A review by the Financial Conduct Authority (FCA) into ESG benchmarks has found “potential widespread failings”.
In a Dear CEO letter published on 20 March, the FCA said the quality of disclosures was “generally poor” following an assessment of a sample of UK ESG benchmark providers, adding they had the potential to contribute towards greenwashing.
The review comes after the regulator highlighted concerns around the misleading construction of ESG benchmarks last September, noting they had the potential to create a “trust deficit” for investors in ESG ETFs.
“In general, [the quality of disclosures] was poor,” Jon Relleen, director of infrastructure and exchanges at the FCA, said. “There were often instances where benchmark administrators did not provide sufficient detail and description of the ESG factors considered in their benchmark methodologies.”
He added some providers had failed to properly implement disclosure requirements introduced as part of the Low Carbon Benchmark Regulation and found examples of benchmark administrators failing to implement their ESG methodologies correctly.
“We became aware of several instances where benchmarks had been miscalculated due to the incorrect application of ESG factors,” Relleen said. “We found administrators had assessed constituents against outdated ESG ratings and data or failed to apply their ESG exclusion criteria when rebalancing.”
Furthermore, he added the FCA had observed that some administrators did not have adequate controls in place to verify ESG factors had been correctly applied.
“In our review, we found a lack of detail in benchmark methodologies. For example, there was little explanation on the ESG factors used in benchmarks and the thresholds benchmark administrators choose to apply when measuring these,” Relleen said.
“We are concerned this can contribute towards or lead to greenwashing.”
The regulator also found that some benchmark methodologies failed to describe when certain ESG factors were applied.
For example, a benchmark with climate objectives also used broader ESG metrics in its methodology without explaining why they were appropriate, given they also factor in social and governance factors.
“Without transparency of these underlying methodologies and clarity on how they are being applied to a benchmark, it may be difficult for users to interpret and compare outputs across administrators, potentially harming competition and end investors,” the FCA said.
Administrators were also found to omit information on data and standards used to calculate the weighted average scores for the ESG factors.