Are new EU climate benchmarks fit for purpose?

EU guidelines on how firms report climate information could help eradicate greenwashing

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Fund groups often bombard investors with acronyms and data on how they are carbon neutral and adhere to the highest green standards. But many fund selectors are sceptical about ‘greenwashing’ and can find an investment’s supposedly environmental credentials do not hold up under close scrutiny.

In June, the European Union published new guidelines on how companies report climate-related information.

As part of this environmental, social and corporate governance (ESG) protocol, two climate benchmarks were introduced: the EU climate transition benchmark and the EU Paris-aligned benchmark.

The benchmarks are designed to disincentivise the practice of greenwashing by bringing greater clarity to what measures companies are taking to combat climate change and increase sustainability, rooting out those merely paying lip service to such issues.

Temperature targets

Until now, there was no established framework to measure the alignment of an investment portfolio with a temperature scenario.

The EU climate benchmarks will indicate which companies can demonstrate they comply with a global temperature increase limit of 1.5°C.

But are the guidelines fit for purpose? Ingrid Holmes, head of policy and advocacy at Hermes Investment, thinks there is value in the transparency and methodology the EU has used in constructing these indices.

Pension fund investors will be able to opt for an off-the-shelf product or buy into the EU view. Holmes argues that from a retail investor’s perspective, an EU endorsement might provide greater assurance as to where their money is being invested.

However, she has a number of concerns about how companies will be kept in check. “It’s not clear who will be responsible for monitoring, whether it will be regulated on a national level or not,” she says. She is also unsure how the climate benchmarks will demonstrate their ability to reduce the intensity of greenhouse gas emissions on a year-on-year basis.

Andrew Howard, head of sustainable research at Schroders, agrees with Holmes that there are positives to be drawn from the initiative but concedes it will take time to evolve. “There is a need for clarity on what benchmarks measure and how they are defined, particularly when they are used to create investment products.

“We expect the biggest impacts to fall on passive managers who develop products from those benchmarks.”

He adds: “It is important to recognise that the investment industry’s understanding of climate change continues to develop, and flexibility is needed to promote new innovations and stronger analysis. However, bringing more clarity to those benchmarks is another piece of the puzzle of reshaping and strengthening the financial system.”

Helena Viñes Fiestas is global head of stewardship and policy at BNP Paribas Asset Management, and a member of the European Commission’s Technical Expert Group on sustainable finance, which developed the EU taxonomy.

She has been closely involved in the development of the EU climate benchmarks and concedes there is work still to be done, but she insists that what has been achieved so far should not be underestimated.

“It is a massive change. Until now, there has been a lack of transparency and clarity on what lies underneath. The benchmarks force companies to look at the methodology behind how a portfolio is aligned.”

She adds: “The climate transition and EU Paris-aligned benchmarks are both ambitious, as they send a very strong message about the 1.5°C increase limit, but the Paris-aligned benchmark is especially ambitious as it sets a 50% emission reduction target relative to the mainstream benchmark.”

Launch opportunities

Climate change has become a hot topic, as protestors barricade the streets and politicians debate solutions, and a raft of climate funds launched this year.

In June, Candriam unveiled SRI Equity Climate Action and, at the beginning of the year, Amundi subsidiary CPR Asset Management set up a thematic fund investing in global equities it deems best equipped to manage climate change-related risks.

As the demand for such funds increases, how can we be sure these investment vehicles will fulfil the EU benchmarks’ requirements on climate change?

Holmes is concerned there could be a rise in bandwagon jumping by fund groups that are keen to tap into the climate theme, but which haven’t bought wholeheartedly into the principle.

“We may see new passive funds underpinned by these EU benchmarks, where managers just say ‘job done’ and fail to take their responsibility any further,” she says.

Scott Thompson, director at Impax Asset Management, takes a similar line, suggesting fund managers in the climate change space should take a more active approach.

“This is an opportunity for active managers to prove their worth in finding and highlighting turnaround stories,” he says, adding that the focus needs to be on more than which companies are ‘in’ or ‘out’ based on the climate benchmark.

“A fund might have a car parts manufacturer within the portfolio that, on the face of it, is in a sector that does not fit with the transition to a low-carbon world. But in this instance, it is a company that specialises in parts for autonomous, electric vehicles.”

This contrasts with, for example, a financial firm that may have a great track record in terms of how it treats its employees but has little direct bearing on carbon reduction.

From green to grey

Whether asset management companies can fully report on their EU taxonomy aligned ‘climate change’ funds will depend on the transparency levels of the companies.

Viñes Fiestas says: “For active fund managers, there is more room for manoeuvre than for index tracker funds. But if they want to market their fund as a climate-focused product they will have to report what percentage of it complies with the taxonomy.”

In theory at least, greenwashing should be much harder because, as Viñes Fiestas explains, the taxonomy serves as a defined reference point.

There will be grey areas, for instance the Schroder International Selection Global Climate Change Equity Fund, invests in Siemens Gamesa, a leading player in the wind energy sector. However, the parent company Siemens Group also has in interest in the mining and oil and gas sectors.

Assuming that a multinational conglomerate such as Siemens is suitably transparent in its ESG reporting, it should be possible to evaluate from its disclosure whether it complies or not.

The ‘green to brown share ratio’ comes into play in relation to where the group derives its revenues from and must be at least equal for the EU climate transition bench benchmark and be multiplied by at least four for the EU Paris-aligned benchmark.

According to the European Commission, benchmarks have an important impact on investment flows, so this should serve as an added incentive to comply.

Unanswered questions

Where might the EU climate benchmarks fall short? Thompson says indices in the past have attempted to quantify aspects such as ‘green revenues’ with limited success.

He believes that, from a taxonomy perspective, the EU climate benchmarks represent the most substantial piece of work in this area so far. The fact there are specifics regarding the ‘green to brown share ratio’ of where companies derive their revenues from represents progress. Carbon and temperature targets also provide a greater degree of clarity.

But in terms of running and monitoring the benchmarks, some questions remain unanswered. First, which third-parties will be responsible in the way FTSE International is for the FTSE4Good Index and Dow Jones & Company is for the DJ Sustainability Index?

As yet, this is not clear, though admittedly we are still in the late planning stages.

The technical expert group on sustainable finance (TEG) is due to publish a final report at the end of August 2019, with proposed implementation following that.

Viñes Fiestas, a member of the TEG, explains that more detail will need to be finalised over the next year. “We still don’t know who will monitor the benchmarks. It may be a body like the European Securities and Markets Authority that is responsible for the EU Green Bond Standard.

“After the final report at the end of August, and the public consultation following that, we will need clarity on who will act as monitor.”

She adds that assuming the report and consultation period progress positively, implementation should follow around 15 months later, estimating early 2021.

While admitting the benchmarks are not perfect, as methodologies still need to improve, Viñes Fiestas insists they will evolve over time and play an important role in making Europe carbon neutral by 2050.

“Do we really know how to conduct thorough scenario analysis today? I would say no. Do we have all the information to provide a carbon footprint of all portfolios? No. It will take time to get the methodology right, but progress will be made.”

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