Index governance comes to the fore in the sustainable finance race

By: Anoushka Babbar, Head of Sustainable Investment Index Policy, FTSE Russell

The norms, principles and conventions that inform sustainable investment are constantly evolving. Sustainable investment options are facing growing scrutiny from investors and wider stakeholders over definitions and standards. To take just a few examples: what should definitely be excluded from an ESG fund? How are controversies and human rights issues captured in sustainable investment indices? How should investors exclude or engage with companies involved with fossil fuels?

Regulation, too, is changing, often with direct impact on sustainable finance. The EU and China taxonomies have defined, for the first time in regulation, activities that policy makers deem to be sustainable. The EU labels for climate benchmarks set minimum standards for indices that aim to be aligned with the EU’s climate goals. The EU’s Sustainable Finance Disclosure Regulation sets minimum requirements for funds labeled as sustainable. Lessons learned from this are reflected in the UK’s proposed Sustainable Disclosure Requirements regime and Hong Kong’s revisions to its 2019 Circular.

This poses challenges and opportunities for companies such as FTSE Russell, which produce rules-based sustainable indices, and for the users of those indices. How should index rules be changed in a way that reflects the evolution of market practice, while providing transparency and certainty to index users?

Although the issues that arise when navigating the evolving sustainable finance landscape can be more complex that those faced in other asset classes, the solution that we have adopted at FTSE Russell is the same: a structured, rigorous and transparent index governance process that gives index users a say in how change is managed, and visibility regarding deliberations and outcomes.

As a regulated benchmark administrator, FTSE Russell is required to meet stringent regulations and requirements regarding index governance and oversight. Our governance framework is charged with maintaining the integrity of our indices. A key part of this is the Index Governance Board which is responsible for approving new index methodologies and changes to methodologies. Methodologies are a detailed and transparent set of rules used to build and govern an index.

FTSE Russell engages with 24 Advisory Committees, which draw on the expertise of around 200 external investment professionals and index users active across financial markets. This ensures that indices meet investor needs in a very transparent process, as the terms of reference and minutes of the Advisory Committees are published. Building on Committee feedback, internal forums then make recommendations to the Index Governance Board.

For fundamental modifications with the potential to change the composition of indices, FTSE Russell undertakes wider public consultations. Such a consultation has just closed on a proposal to apply a minimum set of exclusions to our suite of sustainable investment indices. Explaining how this process works illustrates our broader approach to index governance.

The consultation is a concerted effort to define a minimum, consistent standard given the evolution of market conventions, fund labels and regulation in the sustainable investment market.

Therefore, earlier this year, FTSE Russell consulted on a proposal to introduce a set of exclusions that would apply to all FTSE Russell sustainable investment indices. Specifically, it proposed exclusions of companies producing tobacco and controversial weapons and of those that derive more than 50% of their revenues from thermal coal extraction. It also proposed exclusions related to “controversial conduct” by companies.

These exclusions would apply to all new sustainable investment indices, while they would be gradually applied to existing indices. (Some indices already apply these exclusions, while others already meet higher thresholds.)

The consultation requested feedback on these proposals, their application across asset classes and geographies, on the revenue thresholds, and whether they should go further, among other things. Relevant Advisory Committees were consulted. That feedback and the proposals themselves will be assessed by FTSE Russell’s internal governance forums, the outcome of which will be reviewed and approved by FTSE Russell’s Index Governance Board. A decision about the introduction of minimal standards for sustainable indices is expected later this year.

Index governance can accommodate a wide range of issues. Especially relevant at the moment are how controversies and human rights are taken into account in sustainable investment indices. FTSE Russell has recently published an FAQ explaining both the approach to human rights due diligence at a group level, and how these issues are considered in index construction.

The FAQ explains the data inputs for these decisions, how FTSE Russell manages relationships with third-party data providers, and the governance framework that ensures our indices reflect the underlying market and the appropriate methodologies. This is a crucial area, and it is important for index users to understand our approach and process.

Our index governance process ensures that FTSE Russell’s sustainable investment indices can adapt to issues as they arise. It enables our indices to evolve in line with the market and in concert with the needs and expectations of our clients.

Originally Posted May 4, 2022 – Index governance comes to the fore in the sustainable finance race

This post first appeared on May 4th, 2022 on the FTSE Russell blog




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