The establishment of the regulatory framework for two climate benchmarks, the Paris-aligned Benchmark (PAB) and the Climate Transition Benchmark (CTB), under the Benchmarks Regulation (BMR) in late 2019 predictably led to the launch of numerous ETFs tracking PABs and CTBs.
The requirements of BMR and the Sustainable Finance Disclosures Regulation (SFDR) underpinning such ETFs are relatively new and continue to develop. While the introduction of climate benchmarks gives ETF providers an opportunity to bolster their product range with ETFs tracking climate benchmarks, the interaction of BMR and SFDR requirements also presents such ETF issuers with a unique set of challenges.
The PAB and CTB labels may be used by index providers in respect of benchmarks that meet the detailed BMR requirements broadly aimed at the reduction of carbon emissions.
BMR prescribes the minimum standards for the methodology of both types of climate benchmarks including a reduction in exposure to greenhouse gas (GHG) intensive assets compared to the investable universe, a year-on-year reduction in GHG emissions and activity-based exclusions.
PABs have higher standards than CTBs across a number of metrics, notably a more significant percentage reduction in exposure to GHG intensive assets compared to the investable universe.
The use of PABs and CTBs by funds with a reduction in carbon emissions objective is specifically recognised under SFDR. While BMR requirements in relation to climate benchmarks apply to index providers, ETF issuers using these benchmarks must comply with the disclosure requirements under SFDR.
This includes the classification of funds by reference to their level of sustainability ambition, Article 9 funds being the highest on the scale. SFDR assigns an Article 9 classification to funds tracking PABs and CTBs.
While the correct SFDR classification of other ESG-oriented funds may in many cases cause fund managers to pause for thought, the direct reference to PABs and CTBs in Article 9 of SFDR reasonably leads to an assumption that funds tracking such benchmarks are Article 9 funds.
However, the European Commission Q&A on SFDR published in July 2021 introduced a degree of uncertainty to the scope of the due diligence to be undertaken by ETF issuers when assessing the climate benchmarks to be tracked by their products.
In the Commission’s view, the objective of a reduction in carbon emissions is a specific category of “sustainable investment” under SFDR.
It follows that the portfolios of funds tracking PABs and CTBs must comply with the definition of sustainable investment under SFDR, i.e. the objective of the investment must be to contribute to an environmental or social objective, must not significantly harm any of those objectives and investee companies must follow good governance practices.
Although the Commission Q&A opine that the implementation of BMR requirements by index providers must ensure compliance with the “sustainable investment” requirements under SFDR, the index providers are not required to overlay BMR requirements for the construction of PABs and CTBs with the additional criteria required to determine whether the index meets the “sustainable investment” definition under SFDR.
If the ETF issuers follow the view expressed in the (non-binding but nonetheless significant) Commission Q&A, this additional evaluation of PABs or CTBs against SFDR “sustainable investment” criteria will likely fall to be undertaken by them.
Given the non-alignment between BMR and SFDR requirements, the information published by the index providers may not be sufficient to enable the ETF issuers to make this evaluation.
To compound to the challenge, it is not clear what action an ETF issuer should take if it was to conclude that the portfolio of an ETF tracking PAB or CTB cannot be said to meet the “sustainable investment” criteria under SFDR.
Reclassifying the fund to a non-Article 9 fund would not necessarily be the correct approach under SFDR and would appear as a somewhat extreme step.
Adjusting the portfolio would also present challenges as an index-tracking ETF is likely to be constrained from making active investment decisions, even to realign with Article 9.
In any event, the ETF issuer would presumably be unwilling to do so given the index-tracking nature of the product and tracking error considerations.
The solution probably lies in addressing the divergence in requirements for BMR and SFDR through legislative amendments or further clarifications in the form of guidelines or Q&As. The detailed requirements imposed on index providers to attain PAB and CTB labels for their indices provide a good foundation for the design of products aimed at meeting the EU decarbonisation goals.
It is hoped that future legislative developments assist rather than hinder ETF issuers in bringing to market more climate ETFs, thereby contributing to the reorientation of capital flows towards sustainable investment.
Sergey Dolomanov is a partner at William Fry
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here