internal validity of ratings

Compensation across constituents

Overall ESG ratings of top 10 index constituents by weighting in index


Total weighting of index constituents not meeting the principles of the UN Global Compact (conduct-related

controversy screen)

Heterogeneous ratings

Environmental Average Environmental rating of index (E component of ESG rating) (relative to securities covered by ESG

research)


Compensation across constituents.

High emitting sector exposure (% of total weighting) Acceptable (mapping of NACE to different business classification systems cannot produce perfectly comparable

figures).

Carbon intensity Denominator must be clearly specified. Choice of denominator cannot be left to administrators - all must be

required to report the same metric(s).

Reported vs estimated emissions (%) Heterogeneous quality control methodologies

Portfolio exposure to green economy as measured by % of green revenues or Capex

No definition of green economy or green revenues or CapexChoice of green revenues vs Capex cannot be left to

administrators - all must be required to report the same metric(s)

Exposure to climate-related physical risks Heterogeneous methodologies


75 - Section 3.3.2. and Appendix C of the final report (TEG, 2019c) include this mention of social violations but no definition is provided. Sections 5.11. and 5.12. of the same report refer to the filtering out of issuers involved in societal norm violations. Societal norms therein are defined as including I) UNGC Principles; II) OECD Guidelines for Multinational Enterprises; and III) “the 6 Environmental Objectives”. The latter are a reference to the work of the TEG on the EU Taxonomy: 1) climate change mitigation; 2) climate change adaptation; 3) sustainable use and protection of water and marine resources; 4) transition to a circular economy, waste prevention and recycling; 5) pollution prevention and control; 6) protection of healthy ecosystems.” As for the latter and in the spirit of the EU Taxonomy, we would expect a violation to correspond to significant harm being done to any objective; but again, no definition is provided. We also find it troubling that the TEG expects data in respect of a regulatory proposal that was yet to be approved at the time of its report to become readily available in a matter of months and that certain data providers deliver such data in a matter of weeks. Has the vertical integration of certain index and data industry players become so extensive as to include the regulator?76 - This is a quite restrictive view of diversity but one should remember that there are legal restrictions in certain on collecting data on other dimensions of diversity. This notwithstanding, we observe that the complement of male board members would have provided a more inclusive version of diversity than percentage of female board members.77 - The same problem arises in respect of the metric titled “Portfolio exposure to green economy” as administrators appear to be allowed to measure exposure by either green revenues or Capex.

Social Average Social rating of index (S component of ESG rating) (relative to securities covered by ESG research)



Total weighting of index constituents in controversial weapon sector or tobacco

No definition of involvement in controversial weapons or tobacco provided

No definition of controversial weapons providedNo definition of tobacco provided.

Controversial weapons definition

Tobacco %

Tobacco Definition

Number of companies in the index involved in social violations

No definition of social violations.75

Governance Governance rating of index (G component of ESG rating)

(relative to securities covered by ESG research)



Average degree (%) of board independence No definition of independence provided. Nevertheless acceptable (assuming jurisdiction-specific definitions are

used).

Average degree (%) of board diversity No significant issue as diversify is defined in relation to gender.76

As for indicators of greenhouse gas emissions, we note that while the Level I text (Recital 20) calls for the disclosure of the “total carbon footprint of the benchmark”, Article 3 of the technical advice prepared by the TEG requires the reporting of two exposure metrics of the class it misleadingly labels “carbon intensity.” One corresponds to the exotic metric that it requires for index construction constraining (normalising total emissions by enterprise value) and the other to the total emissions version of the popular WACI that the TCFD recommends for reporting (where normalisation is by revenues).

It is unclear whether both versions are to be reported as Appendix C on ESG reporting calls for reporting of carbon intensity “as per the recommendations in the methodology chapter” of the report, which appears to suggest (at Section 5.3.3.) that reporting of either version is acceptable. Assuming the intention is that both versions be reported, we consider that, as long as the TEG (regrettably) insists on the use of the exotic metric for index construction, it is coherent that this exotic metric be part of reporting. Clear labelling would naturally be required to mitigate the risks of confusion on the part of users.

If however, administrators were allowed to choose to report either of these metrics, this would limit the ability of users to perform meaningful comparisons across funds and would also be a source of error as the label “carbon intensity” is applied to both metrics.77 For maximum confusion, the TEG appears, at Section 3.3.2., to suggest that total capital could be yet another allowable denominator for normalisation of corporate emissions for purposes of reporting.



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78 - One may contend (with tongue in cheek) that leaving the definition to the administrator is preferable given the competence displayed by the TEG in the matter when (at Section 5.9.1.), it conflates distinct treaties and states that European countries are signatories of the (imaginary) “Convention on Landmines and Cluster Munitions.”

In respect of GHG emissions, we also note that the TEG calls for the disclosure of the percentage of reported vs estimated emissions across constituents. We observe that data-provider-specific quality control may lead to rejecting the emissions reported by an issuer as unreliable and to an estimation model be applied as replacement. Hence the choice of data provider will affect the share of “actuals vs estimated” for a given index composition and a lower index weight associated with reported emissions could be a signal of quality.

Due to heterogeneity of data collection and validation methodologies, the comparability of indices according to this metric is superficial and potentially misleading. In addition, should a high percentage of reported emissions be assumed to be synonymous of quality, this would do little to incentivise quality control on the part of data providers and users, which we assume is not the intention of the legislator.

Excessive leeway granted to index administrators in terms of definitions abound. For example involvement in controversial weapons is not given a definition in the context of minimum disclosure requirements (Section 3.3.2.) and even for Climate Benchmark construction (i.e. Section 5.12.), involvement is defined as “selling, manufacturing, etc.” (sic) and the scope of controversial weapons is left unspecified (see Box 2). However, for a definition of involvement to be unambiguous, it should notably:i) state explicitly what value-chain activities constitute involvement (for example involvement could be extensively defined as development or production, sales, stockpiling or transport of controversial weapons); ii) clarify whether key components to such weapons are included or not; andiii) explain whether involvement is only direct or may also be through a subsidiary or joint venture (with or without majority control).

Depending on the definition chosen for involvement, the status of some major developed market aerospace companies as well as some developing market industrial conglomerates will change. Hence, the use of different definitions of involvement for reporting purposes could produce materially different controversial weapon exposure for the same benchmark.

In addition, the definition of what constitutes controversial weapons appears to be left to the appreciation of the administrator.78 There too, different definitions could produce different exposure figures for the same Benchmark. Whether nuclear weapons are always in scope; in scope only when in presence of a breach of the Non-Proliferation Treaty; or never in scope could be especially material. Involvement in nuclear weapons is the most common of controversial weapon involvement by number of companies and major blue chips – including household names such as Airbus and Boeing – are involved.


Box 2: Understanding controversial weaponsControversial weapons are weapons that violate fundamental humanitarian principles through their normal use due to their disproportionate or indiscriminate impact. Their use may be explicitly prohibited or regulated by international treaties or may be subject to stakeholder campaigns and discussions in international institutions regarding possible future regulation. The table lists the main classes of such weapons and the global norms covering their prohibition or regulation.

