Climate Indices: how we can prepare for the future

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For financial professionals only

As COP28 approaches, we’re looking at how climate change indices have developed over the last few years. In Europe alone, investment in climate index funds and ETFs hit $121 bn by the end of 2021 – more than double the previous year’s figure[1].

As climate-friendly investing has evolved, so have the indices and funds that follow them. They’re growing in ambition and sophistication to the point of explicitly investing in line with the goals of the 2015 Paris Agreement, set at COP21.

3 categories of Climate Equity Indices

Capital flows into passive investments, especially those with a climate-based mandate, have seen a huge growth in recent years. Of course, these considerations form part of broad ESG and SRI funds, but the more dedicated climate-change indices generally fall into three categories: low carbon, green revenue/climate solutions and Paris Agreement alignment.

1. Low carbon goals

Some of the most straightforward climate indices have a low carbon mandate, setting carbon targets and creating a portfolio with lower (relative or absolute) levels of emissions than the parent index.

These indices can significantly lower the total emissions of a portfolio and avoid the risk of the assets becoming unusable because of changing regulations or demand by heavily weighting against more polluting sections like energy or utilities. However, they tend to look backwards more than forwards and don't attempt to actively invest in climate solutions. 

2. Green revenue/climate solutions 

These indices use quantitative criteria to select companies making a positive difference within the 'green economy' in terms of products, services or developing technologies for climate change adaptation (flood prevention technology) or mitigation (wind or solar power).

These indices can be attractive as investors can see the positive difference their investments make, but they don't have decarbonisation targets and can lack the diversification to prevent concentrating risk in certain sectors (e.g. clean energy).

3. Paris Agreement alignment

These indices align with the goals of the 2015 Paris Agreement - to keep global average temperature rises well below 2°C (preferably 1.5°C) compared to pre-industrial levels. Here, the first two elements are usually combined while supporting companies transitioning into alignment. 

What steps have already been taken?

Given the broad scope of the three categories, the EU’s Technical Expert Group (TEG) created the Climate Transition Benchmark (CTB) and the stricter Paris Aligned Benchmark (PAB) standards for Index providers to follow. These benchmarks try to standardise requirements and avoid different interpretations, while closely linking with the Paris Agreement objectives. To use these labels, indices and funds must include:

  • Minimum carbon intensity reductions of 30%-50% compared to the parent index
  • 7% year-on-year decarbonisation

The further regulations are shown in the table below.

What does this all mean?

These benchmarks need broad sector exposures, in line with the wider market – giving more diversification and, when tilted towards companies setting strict emissions-based targets, encouraging investment in the transition.

Another consideration is the partial cushion the benchmarks could give against future policy, legal and potential reputational risks as Paris alignment is embedded deeper into the wider economy and into public policy.

There’s still issues though. Discussions are continuing around whether decarbonisation levels are too strict for transitioning companies/sectors, and how best to account for any gaps in reported data. Add to that the differences in methodologies between funds and index providers, and there’s a lot of questions still unanswered. UK and EU regulators are focused on transparency and the consistency of broader ESG themed labelling as they attempt to reduce greenwashing. It's hoped the upcoming UK Sustainability Disclosure Requirements (SDR), alongside the new EU requirements, will address this issue and we'll continue to see improvements in this area. 

Our ESG Passive Solution

All the screened investments in our ESG Passive solution consider both ethical and environmental concerns during the selection process, and around half of the equity explicitly follows a Paris Aligned Benchmark (PAB) index, committing to the carbon reduction requirements.

We would like to expand our PAB coverage further and increase transition alignment. And as always, we’ll have our eye on the market as more passive products are released.

Our ESG Passive solution offers a low-cost way to meet broad ethical goals while factoring in  climate considerations. As the accessibility and sophistication of these products continues to grow, the gap between active and passive investing will narrow.

[1] https://assets.contentstack.io/v3/assets/blt4eb669caa7dc65b2/blt2317a85c41ab1992/6255cf57fea57c4dece51c53/Investing_in_Times_of_Climate_Change_2022_Final.pdf

This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity.

Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.  

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