By Jaakko Kooroshy, head of innovation and standards, sustainable investment
As efforts to reduce greenhouse gas emissions gather pace, the industrial foundations of society are facing a transformation. From the light bulb to the car, from everyday materials like plastics to cement, even our diets will have to adapt in profound ways to make the low carbon economy a reality and to avoid the worst impacts of global climate change.
Institutional investors have taken note. Today, few sizable asset owners or managers don’t proclaim to take climate risks into account in some manner through their investment strategies—whether it means trying to avoid exposure to those that have most to lose in a low carbon future, aiming to back tomorrow’s winners, or even using their influence with companies to accelerate the low carbon transition, it's a subject that once was considered out of the scope of fiduciary duties but is now often a routine part of the investment process.
This includes active investing, but passive investing has been no exception to this trend. Investors can now choose from a growing variety of "low carbon" or "climate" indexes, which typically replicate conventional indexes but try to adjust these "parent indexes" in various ways to align them with climate goals.
There is, however, no clear consensus on what appropriately constitutes such alignment, and methods have evolved rapidly as data and our understanding of climate risks has improved – and are likely to continue to do so into the future.
Early versions of "low carbon" indexes typically excluded fossil fuel companies, or adjusted index weights based on “carbon footprints.” Later versions added carbon reserves as an additional factor into index designs to avoid risks from "stranded assets" or "unburnable carbon."
This early generation of low carbon indexes had some important drawbacks. While easy to communicate, fossil fuels will continue to play a significant role in the medium term even under the most ambitious low-carbon trajectories. Excluding all fossil fuel companies can also introduce sector biases in the resulting index – something that may be undesirable for many institutional investors.
More fundamentally, a focus on narrowly defined "carbon risk" doesn’t necessarily help to effectively position investors’ portfolios for the unfolding low carbon transition. Investors have often been motivated to use carbon footprints based on the expectation of an eventual escalation in carbon pricing – i.e. the idea that as the threat of climate change becomes ever more apparent, governments will eventually put a meaningful price on carbon as the most efficient means to incentivize economy-wide reductions in emissions.
However, the dynamics of the low-carbon transition have turned out very differently so far. Meaningful global carbon pricing remains an elusive a goal as ever for activists and international climate change negotiations. Meanwhile, a suite of disruptive low carbon technologies like solar and electric vehicles and a thicket of sector-by-sector, country-by-country regulations on emissions have created the real prospect of decarbonizing some of the most carbon intensive sectors faster than anyone would have thought. It now looks entirely possible that the last coal-fired power station will be built and the last combustion engine will roll off the assembly line long before meaningful carbon pricing is a global reality.
In such a scenario, adjusting index weights based on carbon intensity may only partially adjust exposure to investment risks related to the low carbon transition. The latest climate indexes, such as the FTSE Global Climate Index Series, therefore integrate additional metrics such as green revenues into the index design, capturing green industries from advanced batteries to efficient lighting. Rather than narrowly focusing on risks tied to carbon emissions, this data helps investors to increase their exposure to those companies that enable, drive and benefit from the low carbon transition.
The evolution of climate indexes is unlikely to stop here. Future versions may, for example, put a greater emphasis on adaptation risks or capture obsolescence risks and growth opportunities across value chains in much more sophisticated ways. As data become ever richer and more granular and the low carbon transition continues to unfold in unexpected ways, a one-size-fits all, standardized climate index is less likely to emerge.
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