Main Classes of Controversial Weapons and Basis for Prohibition or Regulation

Type of weapon Treaty basis for prohibition or regulation

Anti-personnel landmines Convention on the Prohibition of the Use, Stockpiling, Production and Transfer of Anti-Personnel Mines and on their Destruction (1997)

Cluster munitions Convention on Cluster Munitions (2008)

Nuclear weapons Treaty on the Non-Proliferation of Nuclear Weapons (1968)

Treaty on the Prohibition of Nuclear Weapons (no force, 2017)

Bacteriological weapons Protocol for the Prohibition of the Use in War of Asphyxiating, Poisonous or other Gases, and of Bacteriological Methods of Warfare (1925)

Convention on the Prohibition of the Development, Production and Stockpiling of

Bacteriological (Biological) and Toxin Weapons and on their Destruction (1972)

Chemical weapons Protocol for the Prohibition of the Use in War of Asphyxiating, Poisonous or other Gases, and of Bacteriological Methods of Warfare (1925)

Convention on the Prohibition of the Development, Production, Stockpiling and Use of Chemical Weapons and on Their Destruction (1997)

Weapons using non-detectable fragments

The Convention on Prohibitions or Restrictions on the Use of Certain Conventional Weapons Which May be Deemed to be Excessively Injurious or to Have Indiscriminate Effect (1980 revised 1995)

Incendiary weapons

Blinding laser weapons

Depleted uranium weapons White phosphorus munitions

No dedicated treaty - Discussions in international fora and/or prohibition campaigns

Applicable norms may not only target usage of these weapons, but also involvement in their development, production, transfer, stockpiling and exceptionally assistance or encouragement of prohibited activities. Where a norm proscribes assistance, divestment from companies involved in the prohibited activities may be a legal requirement for the investor. In this regard, the 2008 Convention on Cluster Munitions contains language that has been widely interpreted as requiring signatory states to prohibit investment in the production of the weapons banned by the convention and dozens of states have either introduced such prohibitions in domestic law or clarified that interpretation. A number of states have extended such investment prohibitions to other inhumane weapons, primarily to Anti-Personnel Mines which have become widely reviled amongst the public thanks to a successful international campaign. In the absence of applicable law prohibiting investment in companies involved in inhumane weapons, exclusion of such companies is voluntary and may be restricted to companies whose types of involvement in weapons explicitly covered by global norms violate these norms; extend to all companies involved in weapons explicitly covered by global norms; or be generalised to also include involvement in inhumane weapons not (yet) explicitly regulated by a global norm (which

nevertheless fall under the general prohibitions of the law of war and customary international law).



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79 - One may choose to benevolently assume that the reference to social violations by the TEG is an imprecisely worded reference to violations of societal norms, which are given a definition. However, reporting in respect of social violations is included under the Social pillar whereas societal norms cut across all pillars and the specification of baseline exclusions by the TEG is skewed towards the Environment pillar by the reference to the EU Taxonomy.80 - Indeed reporting in respect of social violations is included under the Social pillar whereas societal norms cut across all pillars and the specification of baseline exclusions by the TEG is skewed towards the Environment pillar by the reference to the EU Taxonomy. Also note that reporting in respect of violations of the UN Global Compact Principles is appropriately mandated under Overall ESG Disclosures.81 - What constitutes a violation is not exactly clear and may be different for global norms and the six environmental objectives. In respect of the former, 82 - Fortunately, tobacco offers less room for gaming in practice. For a discussion of potential variations of scope in respect of tobacco involvement, refer to Ducoulombier and Liu (2019).83 - Also referred to as "transitional" and "enabling" activities.

Another example concerns social violations for which the TEG mandates reporting in respect of Benchmark constituents “with social violations and issues” without even discussing what the latter may be or what screening criteria should be used. It is not clear either why the reporting metric is the absolute and relative number of constituents qualifying rather than the percentage weight, as applied to other types of violations.79 One may benevolently assume that the reference to social violations is an imprecisely worded reference to violations of societal norms, which are described as part of the baseline exclusions of Climate Benchmarks, but there is little doubt that this would be a mistaken assumption.80,81

In the same vein, the specification of reporting in respect of tobacco simply is limited to an allusion to a “tobacco sector” and the requirement that the index administrator provide a definition “of what is considered under tobacco”.82

Such material leeway in matters of metric definition considerably reduces the relevance of the mandated reporting for decision-making, notably for cross-Benchmark comparisons. In addition, it does little to promote high ESG standards for Benchmarks as it incentivises administrators to adopt the least demanding definition possible so as to maximise relative reported ESG performance.

The potential relevance of the onerous ESG reporting mandated by the TEG is also limited by a lack of precision in the concepts used. As an illustration, the TEG mandates reporting of exposure to the green economy but leaves the definition of the term to the EU Taxonomy. However, in its Technical Report on the EU Taxonomy (TEG, 2019b), the TEG does not provide such definition but refers to “green economy sectors” in relation to the FTSE Russell Green Revenues proprietary data model and also defines ‘green’ activities (see page 30) as “Activities that are already low carbon (i.e. activities associated with sequestration or very low and zero emissions).” In the TEG report on Benchmarks (TEG, 2019c) however, ‘green’ activities are those making a contribution to the energy transition (see page 52), which at face value appears to correspond to the ‘greening of’ activities of the TEG taxonomy report.

The intention may well be to include not only ‘green’ but also ‘greening of’ and ‘greening by’ activities83

in the parlance of the TEG Taxonomy Technical Report, but we are left in the blue. For anything to be measured in a manner that will allow for comparability across benchmarks provided by different administrators, it is first required that the TEG resolve its internal contradictions where necessary and provide a definition for ‘green economy’ and ‘green’ activities. As an aside, we observe that requiring index administrators to report along the taxonomy lines prior to any reporting obligations being imposed even on EU corporates, is particularly beneficial to parties that propose to estimate companies’ ‘green(ing)’ activities.


84 - These principles are derived from global norms in the areas of Human Rights, Labour Rights, Environment and Anti-Corruption, namely the Universal Declaration of Human Rights, the International Labour Organization’s Declaration on Fundamental Principles and Rights at Work, the Rio Declaration on Environment and Development and the United Nations Convention Against Corruption.85 - Note that what constitutes a violation is not exactly clear and may be different for global norms vs the six environmental objectives of the taxonomy. In respect of the former, the TEG writes that exclusions are for companies “found in violation.” In respect of the latter, exclusions are for companies “being found in controversies”. 86 - Note the potential accumulation of norms-based screening products to be licensed for compliance with this requirement.87 - Violations in relation to the EU taxonomy are being added to baseline exclusions without phase-in period despite the novelty of the taxonomy (on which there was not yet a political consensus at the time of the report and that is not to be fully applied before the end of 2022).

Factors limiting comparability of disclosures also include implicit reliance on ratings for metrics pertaining to the violations of global norms. For illustration, whereas the Ten Principles84 of the UN Global Compact are a popular reference for norms-based screening of companies in respect of conduct, there is no official list of companies that violate these principles. Hence, different data providers produce different lists of violators due to differences in data sources and methodologies.

Some providers include companies that are ineligible to be recognised as participants in the Global Compact (owing to their controversial activities or presence on UN exclusion lists) on their list of violators while others only consider companies facing critical controversies. Criteria for rating controversies and rules for the management of the list of violators vary across providers. In addition, two index administrators sourcing their list of violators from the same data provider may subsequently use it in different ways, e.g. one may use the list “as is” while the other may choose to reprocess the list to delay exclusion and speed up re-inclusion to reduce the severity of filtering.

While some of these differences could be appreciated by comparing disclosures in respect of data sources and methodologies, it would be difficult for investment decision makers to gain relevant insights by comparing exposure metrics deriving from different methodologies. Inviting benchmark users to do so could create perverse incentives for index administrators and data providers to select rating methodologies that minimise reported violations.

As an aside, it is unclear why the final report of the TEG introduces a disconnection between Climate Benchmark construction and minimum ESG disclosures in respect of violations of societal norms. In the interim report, baseline conduct exclusions targeted companies “being found in violations of global norms (e.g. UN Global Compact principles, OECD Guidelines)” and reporting was in respect of violations of the Principles of the UN Global Compact. In the final report, baseline conduct exclusions concern societal norm violations, where norms are specified as including the UN Global Compact Principles, the OECD Guidelines for Multinational Enterprises and the six environmental objectives of the EU Taxonomy.85,86,87

In ConclusionIn the end, we consider that the TEG proposals in respect of ESG disclosures are radically at odds with the objectives of the legislator. On the one hand, the high administrative and data costs associated with the proposed disclosures de-incentivise the offering and adoption of Benchmarks that pursue ESG objectives. On the other hand, the provision of irrelevant and ambiguous quantitative metrics cannot be regarded as enhancing transparency or supporting well-informed decision-making by market participants. From the point of view of the promotion of sustainable investments and practices, the TEG proposals are utterly counterproductive. In addition, by draping itself in the cloak of sustainability without ensuring the respect of best ESG practices, the regulator would reinforce the very adverse selection issues that justify its intervention.



