The EU’s official criteria for climate-focused indices were launched in 2020, after a fractious development period which saw EU bodies being accused of conflicts of interest and sidelining market best practice.
Less than a year later and the first-of-their-kind Climate Benchmarks have emerged as an unlikely success story within the EU’s Action Plan on Sustainable Finance – at least in terms of market acceptance.
In 2021 alone, the Climate Benchmarks criteria has been adopted by the likes of Swedish pension fund AP2, French pension fund Ircantec, asset manager Handelsbanken Fonder, the workplace pension scheme for Dutch company UWV, four German public pension funds and the UK’s Brunel Pension Partnership. Altogether, tens of billions of Euros have been shifted into investments that meet the EU’s climate objectives via instruments based on the Climate Benchmarks.
And its impact has gone beyond passive investing: Banque de France recently adopted fossil fuel exclusions based on the Climate Benchmarks criteria, despite not investing in the benchmarks themselves.
At the heart of the Climate Benchmarks methodology is a requirement to decarbonise significantly compared with parent indices, and then by 7% year-on-year. Investors can choose between the more ambitious Paris-aligned Benchmarks (PABs), which targets a 50% carbon intensity reduction versus the parent universe; or Climate Transition Benchmarks (CTBs), which targets a 30% reduction.
Both categories are described as being aligned with the Paris Agreement’s 1.5°C target, and take into account Scope 1, 2 and 3 emissions.
Aled Jones, who heads FTSE Russell’s sustainable investment business in Europe, believes that a first mover advantage is key to the Climate Benchmarks’s appeal.
“What the PAB criteria does is give investors a degree of clarity on investing in line with the Paris Agreement in a world where there is limited standardisation and a broad range of opinions on the topic. Of course, part of its appeal is that the EU is a credible authority, but the criteria itself is also straightforward enough to be easily understood by the market, and that’s another big advantage.”
There has been some pushback, though. A recent report by Norway’s trillion-dollar oil wealth fund caused a stir when it concluded that climate-tilted indices were not “investable” for large investors due to increased transaction costs and volatility arising from deviations against the parent index. In addition, the fund suggested that such products would be “far less diversified” and that investors would lose out on transition opportunities because of climate constraints.
Not so, says FTSE’s Jones – at least on diversification. According to him, the Climate Benchmarks criteria is broad enough to allow for diversified products which can “function as core or default equity allocations”.
“This is because high carbon emissions are concentrated in a small number of companies and sectors – say around 10% of global benchmarks – which allows us to make some pretty significant adjustments while still minimising any tracking error with the parent index,” he explains.
This appears to be the same for the bulk of PABs and CTBs currently available, which are almost all marketed as closely mirroring the risk and return characteristics of their parent indices. German provider Solactive, for example, caps the weight deviation for stocks in Solactive PABs at 0.5% compared to parent indices, and at 5% for sectors.
In addition, stress tests carried out by S&P Dow Jones Indices (S&PDJI) on their Eurozone PAB revealed that at least 150 stocks were on track to reduce carbon intensity by 80% compared to its benchmark, suggesting that PABs can remain diversified even as they decarbonise.
Providers contacted by RI also challenged the notion that PABs and CTBs were unable to capture transition opportunities for investors.
Jaspreet Duhra, Head of ESG Indices for EMEA at S&P DJI says: “We’ve included elements into our S&P Paris-Aligned and Climate Transition Indices to capture companies which are in transition, not just those which are already ahead. For example, within the utilities sector we take into account when companies provide more green energy relative to ‘brown’, and more broadly we look at a company’s ESG policies, which are good indicators of their ability to successfully transition.”
Jones says that, in some cases, FTSE’s Climate Benchmarks can even overweight high-carbon sectors, because of transition-focused metrics like green revenue.
However, there is credence to concerns over skyrocketing transaction costs – particularly for large passive investors like Norway’s oil fund that can have broad exposure to nearly every listed company in the world. For such investors, the costs associated with switching from a broad market benchmark to a PAB or CTB, and rebalancing their investments annually to meet the EU’s requirements, could be significant.
But Claes Ekman, a Portfolio Manager at AP2 – which developed proprietorial PABs for its equities and bonds portfolios – believes that keeping the focus on organic self-decarbonisation, instead of rebalancing, will help investors manage costs.
“There is a misconception that investing in Climate Benchmarks will become a yearly exercise in shuffling around weights to meet the decarbonisation requirement and will result in high turnover over time. It's important to remind ourselves that the objective is to get companies to lower emissions on a consistent basis, which if done correctly, means that the weightings do not actually need to change very much,” he says.
Since its launch, a number of providers have launched indices eligible under the EU’s definition of Climate Benchmarks. German provider Solactive currently leads the market with a suite of around 20 PABs and CTBs, which cover a range of markets – and is one of only two providers with fixed-income indices, the other being MSCI.
“Our fixed-income Climate Benchmark indices are based on the same criteria as equity indices, but we also incorporate criteria like maturity, rating, and sector buckets to ensure they retain the important risk characteristics of the parent index,” says Solactive’s Strategic Initiatives head Florian Müller.
Investors seeking Climate Benchmark versions of broad-market benchmarks such as the MSCI ACWI, S&P 500, STOXX Europe 600 and Russell 1000 are also well served with each provider having launched PAB index families over the past year, while CTBs are less common.
It should be noted that none of the ready-made PAB or CTB indices currently available are designed with factor strategies in mind, although most providers have reported a slight tilt toward large caps and sectors such as healthcare and tech – both of which have traditionally performed well on ESG-related performance metrics. In addition, the reduced exposure to energy-related stocks has in general resulted in lower dividend yields, and a slight tilt away from Value.
But the Climate Benchmarks criteria also lends itself well to customisation, says Claes Ekman from AP2. Over the past few years, Ekman helped design the customised PABs for the Swedish buffer fund, which incorporate multi-factor strategies and classical risk premia – a yield-focused approach to passive investing.
“I think you can take any investing style and adapt it to PABs or CTBs without any problems,” he says.
In fact, customisation could also help to reduce investor transaction costs, according to Solactive’s Müller.
“We take the view that there will always be a need for customisation because investors have different starting points. If you're a pension fund, you may have historical allocations to fossil fuels and other carbon-intensive activities, so you could choose to stay within the PAB criteria but also build in additional criteria to reduce some of these costs.”