The FCA has published a Dear CEO letter, with findings from its recent ESG benchmarks review. Rashim Arora looks at the key findings, and next steps for benchmark administrators.

The UK government aims to create the world’s first net-zero economy. To achieve this ambitious goal and transition smoothly, firms, and investors need adequate ESG information to make informed decisions. Benchmarks play a key role in this process, helping investors build portfolios that meet key ESG attributes. With the upcoming Sustainability Disclosure Requirements, this is particularly important to prevent greenwashing, and support the new labelling regime.

Findings from the FCA’s recent ESG benchmarks review found that the overall quality of ESG-related disclosures were poor, with limited detail and description of ESG factors considered. Many administrators had unclear methodologies or hadn't implemented them correctly. Collectively, these issues may affect the reliability and robustness of ESG benchmarks.

Benchmark statements

Administrators must publish a statement to support each benchmark, or family of benchmarks, they produce. This outlines what the benchmark measures and the risks of using it. However, the FCA found that these statements were broad and ESG-relevant information wasn't all in the same place, with greater signposting needed.

The FCA found that none of the administrators reviewed gave enough explanation over how they had considered ESG factors, or how they contributed to the benchmark methodology.

Benchmark methodology

Benchmarking methodologies can vary widely, so it’s particularly important to disclose adequate information over how the administrator developed a benchmark and to provide greater assurance over their use. The FCA found that methodologies were often unclear, with limited detail on the ESG factors and thresholds applied. This was still the case for benchmarks that specifically targeted ESG factors. In some cases, administrators had applied broad ESG factors to measure specific objectives, for example around climate, but it was unclear why. Poor methodologies could make it harder to compare and use benchmarks, and ultimate contribute to greenwashing.

ESG data ratings

The ESG data ratings space is still unregulated, although this is due to change with the recent publication of HM Treasury’s Future regulatory regime for Environmental, Social, and Governance (ESG) ratings providers. There’s also the FCA’s recent voluntary Code of Conduct for ESG data and ratings providers, which aims to improve transparency and trust in ESG ratings.

However, ESG ratings can currently vary significantly, despite being embedded in a wide range of investment processes. As such, it’s important to be transparent and clear over how these ESG ratings have been used in the relevant benchmark.

Low carbon benchmarks regulation

Some firms had failed to fully implement the disclosure requirements introduced in the low carbon benchmarks regulation in the UK. Under the low carbon benchmarks regulation, administrators must provide ESG disclosures for their benchmarks. These must include a benchmark statement with relevant ESG factors, which should be aggregated with a weighted average score. The FCA found that there wasn’t enough information on how the weighted average scores were calculated, with limited descriptions of the data sources used. In some instances, firms simply may not have access to the relevant data – in which case, it they should consider ceasing the benchmark and discuss their options with the FCA. Benchmark administrators have a template for these statements, however key information was often missing.

Disclosures must also include details of methodologies used, including listing all ESG factors applied and if they are to be used for selection, weighting or exclusion. They should include information on the data used, how the data has been verified and data quality assurance processes. They should also state which factors are applied to which benchmarks, and highlight any scores that are being voluntarily disclosed (in addition to mandatory ones). Once again, this information was often incomplete.

Making sure the benchmark is robust and reliable

The FCA found that some benchmarks weren’t robust or reliable, with some miscalculations and incorrect application of ESG factors. In some instances, ESG ratings were out of date and firms didn’t correctly apply exclusion criteria. Some administrators didn't have appropriate controls in place to ensure benchmarks were reliable.

Next steps

To continue to comply with the benchmark regulation and low carbon benchmarks regulation, benchmark administrators should review their current processes to ensure:

  • methodologies are clearly defined and recorded for disclosure purposes
  • effective governance processes to make sure good practice is followed
  • data is up to date, of good quality and fit for purpose
  • all disclosure templates are filled out correctly and in full
  • effective controls are in place to ensure reliable and robust benchmarks.

For more insight and guidance, get in touch with Rashim Arora.