September 17, 2021

We are aware of the positive effects of indirect regulation (i.e. regulation by SFDR on a company and fund specific level). We believe the market will naturally center around few trusted ESG benchmark providers, but we are unclear whether there has emerged any form of regulation of the ESG index providers themselves. What would enhance the moat of Sustainalytics through higher regulatory barriers to entry? Could you maybe discuss any developments and thoughts regarding this kind of regulation

The EU’s Benchmark Regulation (Regulation (EU) 2016/1011) (“EU BMR”) introduced a common framework to ensure that benchmarks are robust and reliable and to minimize conflicts of interest. For an index company to qualify as an EU Benchmark administrator and, due to the recent introduction of the UK Benchmark Regulation, as a UK Benchmark administrator, there are two application processes that most providers will need to go through.  Administrators must complete two detailed and time-consuming application processes and then comply with numerous regulatory requirements, including creating a detailed framework around the design and documentation of their processes and procedures in creating and managing indexes. While these requirements are substantial and require staff resourcing, they benefit existing index providers by creating higher barriers to entry.

This barrier is especially relevant for asset managers who might be contemplating lowering costs by moving away from index providers to self-indexing (or already have made this shift). We believe that the increased regulatory and administrator burden, and the significant financial sanctions that apply under the BMRs, mean self-indexing is a less attractive option economically, benefiting existing index providers such as Morningstar.

Morningstar’s recent acquisition of Moorgate Benchmarks bolsters our strength in this regard as they are registered as a benchmark administrator under both the UK and the EU BMR. Furthermore, for those asset managers or other firms who are interested in self-indexing, Moorgate offers services to assist clients with their regulatory obligations, in developing governance structures, policies and processes to ensure their indices are managed to global best practice standards, or with their index development & calculation needs.

Stemming from the EU Action Plan on Sustainable Finance, there is also new regulation for any indexes that a provider is promoting as an ESG product. Any ESG index provider must publicly publish new standardized ESG index disclosures and a number of portfolio-level ESG metrics on its ESG indexes. The requirement to publish portfolio-level metrics raises barriers to entry, as each provider must have the technical ability and a license of underlying ESG data to accomplish this. Providers such as Morningstar, which owns the underlying ESG data (Sustainalytics) and have expertise in portfolio calculations, are at a significant advantage here.

Regulatory attention on sustainability ratings more broadly reflects that ESG factors are an increasingly important component of investor decisions.  We believe emerging regulation is a meaningful starting point, serving as a floor, rather than ceiling of expectations and requirements. From our perspective, key elements of a good regulatory framework include: (i) transparency of ratings processes and methodologies; (ii) transparency and quality of the resultant ESG ratings and disclosures; and (iii) management of conflicts of interest. As in the index sphere, providers such as Morningstar, through its data, methodological expertise, resources (both personnel and infrastructure) and experience of operating regulated businesses and managing potential associated conflicts have an inherent advantage. 

Some examples include:

  • In growing Sustainalytics’ coverage universe, quality was top of mind across two dimensions. The first is quality or reliability of the opinion. Our clients are very demanding and attentive to our research results. We knew that we needed consistent, robust and defendable ratings. We grew our teams rapidly to ensure that we had the research capacity to create reliable ratings and research. The Sustainalytics’ research team is now more than 500 people, which gives you a sense of the scale. The second dimension is breadth of analysis. We knew that clients interacted with our research in various ways. Some clients who are fundamental analysts are likely to read our full research reports. Other clients are more likely to simply rely on our various ESG ratings and data. As our coverage universe grew, we made decisions around what levels of narrative data to include in our company research and reports, so that we were using our research resources to create the most value for clients.  For example, a large cap, high profile company will receive a much longer write up and more information density than a company that is lower profile. But it is important to note, that the research outcomes – the ratings or assessment – of the company are of equal quality and reliability. We have well-staffed teams, logical and thoughtfully-structured research processes, and quality measures to ensure that is the case. 
  • Conflicts are part of many businesses, and we have been consistent in our policy views that conflict mitigation is important across financial services. That is why we supported enhancements to Regulation Best Interest and the recent U.S. Department of Labor Prohibited Transaction Exemption. Morningstar has a long history of managing conflicts related to running a business based on independent research. We have been doing this with respect to our mutual fund ratings for decades, and we have the same standards for ESG research. Our Morningstar Code of Ethics specifically prohibits salespeople from contacting mutual fund and equity analysts. Our practices are thoroughly documented in our policies and procedures, which are reviewed by compliance as well as applicable regulatory authorities. Sustainalytics’ approach to managing conflicts of interest is like-minded and publicly available here.

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