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4. Remedies

48


88 - That of the Intergovernmental Panel on Climate Change 1.5°C scenario (with no or limited overshoot).89 - Given the centrality of these sectors for the transition to a low carbon economy, it would conceivable to require a higher level of relative decarbonisation on such indices than what would be imposed on indices anchored on capitalisation weights. Note that some decarbonised high carbon intensity sectors will remain significantly more carbon-intensive than the overall capitalisation-weighted benchmark (for intuition, refer to Figure 1).

4.1. Promoting High Decarbonisation Across All Index StrategiesThe amended Regulation creates labels intended for Benchmarks whose constituents are selected and weighted either so that the resulting Benchmark portfolio is on a decarbonisation trajectory or is aligned with the global warming target of the Paris Climate Agreement.

The TEG proposal however not only requires that Benchmarks reduce their year-on-year greenhouse gas intensities in line with (or faster than) an ambitious decarbonisation trajectory,88 but also imposes a 30% or 50% cross-sectional decarbonisation requirement defined in relation to the performance of the market capitalisation weighted index of the underlying investment universe (“broad-market index”). This latter constraint disqualifies large swaths of indices which by nature significantly overweight high greenhouse gas intensity sectors. Noting that the underweighting of these sectors would make its cross-sectional constraint easy to circumvent, the TEG further constrains benchmark exposure to greenhouse gas intensive sectors to be on par with or higher than that of the broad market index. This additional constraint not only constrains administrators’ leeway in matters of decarbonisation but also disqualifies large swaths of indices which by nature underweight these sectors.

To avoid narrowing the scope of the Regulation, we recommend avoiding anchoring Climate Benchmarks on market indices and leaving full flexibility in respect of sector exposures to administrators while imposing a high level of cross-sectional decarbonisation in a manner that controls for any sector effects.

In this context, decarbonisation of an index strategy should ideally be assessed relative to the standard or parent version of this strategy. Thus strategies that naturally overweight high carbon intensity sectors (e.g. high carbon intensity sector indices; or single-factor indices targeting Value, Low Volatility or Low Investment and multi-factor indices with such tilts) would not be de facto excluded but would be eligible if they achieved high decarbonisation relative to their (non-climate change) parent version, which is the strategy-relevant benchmark from the point of view of decarbonisation.89

Allowing decarbonisation to be so assessed would give administrators sufficient leeway to address varied investor demand in respect of investment strategies. This would allow the design of climate progressive versions of strategies based on parent indices that overweight high carbon intensity sectors. An investor would then be in a position to switch the different strategies that make up its portfolio to their EU Climate Benchmark equivalents and be assured to achieve the decarbonisation objective of the Regulation at the portfolio level.

In terms of total assets decarbonised, such an approach would be superior to a situation where EU Climate Benchmarks aimed only to displace the parts of portfolio investments that are anchored on broad-market indices. By insisting on the market capitalisation-weighted index as the only possible reference for decarbonisation, this opportunity is lost. Decimating eligible strategies unambiguously simplifies the Climate Benchmark landscape (and as such can be defended by reference to the

4. Remedies

90 - Appropriate disclosures could also add granularity to the label, e.g. to distinguish between benchmarks that, in isolation, would be relevant as replacement for broad market indices and other benchmarks.

comparability objective of the Regulation). However, the EU Climate Benchmarks are intended for institutional rather than individual investors. We trust that the risks of confusion in respect of the decarbonisation achieved by heterogeneous strategies are limited and can be addressed by appropriate disclosures, e.g. by mandating that decarbonisation be reported relative both to the standard or parent index and to the capitalisation-weighted index of the investable universe.90 Irrespective of the choice of what is eventually defined as benchmark for decarbonisation purposes, it is possible and preferable to address target circumvention concerns in respect of sector exposures without imposing sector weights. To do so, it suffices to control sector effects when assessing decarbonisation requirements and require the benchmark-relative decarbonisation target to be achieved both without and with control of sector contributions. The latter would correspond to requiring that in-sector stock selection effects contribute to decarbonisation to an extent that is no less than the desired decarbonisation target. Admittedly, this is a much more stringent requirement in terms of decarbonisation than that put forward by the TEG, which imposes intrusive cumulated weight constraints in respect of high greenhouse gas intensity sectors (as clarified in TEG, 2019d) while leaving administrators free to deliver the decarbonisation targeted through reallocation across such sectors. We trust prevention of greenwashing comes at this cost and that it is a cost worth paying for.

This control can be done by performing straightforward and non-proprietary holding-based decomposition of benchmark-relative portfolio decarbonisation as illustrated in Box 3.

Box 3: WACI decompositionBrinson, Hood, and Beebower (1986) introduced a holding-based decomposition of benchmark-relative portfolio performance into sector-based market timing and security selection. Typically, the model is used to describe a single period. This approach is suitable for short-term periods.

In this spirit, WACI Decomposition decomposes the benchmark-relative WACI of a portfolio into sector effects (underweighting/overweighting of high/low WACI sectors) and (in-sector) stock-selection effects (underweighting/overweighting of high/low Carbon Intensity stocks in each sector); interaction effects capture the impact of the combination of sector and stock effects. This decomposition allows to shed light on the relative WACI of a portfolio and, where relevant, to assess the quality of its decarbonisation.

Let and be the weight of the i-th sector in the index and the benchmark, respectively.Let and be the WACI of the i-th sector in the index and the benchmark, respectively, then:

The excess contribution to the portfolio WACI for the index and the i-th sector is written as:

And it can be decomposed in:

a stock selection effect:

a sector effect:

an interaction effect:

4. Remedies


50


In the example below, we decomposes the WACI of an index between sector effects, stock effects and interaction effects. Without loss of generality, this is done in reference to the 10 Economic Sectors of the Thomson Reuters Business Classification (TRBC) and the benchmark used is a broad-market capitalisation-weighted index.

In the WACI Decomposition table, the excess contribution per sector is found under the ‘Excess’ column and the stock, sector and interaction effects under ‘Stock’, ‘Sector’ and ‘Inter.’

Found in the ‘Total’ row of the table, the sum of the excess contribution across the 10 sectors (i.e. the cell at the intersection with the ‘Excess’ column) is the difference between the WACI of the index and the WACI of the portfolio on which the analysis tries to shed light. The net contribution attributable to the stock selection, sector and interaction effects is found at the intersection with the ‘Stock’, ‘Sector’ and ‘Inter.’ columns, respectively.

SciBeta Dev LCrb HFInt MBeta MStrat 6F4S-EW

Inde

x Se

ctor

W

eigh

t

Inde

x Se

ctor

W

ACI

Inde

x Se

ctor

Co

ntr.

Broa

d C

W

Sect

or W

eigh

t

Broa

d C

W

Sect

or W

ACI

Broa

d C

W

Sect

or C

ontr

.

Exce

ss

Stoc

k

Sect

or

Inte

r.

Energy 2.22 % 249 6 5.10 % 502 26 -20.07 -12.89 -14.47 7.29

Basic Materials 2.88 % 262 8 4.26 % 742 32 -24.07 -20.45 -10.26 6.64

Industrials 10.48 % 53 6 12.08 % 116 14 -8.45 -7.60 -1.85 1.01

Cyclical Consumer 15.73 % 35 5 12.83 % 43 5 -0.01 -1.01 1.23 -0.23

Non-Cyclical Consumer 11.90 % 64 8 8.95 % 56 5 2.62 0.73 1.64 0.24

Financials 21.56 % 34 7 18.72 % 33 6 1.16 0.20 0.93 0.03

Healthcare 9.95 % 24 2 12.85 % 22 3 -0.51 0.18 -0.64 -0.04

Technology 16.08 % 30 5 18.85 % 17 3 1.62 2.44 -0.46 -0.36

Telecoms 3.50 % 33 1 2.79 % 38 1 0.12 -0.12 0.27 -0.03

Utilities 5.70 % 917 52 3.57 % 2 244 80 -27.74 -47.33 47.88 -28.30

Total Index WACI 100 Ref. WACI 175 -75.34 -85.85 24.27 -13.75

Analytics are calculated at the end of the latest quarter and with emissions data updated annually in June on the basis of the figures reported at the end of the previous year. For WACI calculations, corporate revenues are those of the year for which greenhouse gas emissions are reported. Constituent weights used for all carbon exposure metrics are end-of-quarter weights. The sector classification used is the Thomson Reuters Business Classification. The analysis is performed over the latest quarter.

