By Yang Wang, director, research & analytics, Peter Gunthorp, head of equity index research, and David Harris, head of sustainable business
President-elect Joe Biden’s first statement since winning the election has been to reaffirm that the US will rejoin the Paris Agreement on climate change, reinforcing the accord’s importance in the fight against climate change. Inherent in the agreement is measurement and precision: the compact aims to substantially reduce global greenhouse gas emissions in an effort to limit the global temperature increase in this century to 2 degrees Celsius above preindustrial levels, while pursuing means to limit the increase to 1.5 degrees.
As climate considerations become a central consideration for investors, it follows that data providers have both an opportunity and a challenge in providing accurate benchmarks and related data to support Paris-Agreement aligned strategies and portfolios. But how is such an index constructed, and what have been the differences in performance versus "vanilla" equivalents?
The more ambitious of the EU’s two climate benchmarks has created a definition and label for investment products that seek to demonstrate alignment with the goals of the Paris Agreement.
But turning the EU’s list of criteria—covering carbon reductions, exclusions and sector exposure requirements, among other things—into an investible index is a complex undertaking, especially with the transparency investors require.
These criteria include:
- Emission reduction
- Exclusions (controversy and activity based)
- Exposure to highly exposed sectors
- Corporate target setting
An earlier iteration of the benchmark rules included increasing exposure to climate solution industries by using a measure like green revenues. That’s now gone, but we think that is also a crucially important objective.
The EU’s work represents an evolution of how investors—and index providers—approach climate index construction. It sets out to capture within the index design. The EU through a number of quite technical specifications has set the criteria: it has left it to the market to actually create benchmark indexes. So, at FTSE Russell, we set out to create a PAB version of the FTSE All-World Index. We based our approach on our Target Exposure Framework, which allows us to transparently tilt exposure towards and away from index constituents according to a number of exposure objectives. Here, we used emissions intensity and carbon reserves scores, as well as Green Revenue Scores. In addition, we used TPI (Transition Pathway Initiative) management quality and carbon performance scores to address the need to capture corporate target setting as forward looking climate indicators.
An opportunity for climate indexes is to link the index design with corporate engagement. This requires a transparent methodology where the weighing links with a clear framework for engagement with investee companies—a crucial element in achieving transition. By basing this on the TPI scores, which now also underpin Climate Action 100+ (the world’s largest ever collaborative investor engagement initiative, backed by over $40 trillion in assets), companies can understand the improvements they make in TPI will change their weight in index and all portfolios that track it. Investment flows become linked with engagement.
With the right design and a link to an effective corporate engagement process such as TPI, then Paris-Aligned Benchmarks could not only reduce portfolio climate risks: they could also achieve impact through driving change in the real economy towards net-zero.
FTSE All-World PAB Index successfully meets the carbon emission reduction requirement of the EU PAB, which means the index always less than half of the emission intensity of the benchmark and the index is reducing its own emission by 50% in a ten-year window. The index also doubles the amount of Green Revenue compared to the benchmark. As a result of incorporating TPI, the index allocates more weight to companies that align their business models with international climate goals. This not only reinforces investor-corporate engagement but also results in a reallocation of emission budget towards companies whose carbon footprint aligns to decarbonization trajectories required by Paris agreement.
FTSE All-World PAB Index demonstrated a consistent positive excess return compared to the benchmark FTSE All-World Index over the 10-year simulation period. It displays similar levels of volatility, but a smaller maximum drawdown. This analysis suggests delivering climate impact is not inconsistent with delivering market returns. Indeed, over the simulation period the detailed climate objectives of the EU Paris-aligned benchmark were met and there was modest outperformance. The use of TPI data also reinforces corporate engagement and real world impact.
Sign up to the blog.
© 2020 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, “FTSE Canada”), (4) MTSNext Limited (“MTSNext”), (5) Mergent, Inc. (“Mergent”), (6) FTSE Fixed Income LLC (“FTSE FI”), (7) The Yield Book Inc (“YB”) and (8) Beyond Ratings S.A.S. (“BR”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE Canada, MTSNext, Mergent, FTSE FI, YB and BR. “FTSE®”, “Russell®”, “FTSE Russell®”, “MTS®”, “FTSE4Good®”, “ICB®”, “Mergent®”, “The Yield Book®”, “Beyond Ratings®” and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, FTSE Canada, Mergent, FTSE FI, YB or BR. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.
All information is provided for information purposes only. All information and data contained in this publication is obtained by the LSE Group, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data is provided "as is" without warranty of any kind. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the accuracy, timeliness, completeness, merchantability of any information or of results to be obtained from the use of FTSE Russell products, including but not limited to indexes, data and analytics, or the fitness or suitability of the FTSE Russell products for any particular purpose to which they might be put. Any representation of historical data accessible through FTSE Russell products is provided for information purposes only and is not a reliable indicator of future performance.
No responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for (a) any loss or damage in whole or in part caused by, resulting from, or relating to any error (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this document or links to this document or (b) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of the LSE Group is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing contained in this document or accessible through FTSE Russell Indexes, including statistical data and industry reports, should be taken as constituting financial or investment advice or a financial promotion.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.
This publication may contain forward-looking assessments. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking assessments are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially. No member of the LSE Group nor their licensors assume any duty to and do not undertake to update forward-looking assessments.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group data requires a licence from FTSE, Russell, FTSE Canada, MTSNext, Mergent, FTSE FI, YB and/or their respective licensors.