Mark Carney, the UN climate envoy heading up the Glasgow Financial Alliance for Net Zero (GFANZ), puts the figure needed for climate transition at $100 trillion over the next three decades. Finance, he says, must find ways to bolster what governments can (or can’t) do, given realpolitik constraints – witness the jockeying over climate reparations at COP27 in Egypt.
GFANZ investor members, of course, have $130 trillion at their disposal to focus minds.
We need to get smart – and fast – in influencing policymakers and market direction, and make capital allocation decisions clearer for investors. An obvious target for more work is the $20 trillion or so globally invested in the form of index/passive funds – the subject of a recent panel I led at the OECD Green Finance Forum.
Indexing has been the biggest story in investment management over the last 30 to 40 years, and will continue to grow. It is a relatively simple, focal issue. Most institutional and retail investors understand index strategies. The knock-on implications for active investment decisions in equities and bonds are straightforward.
The first iteration of low-carbon index ideas came out in 2016 under the title of “hedging climate risk” and with a snappy tagline of being a “free option” on carbon, which has been borne out by CO2 emissions prices subsequently.
Alongside scale, there are network, competition and feedback effects to climate indices. The more money flows, the greater the effect on the strategies of corporate index constituents that want to remain in the benchmarks, and the better the return if accompanied by serious policy and price tightening.
There is nothing wrong with backing your own horse when it aligns with global policy shifts.
Acting in concert here would be a societal and fiduciary good.
Investors can make this happen by investing in low-carbon indices and engaging robustly with companies and policymakers for the required CO2 reductions and related financial outcomes over clear timeframes. The reverse, of course, is also true.
Håvard Halland, senior economist at the OECD Development Centre, said: “When index funds are not committed to net zero, it is a giant spanner in the wheel against climate action.”
He noted that when most asset managers made net-zero commitments at COP26, it was for active mandates. Index funds were largely unaffected, despite index mutual funds and ETFs accounting for 40 percent of assets.
The potential of indexing for climate transition finance was recognised by the EU via the Climate Transition and Paris-aligned Benchmark (PAB) labels, both of which have been significant profile-boosters. Critics, however, say they focus too much on backward-looking data, volatile “enterprise-value” (versus company revenue) calculations and relative carbon intensity, rather than reducing overall atmospheric carbon volume.
A recent paper by Tom Steffen, head of quant research at Osmosis Investment Management, outlines some of the technical and financial challenges to making PABs work for investors and for real net-zero emissions trajectories.
Some large pension investors are sticking a leg – or at least a foot – in the water.
In September, the New Zealand Superannuation Fund shifted around 40 percent of its investment portfolio – some NZ$25 billion ($15.4 billion; €14.8 billion) – to Paris-aligned indices. This summer, the $312 billion California State Teachers’ Retirement System (CalSTRS) invested $3.9 billion in the MSCI ACWI Low Carbon Target index as part of its net-zero pledge to reduce portfolio emissions by 50 percent by 2030.
Melissa McDonald, head of the ESG and climate index business at MSCI, says investors are increasingly aware of the long-term risk of climate change not being priced efficiently. They also want to incentivise companies to reduce their emissions while shifting capital from laggards to leaders.
But, she says, there is policy and pricing scepticism among many that want to remain as diversified as possible, worried about higher risk from tracking error and input/portfolio turnover: “We’ve started to consider how our clients might look at parallel benchmarking to compare these risk and return factors alongside alignment with climate metrics.”
Investor concern is understandable in current market conditions when fossil fuel and utility company share prices are skyrocketing.
But it doesn’t help the net-zero transition.
MSCI’s own October Net Zero Tracker update summarises the danger, noting that listed companies will warm the planet by 2.9C by the end of the century at current levels. Only 16 percent percent align with global warming at or below 1.5C, while one-third align with keeping global warming below 2C. MSCI estimates that listed companies will use up their share of the global carbon budget for keeping temperature rise below 1.5C by the end of 2026.
Importantly, climate indexes are evolving to decarbonise the real economy and not “relative” portfolio levels.
S&P’s new 1.5C carbon budget benchmark takes the 300 gigatonnes of CO2 Intergovernmental Panel on Climate Change (IPCC) budget for 1.5C and reduces the overall portfolio volume of CO2 every year in line within the IPCC pathway, but without reducing sector constraints. It says tracking error versus a broad market index is currently relatively low – just 30 basis points, but widening over time – while turnover costs remain reasonable. The thinking and methodology are based on a clear, accessible paper by Patrick Bolton of Columbia Business School, Marcin Kacperczyk of Imperial College London and Frédéric Samama, head of strategic development at Sustainable1, S&P Global.
Samama says the index can become a “negotiated roadmap” with corporates, where investors see which constituents will likely remain in the benchmark in one, three, five or 10 years – especially if you add “forward-looking guidance” (akin to earnings guidance) by companies on CO2 output. “For the corporate CEO it’s very powerful because you create competition within each sector to accelerate as quickly as possible towards the net zero economy,” he says.
He argues that the regulatory context of 130 countries committed to carbon neutrality – representing 70 percent of emissions – will provide the top-down push, and notes that some targets are already legally binding in jurisdictions such as Canada, California, UK, the EU, South Korea and Japan.
‘Concrete and credible’
So, what about the tough investor engagement part?
Øystein Børsum, deputy governor at Norges Bank, oversees the $1.2 trillion portfolio of the Government Pension Fund Global, which holds average equity stakes of 1.5 percent in 9,000 companies worldwide. In almost half it is in the top 10 shareholders. Its recently published 2025 Climate Action Plan asks portfolio companies for science-based net-zero 2050 targets, with progress updates. Børsum says: “We want these plans to be concrete and credible, with consistent capital expenditure plans.”
Norges will engage with companies, focusing on the highest emitters. “It’s not a question of if the transition to a low-carbon economy is going to take place, it is how fast?” says Børsum. “We need better market standards, efficient carbon pricing in financial markets, and our portfolio companies to be prepared for a low-carbon economy.”
Børsum says Norges will likely formulate shareholder proposals for company AGMs and increasingly vote against reappointment of directors where the board has not managed climate risks sufficiently.
The only thing missing is the stick of divestment from companies if they fail to respond. Norges has no quantitative targets or timeframes for that sanction.
Such enforcement mechanisms will need to tighten, while the focus on regulators to toughen CO2 pricing pragmatically but clearly will need to be enhanced. Policymakers should require both companies and investors to demonstrate how they are actually reducing CO2 in line with the net-zero pathways and commitments we hear so much about.
Get those right and potent, return-generating, decarbonising index strategies can be big, supporting economic levers for transition.