In this example, a reduction of 43% ([175-100]/175) is observed for the Low Carbon index as a whole and a reduction of 49% ([175-85]/175) is observed excluding sector effects and interaction between in-sector and sector effects. Hence the index clears both the benchmark-relative decarbonisation requirement and the sector-controlled decarbonisation

requirement.

4.2. Adopting Metrics that Recognise the Decarbonisation Efforts of Corporates and Investors and Promoting Rapid Self-DecarbonisationWhile the Regulation mentions climate-change mitigation as the objective of the Climate Benchmarks and accordingly suggests a requirement to disclose the carbon footprint of Benchmarks, the proposal of the TEG targets reduction in exposure to climate risks and fittingly adopts an exposure metric for

4. Remedies

91 - According to the Regulation, the underlying assets of an EU CTB must be “selected, weighted or excluded in such a manner that the resulting benchmark portfolio is on a decarbonisation trajectory” where the latter is defined as “a measurable, science-based and time-bound trajectory towards alignment with the objectives of the Paris Agreement by reducing Scope 1, 2 and 3 carbon emissions”.92 - We note that it is perfectly possible to extend the Scope 1+2 Carbon Footprint metric reviewed by the TCFD to make it applicable beyond equities as long as the volatility of market values is understood and accepted.

both index construction and reporting. Since the vocabulary around decarbonisation is sometimes used in a loose manner, we give the TEG the benefit of the doubt and assume a focus on exposure is consistent with the intention of the Regulation.

However in this context, we strongly object to the TEG adopting an exotic metric based on Total Emissions and Enterprise Value metric in lieu of the widely used version of WACI (based on Scope 1+2 emissions and revenues) that is also the metric that the TCFD recommends for reporting. This is first and foremost because Total Emissions lack the precision required to recognise decarbonisation efforts made by issuers and thus guide security selection. In addition, the substitution would penalise the various stakeholders that have already expended resources in respect of climate initiatives centred on WACI. We also observe that, while Enterprise Value conflates the market capitalisation of equity and the book values of net debt, it inherits enough volatility from the former to create material implementation issues for the self-decarbonisation requirement that the TEG mandates for Climate Benchmarks.

Until challenges linked to the setting of science-based decarbonisation targets are addressed that would make it possible to reduce reliance on standard emissions-based metrics, we recommend that:• unless one wishes to cynically disregard efforts made by companies in the mitigation of their greenhouse gas emissions, Scope 3 emissions not be directly used for security-level decisions and (cross-sectional and year-on-year) emissions-based decarbonisation requirements until their reporting by corporates and modelling by data providers are of sufficient extent and quality to make them fit for purpose of stock selection. We underline that the Regulation requirement that the decarbonisation trajectory91 include the reduction of Scope 3 emissions may still be respected by including in index construction Scope 3 emissions related metrics that can support security-level analysis, including but not limited to fossil fuel reserves. We note that this approach is considered acceptable by the TEG itself although it limits its application to the first phase of its Scope 3 data phase-in schedule (the duration of which is limited to two years despite the admission that data limitations will remain for “the foreseeable future”.)

• if a single carbon-exposure metric is to be adopted for index construction,92 revenues should be used as denominator for the calculation of what the TEG calls “carbon intensity”. This means the emissions-related decarbonisation requirement should be expressed in terms of the standard version of WACI. This indicator is readily applicable to equity and fixed income investments, is already widely used and accepted and also corresponds to the metric recommended by the Taskforce on Climate-related Financial Disclosures for reporting (FSB, 2017). There is simply no scientific or business basis to substitute the exotic indicator put forward by the TEG for the standard version of WACI, upend widely accepted practices and punish investors that have preceded or followed TCFD recommendations.

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93 - Note that revenues may rise as a result of increased quantities and/or increased prices.94 - We find the reference made by the TEG to an adjusted target based on the original trajectory confusing as it may be interpreted to mean that, whether the carbon exposure achieved in a given period is the maximum allowed or lower, it must be improved by 7% per annum in the subsequent period. Should such an interpretation be correct, this would further incentivise the slowest possible self-decarbonisation.95 - Note that we are not suggesting that over performance in a given period be allowed to compensate for under performance in a subsequent period but merely that it be disregarded when setting the objective of the subsequent period.96 - Note that the least ambitious decarbonisation pathway allowed is in itself coherent with the decarbonisation trajectory from the IPCC’s 1.5°C scenario (with no or limited overshoot).

The self-decarbonisation requirement put forward by the TEG is couched in terms of carbon exposure metric and adjusted for inflation in its denominator (Enterprise Value). Deflation in the same, which can quickly make the self-decarbonisation requirement untenable, is not considered.

While the denominator of the standard version of WACI is less affected by market fluctuations than that of the exotic metric put forward by the TEG, the pursuit of a steady reduction in absolute emissions associated with Climate Benchmarks requires an adjustment of the decarbonisation requirement whatever the change in denominator, i.e. the direction of corporate revenues for the standard version of WACI.93

In the presence of a change of revenues over the year, the self-decarbonisation rate expressed in terms of WACI is no longer 7% but:

Where Change% is the percentage inflation (positive number) or deflation (negative number) in the revenues.

The TEG final report (TEG, 2019c) mandates that for the computation of the self-decarbonisation requirement “intensity shall be calculated with restated enterprise value to reflect the potential effects of inflation in the average enterprise value in the investable universe.” The recommendation is different in the TEG handbook (2019d) where inflation is to be computed as the ratio of the average denominator of benchmark constituents at the end of the calendar year by the average denominator of benchmark constituents at the end of the previous calendar year. Neither the final report not the handbook define how the average should be computed.

We suggest a precise definition be given to the term average, e.g. either equally-weighted average or capitalisation-weighted average, and that all universe constituents be included in this computation as hinted in the final report (but contradicted by the handbook).

By simultaneously imposing a benchmark-relative decarbonisation requirement (of 30% or 50%) and a year-on-year self-decarbonisation requirement (of 7%), the TEG incentivises administrators to design Benchmarks that will align with the maximum carbon exposure allowed at any time (so as to mitigate the risk of failing the self-decarbonisation constraint at subsequent periods). The wisdom of incentivising administrators to delay benchmark decarbonisation is not obvious whether from a climate change or a climate risk perspective. For this reason, we suggest that compliance with the self-decarbonisation requirement always be assessed as if the benchmark had always remained on the trajectory defined by the minimum constraints, i.e. an initial carbon exposure level of 30% (for CTBs) or 50% (for PABs) below benchmark and a year-on-year reduction of 7% on that level.94,95 Thus methodologies that achieve higher decarbonisation earlier will not be penalised vis-à-vis methodologies that strictly adhere to the least ambitious decarbonisation pathway allowed.96

4. Remedies

We also note that the TEG appears to leave administrators free to choose the base year in relation to which Benchmark decarbonisation trajectory will be assessed. In the absence of regulation pertaining to the publication of back-tested index performance, it is acceptable to let administrators determine Benchmark base date on a case-per-case basis in a manner that (hopefully) reconciles investors’ need for informative back-tested track records with data limitations. Given the objectives of the amended Benchmark Regulation, however, it would not be reasonable to extend to administrators the same freedom with respect to the base year for decarbonisation assessment. Indeed this would not only limit comparability across Benchmarks, but it would also create significant room for gaming the decarbonisation trajectory, e.g. by selecting for each Benchmark the base year that minimises the difficulty of decarbonising.

Figure 5 presents the decarbonisation trajectories, in respect of the same parent index, that result for three different base years taken within a five-year span – while the required year-on-year decarbonisation is by design the same whatever the choice of base year, the use of December 2018 as base date and base year in this example makes the absolute level of decarbonisation materially less demanding all along the trajectory than that of December 2014. Against this backdrop, we recommend that, irrespective of base date, the same base year be imposed upon all Climate Benchmarks for the computation of the decarbonisation trajectory and that the minimum decarbonisation in respect of (earlier or) subsequent years be worked out by applying the self-decarbonisation constraint.

