Paris-aligned benchmarks ‘push investors into low-revenue portfolios’

Osmosis Investment Management has warned that Paris-aligned benchmarks are pushing investors into building portfolios of low revenue-generating companies.

An article by Tom Steffen, the firm’s head of quant research, claims that flaws in the way estimated Scope 3 emissions are calculated will lead PABs to invest increasingly in low-revenue companies.

As the state of Scope 3 emissions disclosure is generally poor, index providers are resorting to estimation models. Given the proportion of firm emissions made up of Scope 3 emissions, Steffen said the result is “indices that effectively assign higher importance to estimated data over reported data”.

Furthermore, Osmosis research has shown that estimations are generally derived from firm revenues multiplied by an industry emissions factor.

“If a firm’s intensity is computed as Scope 1 + 2 + 3 emissions [divided by] EVIC, then effectively Scope 1 and 2 emissions matter little given their small magnitude compared to Scope 3 emissions,” Steffen said. “The intensity is thus largely dependent on estimated Scope 3 emissions, which can be simplified to constant emissions factor * (revenue/EVIC).”

“Given that PABs actively seek to reduce emission intensities calculated as described above, the index construction rules will minimise revenue [divided by] EVIC thereby pushing investors into portfolios with low revenue generating companies.”

Steffen says this is not only self-defeating from an investment perspective but also “inconsequential from an environmental perspective”.

His criticisms of the PAB model go beyond Scope 3 data. The regulation mandates an immediate 50 percent emissions reduction against the benchmark and a 7 percent yearly decarbonisation, but this is not the only way to achieve a Paris-aligned portfolio. Steffen warns that prescribing the emissions trajectory removes the flexibility of the industry to innovate on achieving Paris alignment, whereas the focus could also be placed on cumulative emissions.

Aligning a portfolio to Paris also implies a real economy transition which is currently not happening. The Osmosis piece cites one index provider as saying that 90 percent of the world’s public companies have an implied temperature rise of above 1.5C, making index alignment “exceedingly difficult”.

In order to achieve alignment, benchmarks are forced to be actively underweight in high-impact sectors – such as energy, materials and utilities – and overweight industrials, IT and financials. This, Steffen said, “means there is a clear decoupling between the real economy and Paris-aligned Benchmarks”.

Finally, the “rigid focus” on year-on-year decarbonisation means that the prescribed carbon footprint determines portfolio composition, with active risk “indiscriminately accepted as collateral damage”. A portfolio aiming for both environmental and financial impact would target best-in-class companies in each sector, and would reflect the most sustainable state of the current real economy.

Provider concerns

Osmosis is not the only market participant to raise concerns about PABs. One senior figure at an index provider that is looking at bringing out its own PABs and climate transition benchmarks said they were struggling with identifying a standardised methodology.

“It starts getting really complex,” they said. “To really understand the indices at that level you almost need to have a science degree.”

In order to produce and market the indices, they said, the provider has to be happy that both it and the end customer fully understand how the index works. However, while some established ESG managers have the necessary experience and expertise, there is “an education gap” in the broader market.