Why some UK ‘sustainability improvers’ funds face greenwashing risk

Funds that passively track the EU’s Paris-Aligned Benchmarks (PABs) and Climate Transition Benchmarks (CTBs) while displaying the ’sustainability improvers’ label in the UK risk falling foul of the Financial Conduct Authority’s (FCA’s) anti-greenwashing rule. This is because products tracking such benchmarks do not meaningfully contribute to the achievement of climate objectives and promotional statements about these funds may be misleading.

The sustainability improvers label

From 31 July 2024, a new labelling regime will begin to operate in respect of investment products regulated in the UK. The labelling regime sits alongside new sustainability disclosure requirements (SDR) that were set out by the FCA in November 2023.

Under the labelling regime, asset managers can select one of four ‘labels’ to apply to investment products where those products seek “positive sustainability outcomes” – either environmental or social – provided the products meet set criteria to qualify for labelling. The ‘sustainability improvers’ label is one of the four labels and can be used by funds which have an objective of investing in assets that have the potential to improve environmental and/or social sustainability over time. The required improvement can be determined at the individual asset level (the asset level approach) or at the portfolio of assets level (the product level approach).

Whether a sustainability improvers fund adopts the asset level approach or product level approach will have significant implications for its sustainability profile.

Under the asset level approach, a sustainability improvers fund will be investing in assets which are individually improving their sustainability performance over time measured through appropriate KPIs reported by the assets individually. Whereas, under the product level approach a sustainability improvers fund will be investing in a portfolio which is improving its sustainability performance over time measured through KPIs reported at the portfolio level without regard to the individual constituents of that portfolio.

PAB and CTB benchmark methodologies

In its policy statement, the FCA cited example financing strategies identified by the Glasgow Finance Alliance for Net Zero (GFANZ) – a coalition of financial institutions, established around the time of COP26 in Glasgow, that has committed to accelerating the climate transition. In one such example, it cited PABs and CTB trackers, stating that “both aligned and aligning financing strategies – including, for example, products tracking a Paris-Aligned and Climate Transition benchmark – may form part of the asset selection approach in a sustainability improvers product, where that product is directed towards a future 1.5C emissions profile for assets”.

Minimum standards for PABs and CTBs are set out in EU regulation. In brief, these minimum standards require that:

• PABs and CTBs must align to one of the gold standard Paris Agreement targets of limiting the global rise in temperatures to just 1.5C by the end of this century – it is currently projected to rise by nearer to 3C;
• A benchmark’s exposure to high climate impact sectors must be no less than that of the underlying investable universe;
• ‘Scope 3’ greenhouse gas emissions – emissions indirectly linked to a business’ operations but that fall outside of its direct control – must be incorporated into emissions calculations;
• Benchmark administrators at least consider overweighting constituents which have published greenhouse gas (GHG) emission reduction targets;
• PABs and CTBs must decarbonise at a rate of 7% per annum;
• PABs must have an emissions intensity at least 50% less than the underlying investable universe, while CTBs must have an emissions intensity at least 30% less than the underlying investable universe;
• PABs and CTBs must exclude certain companies and activities from the benchmark.

The recitals to the EU regulations indicate that achieving the goals of the Paris Agreement requires “making investment flows consistent with a pathway towards low greenhouse gas emissions”, “reorient[ing] capital flows towards sustainable investment”, and that “new infrastructure investments are sustainable in the long term”.

Some industry participants have critiqued the EU climate benchmarks, making the controversial allegation that the stated objectives of PABs and CTBs can be met through data mining and security re-weighting rather than genuine change in the real economy. Such outcomes give rise to “paper decarbonisation” – something that regulators will be on the lookout for, since it can mislead consumers and undermine trust in sustainable funds.

Assessing if PAB and CTB trackers meet the ‘sustainability improvers’ criteria

The ‘sustainability improvers’ label can be used by funds which have an objective of investing in assets that have the potential to improve environmental and/or social sustainability over time.

There are three specific criteria asset managers must meet if they wish their funds to display the ‘sustainability improvers’ label. The manager of the fund must:

• identify the period of time by which the product and/or the assets in which the product invests is expected to meet a robust, evidence-based standard of sustainability;
• identify short and medium-term targets for improvements in the sustainability of the product and/or the assets in which the product invests, commensurate with the investment horizon of the product;
• ·obtain robust evidence to satisfy itself that the assets in which the product invests have the potential to meet a robust, evidence-based standard of sustainability.

The first criteria

When it comes to PABs and CTBs, they typically don’t set a target date by which the product will be “sustainable”, as the benchmark methodologies are designed to construct an index of companies which are decarbonising over time. Strictly interpretated, it could be argued that managers of such products fail to satisfy the first of the criteria, although managers could seek to argue that a default date of 2050 applies for decarbonisation.

Notwithstanding that, fund managers could also argue that they meet the first criteria by the requirement for such benchmarks to be aligned to a 1.5C scenario, as this can be considered an absolute measure of environmental sustainability with respect to the objective of climate change mitigation. Additionally, PABs and CTBs must also exclude certain companies associated with business activities considered to conflict with other sustainability objectives, thereby ensuring some minimum standards.

In my view, however, alignment to a 1.5C scenario and minimum exclusions does not represent a particularly high standard of sustainability. In short therefore, it is arguable whether the benchmark methodologies for PABs and CTBs meet the first of the three criteria.

The second criteria

The position in relation to the second criteria is clear cut. It is met by virtue of the annual 7% decarbonisation requirement for PABs and CTBs.