Figure 5: Decarbonisation trajectories for different decarbonisation base years

The figure shows the maximum WACI (as per the definition of the TCFD) allowed along the decarbonisation trajectory of indices that are assessed against the same reference index for the purpose of decarbonisation. The trajectories are determined for indices with three different base dates and assuming the base date determines the base year for decarbonisation relative to the reference index. For illustration, the latter index is the capitalisation-weighted index of the Scientific Beta Developed Universe. Emissions data are provided by Institutional Shareholder Services. WACI is expressed in tons of CO2 equivalent per USD million of revenues. Decarbonisation trajectories are not adjusted for observed changes in revenues.

Figure 6 shows the unique decarbonisation trajectory that results for all Benchmarks assessed relative to the same reference index once the base date for decarbonisation assessment is imposed (December 2016 in this illustration).

4. Remedies


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Figure 6: Decarbonisation trajectory with imposition of single decarbonisation base year (2016)

The figure shows the maximum WACI (as per the definition of the TCFD) allowed along the decarbonisation trajectory of indices that are assessed against the same reference index for the purpose of decarbonisation. The trajectories are determined for indices with three different base dates and assuming that 2016 is the base year for decarbonisation relative to the reference index whatever the index base date. For illustration, the reference index is the capitalisation-weighted index of the Scientific Beta Developed Universe. Emissions data are provided by Institutional Shareholder Services. WACI is expressed in tons of CO2 equivalent per USD million of revenues. Decarbonisation trajectories are not adjusted for observed changes in revenues.

4.3. Avoiding Misleading or Irrelevant ESG Disclosures and Keeping ESG Data Costs Under CheckThe legislator has delegated to the Commission the specification of criteria for asset exclusion in the context of Climate Benchmarks and of minimum disclosure obligations in respect of the incorporation of ESG factors in the context of all Benchmarks pursuing ESG objectives. The latter disclosures should enhance transparency and enable market participants to make well-informed choices.

The TEG introduces exclusions in respect of controversial weapons, violation of global norms and environmental controversies although the basis for such exclusions in the amended Regulation is ambiguous. Definitions and exclusion criteria appear to be left to the appreciation of administrators, which is at odds with the Regulation’s objective of a harmonised framework ensuring a high level of investor protection.

In respect of ESG disclosures, the proposals of the TEG extend far beyond specifying the minimum content of qualitative explanations of how the key elements of Benchmark methodology may reflect ESG factors (as expected under Benchmark Regulation amended Article 13) or of how ESG factors may be reflected in each Benchmark or Benchmark family in the context of the Benchmark statement (as expected under amended Article 27). Indeed, the “minimum” disclosures the TEG recommends for all Benchmarks also include 25 quantitative ESG indicators to be computed and disclosed as part of the Benchmark statement. We are of the view that the proposals of the TEG modify the purpose of the Benchmark statement and introduce material costs, either of which would make their adoption ultra-vires under the Treaty on the Functioning of the European Union.

4. Remedies

97 - Note that the Regulation exempts interest rate and foreign exchange Benchmarks.

Irrespective of this legal point, the proposed disclosures would do little to promote well-informed choice. Indeed, the majority of the quantitative disclosures (14 in the case of equity indices) concern ESG ratings, a class of indicators whose lack of consistence across providers is well established and whose intrinsic divergence has been described in academic research as “an impediment to prudent decision-making that would contribute to an environmentally sustainable and socially just economy” (Berg et al., 2019).

Note that even if ESG ratings acquired sufficient convergence, which is not a short or medium term prospect, the relevance of portfolio-level ESG or E/S/G ratings would remain disputable as such composites allow for the compensation of strengths and weaknesses across Benchmark constituents. Constituent-level ESG or E/S/G ratings, as composites of strengths and weaknesses, could also be rightfully challenged.

In addition, most of the other quantitative ESG indicators put forward by the TEG lack proper specification or standardisation to support meaningful uses by investors and notably comparisons of Benchmarks relying on different definitions or methodologies.

Since the acquisition of ESG data for use in index construction and disclosure (redistribution) would typically involve the index administrator paying fees to ESG data providers with obvious cost implications to the detriment of benchmark administrators and users, it should not be advised in the absence of material benefits for Benchmark users. It is worth noting that considerable competition issues arise when ESG data provision is controlled by parties that are also index administrators, which is the case. Indeed, such parties may choose to deny access to the data to entities that compete with them in the index administration space or make such access economically punishing.

It should also be observed that mandating ESG disclosures at the index administrator (via the amended Benchmark Regulation) as well as the fund level (via the new Regulation on sustainability‐related disclosures in the financial services sector, i.e. Regulation (EU) 2019/2088) will result in the multiplication of fees to be paid to ESG data providers by multiple parties across the investment value chain. While ESG data providers were richly represented in the Benchmark Working Group, the regulator should be concerned about such cost increases and wealth transfers.

Last but not least, the onerous proposals of the TEG, because they only apply to Benchmarks pursuing ESG objectives as per the amended Benchmark Regulation, contribute to de-incentivising the offering of such Benchmarks.

For the above reasons, we think that the mandated ESG disclosures should be kept to the minimum required by the Regulation.97 In compliance with Article 27 (2a), Benchmark statements should state whether or not ESG objectives are pursued and, where relevant, include an explanation of how ESG factors are reflected. In compliance of Article 13(1d), the methodologies of Benchmarks pursuing ESG objectives should explain how the key elements of the methodology reflect ESG factors.

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98 - Disclosure: Scientific Beta implements voluntary reporting in respect of ESG norms and Climate Change. This reporting is applied to all indices and Benchmarks, whether or not pursuing ESG objectives. Climate Change reporting include inter-alia reporting on all greenhouse gas emissions based TCFD metrics, i.e. the carbon footprinting metrics known as Carbon Footprint and Carbon Intensity and the carbon exposure metric known as WACI. 99 - We note that a number of public bodies in several Member States already maintain such lists.

In the spirit of Recital 20 of the Regulation, administrators should disclose the “carbon footprint” of their Climate Benchmarks; for practical reasons, this could be interpreted as a reference to the carbon exposure metric recommended for reporting by the TCFD.98

The lack of convergence and relevance of ESG ratings render these indicators at best misleading for decision making and quite possibly counter-productive from the point of view of promoting sustainability. As such it is critical that ESG ratings not be given regulatory endorsement and that they remain excluded from minimum disclosures.

To enable market participants to make well-informed choices, it is critical that any indicator that is considered for inclusion into minimum disclosures beyond what is strictly required under the Regulation not only be theoretically relevant but also be specified and implemented in a manner that allows for meaningful comparisons across Benchmarks. In addition, the potential benefits of additional disclosure requirements should be balanced against the administrative and data procurement costs that they would create. By keeping mandatory disclosures reasonable and taking steps to minimise their cost, the Regulator would mitigate disincentives to the offering of Benchmarks pursuing ESG objectives and encourage voluntary reporting on the same bases.

The TEG has provided a precise definition of high climate impact sectors in the framework of a non-commercial business activity classification (2019c) and mapped the latter to multiple commercial classifications (2019d) which currently can be licensed under reasonable financial terms. Against this backdrop, the inclusion of an indicator of Benchmark exposure to high climate impact sectors would be both informative and not particularly onerous.

Provided definitions and criteria were fully specified, Benchmark exposure to activities that are contrary to the objectives of norms and standards could assist in decision making. In this regard and given current investor interests, disclosure of Benchmark exposures to issuers involved in controversial weapons and tobacco would probably be welcomed and the definitions provided by the United Nations for recognition of participation in the Global Compact could be used for standardisation (see Ducoulombier and Liu, 2019). The reporting of Benchmark exposure to issuers that are facing controversies in relation to norms, while also a matter of investor interest, entails significant issues of comparability as controversy assessment is by nature more subjective and provider methodologies diverge.

