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February 23, 2022updated 19 Mar 2022 3:14pm

Why asset owners are divided over off-the-shelf climate indices

Low-carbon indices are growing in popularity as investors seek to cut portfolio emissions. But some, such as Norway’s sovereign wealth fund and Swedish pension fund AP4, prefer different approaches. Here's why.

By Vibeka Mair

Sunset for big emitters in passive equity portfolios? (Photo by kamilpetran / iStock)
  • Index providers report strong growth in the amount of passive equity assets tracking low-carbon or climate-related indices.
  • Brunel Pension Partnership, New York Common Retirement Fund and Schroders are among those to have put money into such strategies recently.
  • Some asset owners, such as Sweden’s AP4 and Norway’s $1.3trn state fund, are using in-house-developed approaches to cut equity portfolio emissions.

Passive investing has boomed in recent years, and has been accompanied by an increasingly fierce debate over whether such strategies can help achieve social and environmental goals. Many argue that responsible allocation of capital demands active intervention, while index investing proponents point out that they can exercise influence by dint of owning assets – such as by voting as shareholders.

The rising popularity of low-carbon or climate-focused indices makes them an increasingly important part of the conversation.

As investors strive to ‘green’ their portfolios – often in line with net-zero pledges – more are adopting such indices to help decarbonise their equity allocations. They are above all being used as a basis for passive index-tracking funds or mandates, but some investors are using them as benchmarks for active or semi-active equity portfolios – and some are combining both, as this article illustrates.

Climate-focused indices will ultimately become commonplace, says Adam Matthews, chief responsible investment officer for the Church of England Pensions Board, which worked with FTSE Russell to devise its Transition Pathway Initiative (TPI) climate transition index series. “The outliers will be those that don’t take these considerations into index construction,” he adds.

Climate-focused indices will ultimately become commonplace. The outliers will be those that don’t take these considerations into index construction. Adam Matthews, Church of England Pensions Board

Low-carbon strategies typically incorporate environmental factors into passive benchmarks or allocation models with the aim of reducing emissions in line with 2015 Paris Agreement targets. They are also becoming more sophisticated, with forward-looking data – in the past seen as a major challenge – now being employed to account for energy transition, and other climate-related risks.

Yet tracking error – the divergence between the price behaviour of a position or portfolio and that of a benchmark – remains an issue. The more a portfolio tilts to low-carbon stocks, the more it deviates from standard market benchmarks, such as the S&P 500 or MSCI All World. Low-carbon benchmarks are designed to minimise such risk, but doing so is challenging.

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Climate index take-up

Hence index providers and other industry experts say investors should attribute less importance to tracking error if they want to achieve net-zero portfolio emissions. And some asset owners appear to be accepting that reality. UK local authority retirement scheme pool Brunel Pension Partnership and the New York Common Retirement Fund are two recent examples of asset owners allocating capital to climate index strategies.

The amount of exchange-traded fund (ETF) assets tracking MSCI’s ESG (including climate) indices stood at £227bn at the end of 2021, up 115% year on year, says Christine Chardonnens, executive director of global ESG index product at MSCI. Even more institutional capital is likely to be flowing into segregated mandates or pooled funds that benchmark against such indices, she adds.

Christine Chardonnens of MSCI says the amount of exchange-traded fund assets tracking MSCI’s ESG indices had more than doubled year on year to £227bn as of December 2021. (Photo courtesy of MSCI)

Moreover, passive assets across ETFs and segregated mandates tied to FTSE Russell’s sustainable indices grew by 30% to £167bn between December 2020 and June last year, says Aled Jones, the company’s head of sustainable investment for Europe. FTSE Russell says that is the latest figure it currently has available.

The low-carbon index growth trend looks set to continue. In November, index fund giant State Street Global Advisors published findings of a survey of 300 institutions, 78% of which were pension funds. Some two-thirds (65%) of respondents said switching to an ESG or climate-specific benchmark would be the preference for their index portfolios over time (75% in Europe and 52% in North America – see chart below).

