The Focus on ESG Benchmarks: Key messages from the FCA Dear CEO Letter to Benchmark Administrators

ESG data, disclosure and reporting is an area of focus for the FCA, as well as many other regulators globally. As the need for high quality information continues to grow, risks associated with the completeness and accuracy of that information present challenges to the credibility of this information, and increases the potential for greenwashing risks to emerge. The FCA has completed a preliminary review on ESG benchmarks, focusing on the quality of disclosures, and published the results of their review in another Dear CEO Letter on 20th March 2023.

In our previous blog, we discussed the key messages from the Dear CEO Letter issued to benchmark administrators in September 2022 which outlined the FCA’s supervisory strategy. In the letter, the FCA expressed its concern that the quality of ESG benchmarks may not align with the expectations of users and end investors, impacting trust in the market for ESG-labelled products and the transition to a net zero economy.

In this blog, we step through the key concerns highlighted by the FCA in the recent letter and set out what administrators should consider in response to it, what users should expect in the governance and control of the ESG benchmarks they use.

The conclusion of the review on the quality of disclosures for ESG benchmarks was in general, “poor”.

Given previous concerns raised by the regulator on the quality of ESG benchmarks, the strength of wording in the letter signals a clear need for focus on ESG benchmark and index administration. For such concern to arise in a public Dear CEO letter, in the context of almost a decade of existing regulation in the UK BMR and the additional requirements from the Low Carbon Benchmark Regulation that should enhance the quality of benchmark administration, provides a clear indication of the Regulator’s current view of the application of these standards to ESG benchmarks.

Whilst findings identified are related to ESG benchmarks, some are thematic in nature. Firms should develop plans to address the concerns outlined in the letter, with a focus on these benchmarks.

Importantly, benchmark and index Oversight committees should be asking questions and challenging administration teams on compliance, to help ensure they meet their regulatory requirements and the concerns outlined in the letter are being addressed. Equally, users should pay close attention to the comments outlined in the letter, and be satisfied that the ESG benchmarks that they use are sufficiently robust for their needs.

The Dear CEO letter marks a notable rise in the regulatory interest in ESG benchmarks alongside other regulatory communication on this subject, notably the EU Commission publishing their study on the feasibility, minimum standards and transparency requirements of an EU ESG Benchmark label in December 2022. From these communications, it is clearer that the level of scrutiny and supervision will only increase and firms which address the concerns in the letter will be best placed to manage further supervisory challenge and oversight from the regulatory community.

Benchmark Statements

The BMR allows firms to publish benchmark statements for individual benchmarks or for families of benchmarks. However, the review considered the description of the market or economic reality measured by ESG benchmarks to be generic, especially for those covering a broad range of benchmarks and questioned the general usability of the statements where some information might be disclosed in the methodology rather than in the statement.

Administrators should look at the benchmark families they currently have in place and whether they remain suitable, given that many benchmark families were established in the initial period of BMR compliance. Given the additional requirements required for ESG, Paris-Aligned and Climate Transition benchmarks in 2019 and 2020, firms may wish to consider whether separate benchmark statements and methodologies will make these documents easier to navigate for users and demonstrate compliance to the regulation.

The sample reviewed by the FCA, in their opinion all failed to sufficiently explain how ESG factors are reflected in the benchmark statements. This could be an area of difference between how firms have interpreted the requirements and firms should look at the level of disclosure and whether it explains the factors and the rationale for adopting it.

Benchmark Methodologies

The regulator’s review of ESG benchmark methodologies identified similar areas of concern to benchmark statements, especially on the level of disclosure on how ESG factors are considered for benchmarks.

The lack of detail in disclosure could give rise to an increased risk of greenwashing and the regulator highlighted that benchmarks may use ESG metrics, but may not explain why such metrics are appropriate, particularly if a benchmark purposes to have climate objectives only.

The use of ESG data and ratings are an area of focus for the FCA and other regulators, beyond its use in benchmarks. As users of this information, administrators should ensure that the underlying methodology for data and ratings used is made available to users and disclose how they are used in the methodology.

Administrators should take note of the wider initiative by the FCA to establish an ESG Data and Ratings Code of Conduct Working Group with current expectations for a Code to be out for consultation in Summer 2023 and finalised in Q4 2023. Administrators, particularly those who are part of wider organisations with a ESG data and/or rating business unit should be encouraged to engage in the process to ensure their needs are met and obtain the appropriate level of confidence in the data used in the proposed Code of Conduct.

In addition, Firms should look to consider the appropriateness of the benchmark methodologies, especially if part of a benchmark family, and whether it meets the needs of users to understand how the benchmark is determined and incorporates those ESG features.

Robustness and Reliability of ESG Benchmarks

Article 12 of the BMR requires benchmark methodologies used to be robust and reliable. The letter highlights that the FCA is aware of several instances where benchmarks were miscalculated due to the incorrect application of ESG factors, including when outdated ESG ratings or data is applied.

The letter does also require firms to consider, as part of procedures for incidents to consider how, for ESG benchmarks how users’ and end-users’ could be impacted by any incidents. This indicates a need for administrators to think beyond the user licencing the benchmark and how it is used in other users where they may not have a direct relationship with.

Firms are required to have control frameworks to ensure they meet the requirements of the regulation. Instances where failure in the robustness and reliability of the benchmark demonstrates a need for firms to review their overall internal control environment and be confident that it adequately meets the needs of their business, across their benchmark types.

Finally, with a clear focus on quality of data provision, Administrators should review their controls around the use of third party data such as ESG data and ratings and whether they have controls in place to ensure the appropriate data is used.