To address the issue of comparability of ESG disclosures, we recommend that an administrative body be tasked with maintaining a public list of issuers that are considered to fail/oppose the norms and standards of interest and that this list be the only accepted reference for preparation of the mandated disclosures. As is the case with the UN Sanctions List and the UN list of ineligible vendors, this list would be freely used by index administrators for index construction and reporting. Such an approach would ensure that minimum ESG disclosures are truly comparable and would minimise direct and indirect costs to investors.99 To allow continued innovation in the ESG reporting space, index providers would remain free to voluntarily report other ESG indicators based on their own or third-party data.

4. Remedies

Conclusion

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The proposals of the TEG fail to deliver on the main objectives of the Climate Benchmarks created by the amended Benchmark Regulation, which the TEG (2019c) summarises as follows: (i) allow a significant level of comparability of Climate Benchmarks methodologies while leaving Benchmarks’ administrators with an important level of flexibility in designing their methodologies; (ii) provide investors with an appropriate tool that is aligned with their investment strategy; (iii) increase transparency on investors’ impact, specifically with regard to climate change and the energy transition; and (iv) de-incentivise greenwashing.

In respect of the objectives of flexibility and alignment with investor needs (objectives (i) and (ii)), we conclude that the overly prescriptive nature of the proposal and its anchoring on broad-universe capitalisation weights considerably reduces the flexibility of administrators to provide investors with Climate Benchmarks aligned with the diversity of their investment strategies. While there is no doubt that Climate Benchmark versions of broad-universe capitalisation-weighted indices would be important tools for investors, index-based investment strategies have traditionally included sector indices and have diversified considerably over the last 15 years. For Climate Benchmarks to have the widest relevance allowed by the Regulation, the diversity of index-strategies should be respected in the delegated acts. In this regard, we feel strongly that climate-conscious investors should not be corralled into one particular class of indices or excessively restricted by implicit methodological options. Ensuring flexibility and alignment with investor needs would also contribute to combatting greenwashing (objective (iv)) by enhancing the scope of effective control exercised over the quality of the claims made by administrators in respect of the climate characteristics of their products.

To avoid narrowing the scope of the Regulation, we thus recommend that Climate Benchmarks retain full flexibility in respect of sector exposures while being required to achieve a high level of decarbonisation in a manner that controls for any sector effects. Specifically, we recommend that the targeted level of decarbonisation be achieved through intra-sector security selection and weighting choices. Doing so prevents the gaming of decarbonisation by cross-sector reallocation, which the TEG proposal encourages and which in our view constitutes greenwashing (incompatible with objective (iv)). We also recommend that the respect of the decarbonisation target of an index strategy be assessed in relation to its non-decarbonised version rather than the market benchmark. Concerns about the risks of confusion and misleading claims about the extent of decarbonisation could be assuaged by appropriate disclosures, e.g. by requiring that decarbonisation be reported relative to the market benchmark.

With respect to the objective of enhanced transparency on Climate Change impact (objective (iii)), we note that the carbon metrics mentioned in the proposal are exposure metrics rather than measures of indirect contribution to Climate Change through financed emissions, i.e. carbon footprints in a strict sense. We recognise however that the self-decarbonisation constraint put forward by the TEG promotes continued reduction in financed emissions and we admit that there are considerable

Conclusion

benefits with using carbon metrics that have achieved wide acceptance such as the standard version of WACI.

However, we have grave reservations about the novel “carbon intensity” measure introduced by the proposal. At the very least, this innovation of the working group appears counterproductive with regard to the investments already made by concerned parties in the education of the investment management industry and the wider public and in the design of relevant investment product and solutions. We strongly feel that the introduction of novel metrics should be supported by both academic and cost-benefit analyses documenting their superiority over those metrics that have achieved a wide consensus. We also find that even casual observation of the proposed metric is sufficient to reveal multiple flaws. Biases introduced in respect of capitalisation multiples and cash to asset ratios make the approach susceptible to accusations of greenwashing.

Even more problematic is the fact that the volatility the metric imports from equity market values makes is incompatible with the self-decarbonisation requirement imposed by the TEG that fails to consider the consequences of market downturns. We understand that the proposed metric allows the TEG to claim that it does not mandate climate change exclusions for EU CTBs while still targeting divestment of the coal industry. However the consequences of this tweaking have not been thought through and the regulator would be well advised to shelve this half-baked proposal. Where the TEG feels a sector should be subjected to divestment, it should simply require it explicitly to avoid unintended and detrimental consequences from indirect targeting. Coal divestment is already an uncontroversial dimension of decarbonisation for most investors and see no issue with addressing it directly in the context of the CTBs as is done in the context of the EU PABs. By providing an unneeded subsidy to coal divestment, the exotic carbon metric of the TEG allows less ambitious decarbonisation programmes to meet the requirements for qualification as Climate Benchmarks.

Another key issue with the metric the TEG suggest for assessing decarbonisation is its consideration of Scope 3 emissions, which by the very admission of the TEG will not be fit for the purpose of stock selection “for the foreseeable future.” As Scope 3 emissions are larger than the sum of Scope 1 and 2 emissions by an order of magnitude, their combination will drown out any corporate-level signal present in Scope 1-2 emissions in a sea of noisy product and activity based Scope 3 estimated emissions. Unless one wishes to cynically disregard efforts made by companies in the mitigation of their greenhouse gas emissions, we recommend the consideration of Scope 3 emissions be done indirectly via related metrics that can support security-level analysis, including but not limited to fossil fuelreserves.

For the above reasons, we strongly recommend that the standard version of WACI (i.e. that with Scope 1+2 as the numerator and revenues as the denominator of constituent-level carbon intensities) be used for assessing decarbonisation as well as for reporting, which is in line with the recommendations of the Taskforce on Climate-related Financial Disclosures.

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The proposal of the TEG also dramatically fails to enhance transparency and enable market participants to make well-informed choices when it comes to the incorporation of ESG factors into Benchmarks. Instead of specifying how explanations on the incorporation of ESG factors should be provided as per the terms of the amended Regulation, the proposal of the TEG presents long lists of ESG indicators to be computed and disclosed as part of the Benchmark statement (25 for equity indices). That such extensive ESG disclosures would create significant administrative costs and material data licensing costs for Benchmark administrators as well as harm competition in the industry does not appear to be a major concern for a TEG whose composition is skewed towards parties that stand to benefit from the proposal. The TEG proposal modifies the nature of the Benchmark statement and entails material costs for Benchmark administrators (and indirectly end-users); for either reason, it may be viewed as ultra-vires.

To add insult to injury, the overall informational potential of these “minimum” disclosures is low. Indeed, the majority of the mandated quantitative disclosures are in respect of metrics – ESG ratings – whose divergence frustrates the possibility of meaningful comparisons across providers and that have serious theoretical limitations as indicators of ESG performance or risks. With rare exceptions, the rest of these disclosures lack proper specification or standardisation to support meaningful uses by investors.

We consider it critical that any indicator that is considered for inclusion into minimum disclosures beyond what is strictly required under the amended Regulation not only be theoretically relevant but also be specified and implemented in a manner that allows for meaningful comparisons across Benchmarks. In addition, the potential benefits of additional disclosure requirements should be balanced against the administrative and data procurement costs that they would create. By keeping mandatory disclosures reasonable and taking steps to minimise their cost, the Regulator would mitigate disincentives to the offering of Benchmarks pursuing ESG objectives and encourage voluntary reporting on the same bases.

In light of the above, it is critical that ESG ratings not be given regulatory endorsement and that they remain excluded from minimum disclosures. To be informative, quantitative disclosures in respect of ESG factors should be focused on exposure to desirable or controversial activities precisely defined and highly standardised. To keep cost inflation in check and ensure perfect comparability, the list of indicators should be as short as possible and an administrative body should be tasked with maintaining a public list of compliant and non-compliant issuers.