For instance, New York Common said in December it would allocate $2bn of its public equity portfolio to FTSE’s Russell 1000 TPI Climate Transition Index (CTI). This new allocation uses five key criteria to evaluate corporate efforts to transition to the emerging net-zero economy, said the $255bn fund in a release about the move. The CTI examines companies’ fossil fuel reserves, carbon emissions, green revenues, management quality and carbon performance, which will be used to overweight, underweight or exclude businesses based on their transition readiness.

This is the third passive domestic investment under New York Common's $20bn sustainable investment and climate solutions programme, of which it had allocated $15.3bn as of December.

Meanwhile, Brunel Pension Partnership, which manages around £30bn ($48bn) for various local authorities, said in November it was switching £3bn of passive equity allocations to the FTSE Russell Paris-aligned benchmark series. Most of the assets previously tracked the MSCI Low Carbon index, but some were based on the FTSE All Share and the fund’s global developed equity passive fund, a Brunel Pension spokesman tells Capital Monitor.

The FTSE Paris-aligned benchmark series achieves a 50% reduction in carbon emissions over a ten-year period and integrates forward-looking metrics from the TPI, said Brunel. The TPI, an asset owner-led initiative, provides assessments of how the world’s largest and most carbon-exposed companies are managing the climate transition.

Designing benchmarks that enable passive funds to target net zero has been one of the major challenges facing the financial sector. Brunel Pension Partnership

Brunel Pension says it worked closely with FTSE Russell to support the launch of the Paris-aligned benchmark series last year. “Designing benchmarks that enable passive funds to target net zero has been one of the major challenges facing the financial sector,” the pension pool added.

Asset managers are also getting on board. UK asset manager Schroders’ Global Climate Leaders fund, launched on 16 December, uses the MSCI All Country World Index (Acwi) as a performance benchmark and the MSCI Acwi Paris-aligned benchmark to measure different climate factors such as carbon intensity.

Scottish fund house Baillie Gifford and others in Europe have used similar approaches, says MSCI’s Chardonnens.

Regulatory impetus

The trend is spreading to the US too, driven by policy in Europe, where low-carbon financial products must disclose in relation to Paris alignment, she adds.

In December 2020, the European Union launched decarbonisation-focused benchmarks as part of its sustainable finance action plan. Investors must follow them if they want to launch indices labelled as aligned with climate transition or the Paris Agreement. Among other things, the EU Climate Transition Benchmark requires overall cutting of carbon emissions by 30%, while the more ambitious EU Paris-Aligned Benchmark requires a 50% cut and sets various exclusion requirements.

MSCI’s Chardonnens says the European regulation gives the market direction. “A lot of investors need something laid out for them to have a solid starting point,” she adds, and the benchmarks also aid comparability across indices.

Preference for proprietary strategies

Others, however, are less convinced by off-the-shelf low-carbon benchmarks. Certain asset owners have instead developed in-house stock selection or exclusion strategies to reduce emissions or sustainability risks generally, while retaining standard benchmarks

Norway’s NKr11.93trn ($1.34trn) sovereign wealth fund, for instance, shuns what it calls “climate-adjusted indices” for issues related to their volatility and because it says there is no index industry standard for their design.

In December, Norges Bank Investment Management (NBIM), which invests the fund, said it had begun systematically “pre-screening” for sustainability risks all the companies that enter its equity index, the FTSE Global All Cap, each quarter. As result of this process, NBIM has so far excluded nine stocks from the portfolio, despite them being added to the index it tracks.

In a similar vein, Swedish state pension fund AP4, an early mover into low-carbon indices in 2012, has now ditched them. Since 2017 it has been using a low-carbon equity strategy it developed combining active and passive investing and using traditional benchmarks. Capital Monitor will be taking a closer look at the SKr489.8bn ($54bn) fund’s approach in a separate article.

Research published in December by the Bank for International Settlements (BIS) supports such thinking. The Basel-based central bank for central banks says there are simple allocation rules whereby passive investors can trim the carbon footprint of their portfolios. By 2019 they could have achieved a cumulative reduction of 64% of carbon emissions relative to the 2010 MSCI global stock portfolio by excluding 11% of the most polluting corporates, the BIS argues.

Whether most investors have the resources to pursue such strategies is another matter. In the meantime, the rise of off-the-shelf low-carbon benchmarks – whether for tracking or benchmarking purposes – looks set to continue. Time will presumably tell how effective they are at reducing emissions.

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