The third criteria

Assessing alignment between the PAB and CTBs minimum standards and the third ‘sustainability improver’ labelling criteria is more complicated.

For example, while a benchmark’s exposure to high climate impact sectors must be no less than that of the underlying investable universe, this is hitched to the aim of ensuring the benchmark is exposed broadly to the real economy, including high climate impact sectors, and that it does not just take a subset of the economy to achieve decarbonisation objectives. The intention, therefore, is that the benchmark’s year on year decarbonisation is genuine. Fund managers might rely on this requirement as robust evidence that the product is aligned to a 1.5C scenario.

Nonetheless, the sectoral constraint is very crude. Benchmark administrators can simply exclude or decrease the weight of the most carbon intensive companies within each high climate impact sector or re-allocate across them to achieve the decarbonisation objective while still falling within the rules.

Another requirement of the benchmark methodologies is to incorporate Scope 3 emissions into emissions calculations.

Putting to one side the data issues associated with Scope 3 emissions information, which the European Commission has acknowledged, the PAB and CTB benchmark methodologies presume that Scope 3 emissions are a proxy for climate risk. However, many companies involved in climate change mitigation solutions report significant Scope 3 emissions numbers.

Unfortunately, the GHG Protocol for calculating Scope 3 emissions does not account for the positive benefits achieved by low carbon technology. As a result, there has been increasing discussion around so-called “Scope 4” emissions – the emissions avoided by using a product or service, such as energy efficient lightbulbs. Incorporating consideration of such avoided emissions would support tilting portfolios towards companies which will advance the transition to a low carbon economy, but the data quality issues for Scope 4 are even worse than for Scope 3, which currently makes it problematic to integrate such a metric into benchmark methodologies. They may therefore be more suited to actively managed products.

The point highlights, though, that incorporating Scope 3 emissions into carbon intensity metrics can lead to the perverse effect of reducing the weightings to companies whose products and services enable the transition to a low carbon economy. Recognising this shortcoming, some benchmark administrators have introduced a requirement to increase weights in companies deriving revenues from environmentally sustainable products or services versus the underlying investable universe.

The PAB and CTB benchmark methodologies use enterprise value including cash (EVIC) in emissions calculations – despite feedback from industry regarding the unsuitability of calculating emissions intensity metrics using EVIC. In brief, changes in EVIC, as a result of market performance, can significantly influence emissions intensity, which will in turn influence benchmark weightings. Given that volatility in EVIC is higher than volatility in year-on-year emissions performance, this means that changes in EVIC is likely to have a higher impact on security weightings within the benchmark than a company’s performance on decarbonisation. Such impacts may be less pronounced when looking at the evolution of the benchmark over multiple years. Nonetheless, it undermines the credibility of the benchmark to promote decarbonisation.

There is a more general point. Providing for use of a ‘sustainability improvers’ label implies that the regulator is keen for managers to feel incentivised to make improvements to their fund’s sustainability performance. Such a reading would align with a number of net zero frameworks which promote decarbonisation in the real economy, by supporting engagement with all companies and the adoption of net zero transition plans. However, aspects of the PAB and CTB benchmark methodologies do not do that. Instead, they require an upfront reduction in the carbon intensity of the benchmark versus the underlying investable universe and mandate certain exclusions.

It can therefore be assessed that PABs and CTBs do not offer robust evidence that a fund tracking them would be able to demonstrate a meaningful potential to meet a robust, evidence-based standard of sustainability.

Guidance produced by the FCA in relation to index-tracking strategies on its SDR website suggests it will take a hard stance on products that merely track such benchmarks. That guidance states: “Products tracking Paris Aligned Benchmarks and Climate Transition Benchmarks can qualify for labels, provided that the qualifying criteria are met. But tracking those benchmarks alone doesn’t necessarily mean they meet the criteria for a label.”

The risk of breaching the anti-greenwashing rule

The FCA’s anti-greenwashing rule requires that, in any communication, a reference to the sustainability characteristics of a product or service is: consistent with the sustainability characteristics of the product or service; and fair, clear and not misleading.

According to guidance the regulator has issued in relation to the rule, sustainability references should be:

• correct and capable of being substantiated;
• clear and presented in a way that can be understood;
• complete and not omitting important information; and
• comparisons to other products or services should be fair.

Given the various shortcomings of PABs and CTBs, fund managers using them as benchmarks should be very careful when making sustainability statements about their products. There is a risk that such statements could potentially overstate the product’s sustainability, contain claims that cannot be substantiated, misrepresent how the product meets sustainability preferences, or omit relevant information to enable the nature of the product to be understood.

Actions for asset managers

Many critiques of PABs and CTBs have been published. Fewer pieces have been published on what good climate indices should look like.

In November 2022, the UN-convened Net Zero Asset Owners Alliance (NZAOA) published a document in which it outlined 10 key principles for net zero benchmarks.

These principles offer a good reference point for asset managers seeking to address the shortcomings of PABs and CTBs. The principles, among other things, recommend no mechanical exclusions of high emitting sectors; that benchmarks take into account differences in decarbonisation trajectories across sectors and geographies; and that greater emphasis should be placed on forward-looking assessments, rather than backward-looking metrics which may be unduly influenced by equity market volatility.

If getting it right means abandoning the use of PABs and CTBs, this could be very disruptive to existing products. Therefore, to ensure that investors are not misled, fund managers should consider uplifting their disclosures so that investors are presented with all material information and product-related communications are fair, clear and not misleading.