Conclusion

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• Scientific Beta (Scientific Beta SAS), 2019. Response to the Call for Feedback on Interim report on Climate Benchmarks and Benchmark ESG Disclosures, 31 July 2019, available at: https://ec.europa.eu/eusurvey/files/b599b1d8-5de8-4734-83ac-c52bc241e1b0/f87cf95e-edfe-401c-bf85-f0e611de3523

• Semenova, N. and L. G. Hassel, 2015. On the Validity of Environmental Performance Metrics. Journal of Business Ethics, Volume 132 Issue 2, pp. 249–258.

• SPDJI (S&P Dow Jones Indices LLC), 2019. S&P Dow Jones Indices Comments on EU Technical Expert Group on Sustainable Finance Report on Benchmarks, July 2019, available at: https://ec.europa.eu/eusurvey/files/b599b1d8-5de8-4734-83ac-c52bc241e1b0/08780822-672d-4be9-9754-3623fc0d144c

References


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• Swiss Sustainable Finance (SSF), 2019. Swiss Sustainable Finance consultation response to EU Commission’s interim report on Climate Benchmarks and Benchmarks’ ESG Disclosures, July 2019, available at: https://ec.europa.eu/eusurvey/files/b599b1d8-5de8-4734-83ac-c52bc241e1b0/1d083ad6-f4b2-4d81-92c3-bbf0296d7d30

• TEG (Technical Expert Group on sustainable finance), 2019a. TEG interim report on EU Climate Benchmarks and benchmarks’ ESG disclosures, 18 June 2019, available at: https://ec.europa.eu/info/sites/info/files/business_economy_euro/banking_and_finance/documents/190618-sustainable-finance-teg-report-climate-benchmarks-and-disclosures_en.pdf

• TEG (Technical Expert Group on sustainable finance), 2019b. TEG report on EU taxonomy, 18 June 2019, available at: https://ec.europa.eu/info/sites/info/files/business_economy_euro/banking_and_finance/documents/190618-sustainable-finance-teg-report-taxonomy_en.pdf

• TEG (Technical Expert Group on sustainable finance), 2019c. TEG final report on EU Climate Benchmarks and benchmark ESG disclosures, 30 September 2019, available at: https://ec.europa.eu/info/sites/info/files/business_economy_euro/banking_and_finance/documents/190930-sustainable-finance-teg-final-report-climate-benchmarks-and-disclosures_en.pdf

• TEG (Technical Expert Group on sustainable finance), 2019d. Handbook on Climate Benchmarks and benchmarks’ ESG disclosures, 20 December 2019, available at: https://ec.europa.eu/info/sites/info/files/business_economy_euro/banking_and_finance/documents/192020-sustainable-finance-teg-benchmarks-handbook_en_0.pdf

• UNEP (United Nations Environment Programme), 2019. Emissions Gap Report 2019. UNEP, Nairobi, 26 November 2019, available at: https://wedocs.unep.org/bitstream/handle/20.500.11822/30797/EGR2019.pdf?sequence=1&isAllowed=y

• World Resources Institute (WRI) and World Business Council for Sustainable Development (WBCSD), 2004. The Greenhouse Gas Protocol – A Corporate Accounting and Reporting Standard – REVISED EDITION (March), available at: https://ghgprotocol.org/sites/default/files/standards/ghg-protocol-revised.pdf

• WWF (WWF) European Policy Office), 2019. Response to the Call for Feedback on the TEG interim report on EU Climate Benchmarks and benchmarks’ ESG disclosures, July 2019, available at: https://ec.europa.eu/eusurvey/publication/teg-report-climate-benchmarks-and-disclosures

European Regulations• Interinstitutional Agreement between the European Parliament, the Council of the European Union and the European Commission of 13 April 2016 on Better Law-Making, Official Journal of the European Union, 12 May 2016, available at: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32016Q0512(01)

• Regulation (EU) 2016/1011 of the European Parliament and of the Council of 8 June 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds and amending Directives 2008/48/EC and 2014/17/EU and Regulation (EU) No 596/2014, Official Journal of the European Union, 29 June 2016, available at: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A32016R1011

• Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector, Official Journal of the European Union, 9 December 2019, available at: https://eur-lex.europa.eu/legal-content/EN/TXT/?qid=1582093554068&uri=CELEX:32019R2088

References

• Regulation (EU) 2019/2089 of the European Parliament and of the Council of 27 November 2019 amending Regulation (EU) 2016/1011 as regards EU Climate Transition Benchmarks, EU Paris-aligned Benchmarks and sustainability-related disclosures for benchmarks, Official Journal of the European Union, 9 December 2019, available at: https://eur-lex.europa.eu/legal-content/EN/TXT/?qid=1582093487977&uri=CELEX:32019R2089

• Treaty on the Functioning of the European Union, Official Journal of the European Union, 26 October 2012, available at: https://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:12012E/TXT:EN:PDF

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About Scientific Beta

67

EDHEC-Risk Institute set up Scientific Beta in December 2012 as part of its policy of transferring know-how to the industry. Scientific Beta is an original initiative which aims to favour the adoption of the latest advances in “smart beta” design and implementation by the whole investment industry. Its academic origin provides the foundation for its strategy: offer, in the best economic conditions possible, the smart beta solutions that are most proven scientifically with full transparency of both the methods and the associated risks. Smart beta is an approach that deviates from the default solution for indexing or benchmarking of using market capitalisation as the sole criterion for weighting and constituent selection.

Scientific Beta considers that new forms of indices represent a major opportunity to put into practice the results of the considerable research efforts conducted over the last 30 years on portfolio construction. Although these new benchmarks may constitute better investment references than poorly-diversified cap-weighted indices, they nevertheless expose investors to new systematic and specific risk factors related to the portfolio construction model selected.

Consistent with a full control of the risks of investment in smart beta benchmarks, Scientific Beta not only provides exhaustive information on the construction methods of these new benchmarks but also enables investors to conduct the most advanced analyses of the risks of the indices in the best possible economic conditions.

Lastly, within the context of a Smart Beta 2.0 approach, Scientific Beta provides the opportunity for investors not only to measure the risks of smart beta indices, but also to choose and manage them. This new aspect in the construction of smart beta indices has led Scientific Beta to build the most extensive smart beta benchmarks platform available which currently provides access to a wide range of smart beta indices.

About Scientific Beta


Scientific Beta Publications

69


2020 Publications• Amenc, N., and F. Ducoulombier. Unsustainable Proposals (February).

• Amenc, N., F. Goltz, and B. Luyten. Intangible Capital and the Value Factor: Has Your Value Definition Just Expired? (February).

• Amenc, N., F. Goltz, B. Luyten and D. Korovilas. Assessing the Robustness of Smart Beta Strategies. (February).

• Aguet, D., N. Amenc. Improving Portfolio Diversification with Single Factor Indices. (January).

• Aguet, D., N. Amenc and F. Goltz. Managing Sector Risk in Factor Investing. (January).

• Aguet, D., N. Amenc and F. Goltz. What Really Explains the Poor Performance of Factor Strategies Over the Last Four years? (January).

2019 Publications• Amenc, N., and F. Goltz. A Guide to Scientific Beta Multi-Smart Factor Indices. (December).

• Mathani, R. Effective Frameworks for Forecasting Volatility (December).

• Aguet, D. and M. Sibbe. Scientific Beta Analytics: Examining the Financial Performance and Risks of Smart Beta Strategies (November).

• Aguet, D. and N. Amenc. How to Reconcile Single Smart Factor Indices with Strong Factor Intensity (November).

• Aguet, D. and M. Sibbe. Scientific Beta Analytics: Examining the Financial Performance and Risks of Smart Beta Strategies (November).

• Bruno, G. and F. Goltz . Do we Need Active Management to Tackle Capacity Issues in Factor Investing? Exposing Flaws in the Analysis of Blitz and Marchesini (2019) (November).

• Bregnard, N., G. Bruno and F. Goltz. Do Factor Indices Suffer from Price Effects around Index Rebalancing? (September).

• Aguet, D., N. Amenc and F. Goltz. What Really Explains the Poor Performance of Factor Strategies Over the Last 3 years? (September).

• Ducoulombier, F. and V. Liu. Scientific Beta ESG Option – Upholding Global Norms and Protecting Multifactor Indices against ESG Risks. (August).

• Amenc, N., P. Bielstein, F. Goltz and M. Sibbe. Adding Value with Factor Indices: Sound Design Choices and Explicit Risk-Control Options Matter. (July).

• Gautam, K. and E. Shirbini. Scientific Beta Global Universe. (July).

• Aguet, D., N. Amenc and P. Bielstein. Scientific Beta Factor Analytics Services (SB FAS) - A New Tool to Analyse and Improve your Portfolio. (July).

• Amenc, N., F. Goltz and B. Luyten. Tackling the Market Beta Gap: Taking Market Beta Risk into Account in Long-Only Multi-Factor Strategies. (July).

• Esakia, M., F. Goltz, B. Luyten and M. Sibbe. Does the Size factor still have its place in multi-factor portfolios? (July).

• Ducoulombier, F. and V. Liu. Scientific Beta Enhanced ESG Reporting – Supporting Incorporation of ESG Norms and Climate Change Issues in Investment Management. (July).

• Aguet, D., and N. Amenc. How to reconcile single smart factor indices with strong factor intensity. (June).



A Scientific Beta Publication — Unsustainable Proposals — February 2020Copyright © 2020 Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document. 71

• Aguet, D., N. Amenc and F. Goltz. How to Harvest Factor Premia without Suffering from Market Volatility: The Case for a Long/Short Multi-Factor Strategy. (June).

• Amenc, N., G. Bruno and F. Goltz. Investability of Scientific Beta Indices. (June).

• Ducoulombier, F. and V. Liu. Scientific Beta Low Carbon Option – Supporting the Transition to a Low Carbon Economy and Protecting Multifactor Indices against Transition Risks. (June).

• Shirbini, E. Misconceptions and Mis-selling in Smart Beta: Improving the Risk Conversation in the Smart Beta Space. (June).

• Amenc, N., M. Esakia, F. Goltz, and B. Luyten. A Framework for Assessing Macroeconomic Risks in Equity Factors. (May).

• Bruno, G., M. Esakia and F. Goltz. Towards Cost Transparency: Estimating Transaction Costs for Smart Beta Strategies. (April).

• Amenc, N., P. Bielstein, F. Goltz and M. Sibbe. Adding Value with Factor Indices: Sound Design Choices and Explicit Risk-Control Options Matter. (March).

• Amenc, N., F. Goltz, and B. Luyten. Assessing the Robustness of Smart Beta Strategies. (March).

• Amenc, N., F. Goltz, M. Esakia and M. Sibbe. Inconsistent Factor Indices: What are the Risks of Index Changes? (February).

• Aguet, D., N. Amenc and F. Goltz. A More Robust Defensive Offering (February).

• Goltz. F. and B. Luyten. The Risks of Deviating from Academically Validated Factors. (February).

• Scientific Beta Analytics: Examining the Performance and Risks of Smart Beta Strategies. (January).

2018 Publications• Amenc, N. and F. Goltz. A Guide to Scientific Beta Multi Smart Factor Indices. (December).

• Amenc, N., F. Goltz, A. Lodh and B. Luyten. Measuring Factor Exposure Better to Manage Factor Allocation Better. (October).

• Amenc, N., P. Bielstein and F. Goltz. Adding Value with Factor Indices: Sound Design Choices and Explicit Risk-Control Options Matter. (October).

• Aguet, D., N. Amenc, F. Goltz and A. Lodh. How to Harvest Factor Premia without Suffering from Market Volatility: The Case for a Long/Short Multi-Factor Strategy. (October).

• Aguet, D., N. Amenc, F. Goltz, and A. Lodh. Scientific Beta Multi-Beta Multi-Strategy Solution Benchmarks. (October).

• Goltz, F. and S. Sivasubramanian. Overview of Diversification Strategy Indices. (June).

• Lodh, A. and S. Sivasubramanian. Scientific Beta Diversified Multi-Strategy Index. (June).

• Ducoulombier, F. and V. Liu. High-Efficiency Carbon Filtering. (May).

• Gautam, K., A. Lodh, and S. Sivasubramanian. Scientific Beta Efficient Maximum Sharpe Ratio Indices. (May).

• Goltz, F. and A. Lodh. Scientific Beta Efficient Minimum Volatility Indices. (May).

• Goltz, F., and S. Sivasubramanian. Scientific Beta Maximum Decorrelation Indices. (May).

• Lodh, A. and S. Sivasubramanian. Scientific Beta Diversified Risk Weighted Indices. (May).

• Sivasubramanian, S. Scientific Beta Maximum Deconcentration Indices. (May).


• Christiansen, E. and F. Ducoulombier. ESG Incorporation – A Review of Scientific Beta’s Philosophy and Capabilities. (March).

• Christiansen, E. and M. Esakia. The Link between Factor Investing and Carbon Emissions. (February).

• Amenc, N., F. Goltz, A. Lodh and S. Sivasubramanian. Robustness of Smart Beta Strategies. (February).

• Amenc, N. and F. Ducoulombier. Scientific Beta Comments on the Mercer Report “Factor Investing: From Theory to Practice”. (January).



DisclaimerThe information contained on the Scientific Beta website (the "information") has been prepared by Scientific Beta Pte solely for informational purposes, is not a recommendation to participate in any particular trading strategy and should not be considered as an investment advice or an offer to sell or buy securities. All information provided by Scientific Beta Pte is impersonal and not tailored to the needs of any person, entity or group of persons. The information shall not be used for any unlawful or unauthorised purposes. The information is provided on an "as is" basis. Although Scientific Beta Pte shall obtain information from sources which Scientific Beta Pte considers to be reliable, neither Scientific Beta Pte nor its information providers involved in, or related to, compiling, computing or creating the information (collectively, the "Scientific Beta Pte Parties") guarantees the accuracy and/or the completeness of any of this information. None of the Scientific Beta Pte Parties makes any representation or warranty, express or implied, as to the results to be obtained by any person or entity from any use of this information, and the user of this information assumes the entire risk of any use made of this information. None of the Scientific Beta Pte Parties makes any express or implied warranties, and the Scientific Beta Pte Parties hereby expressly disclaim all implied warranties (including, without limitation, any implied warranties of accuracy, completeness, timeliness, sequence, currentness, merchantability, quality or fitness for a particular purpose) with respect to any of this information. Without limiting any of the foregoing, in no event shall any of the Scientific Beta Pte Parties have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits), even if notified of the possibility of such damages.

All Scientific Beta Indices and data are the exclusive property of Scientific Beta Pte.

Information containing any historical information, data or analysis should not be taken as an indication or guarantee of any future performance, analysis, forecast or prediction. Past performance does not guarantee future results. In many cases, hypothetical, back-tested results were achieved by means of the retroactive application of a simulation model and, as such, the corresponding results have inherent limitations. The Index returns shown do not represent the results of actual trading of investable assets/securities. Scientific Beta Pte maintains the Index and calculates the Index levels and performance shown or discussed, but does not manage actual assets. Index returns do not reflect payment of any sales charges or fees an investor may pay to purchase the securities underlying the Index or investment funds that are intended to track the performance of the Index. The imposition of these fees and charges would cause actual and back-tested performance of the securities/fund to be lower than the Index performance shown. Back-tested performance may not reflect the impact that any material market or economic factors might have had on the advisor's management of actual client assets.

The information may be used to create works such as charts and reports. Limited extracts of information and/or data derived from the information may be distributed or redistributed provided this is done infrequently in a non-systematic manner. The information may be used within the framework of investment activities provided that it is not done in connection with the marketing or promotion of any financial instrument or investment product that makes any explicit reference to the trademarks licensed to Scientific Beta Pte (SCIENTIFIC BETA, SCIBETA and any other trademarks licensed to Scientific Beta Pte) and that is based on, or seeks to match, the performance of the whole, or any part, of a Scientific Beta index. Such use requires that the Subscriber first enters into a separate license agreement with Scientific Beta Pte. The Information may not be used to verify or correct other data or information from other sources.

The terms contained in this Disclaimer are in addition to the Terms of Service for users without a subscription applicable to the Scientific Beta website, which are incorporated herein by reference.

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