- Sustainability commitments such as net-zero targets are increasingly driving dual objectives within investment strategies, creating an expectation for managers to balance financial and sustainability objectives.
- Climate benchmarks can play a key role in driving measurable outcomes, but investors must be aware that not all climate benchmarks are created equal and have different outcomes.
- All investors should recognise that the selection and design of a climate benchmark is an active decision regardless of passive or active implementation.
Climate benchmarks are receiving increasing investor attention due to net-zero commitments. We recently published our deep dive research on the practical implications of climate benchmarks, offering guidance on how asset managers should be tackling some of the investor challenges.
Benchmarks are used to assess performance and often reflect an investment universe. Because of this, they are tied to concepts of fiduciary duty. We recognise that many clients want to align their assets with a sustainability objective. The choice, design, and objective of a benchmark should therefore go hand-in-hand with their investment objectives.
While traditional market benchmarks produce very similar outcomes across index providers, climate benchmarks are not all created equal and can produce different outcomes from one another – despite having similar objectives. This raises issues around the potential for unintended consequences. It is, for example, common for climate benchmarks to overweight sectors like Technology and Real Estate. However, the outcomes for these sectors are not consistent across index providers. It’s important for managers to assess whether these outcomes are both intended and aligned to the sustainability and investment objectives of their clients.
Chart: Equity Paris-Aligned Benchmark (PAB) index provider sector weights vs parent benchmark sector weights.
Source: abrdn (2023)
We also find variations in outcomes when assessing regional benchmarks from the same index provider. These variations are driven by several factors, such as differences in data coverage, estimation methodologies, implementation of climate metrics, and their use of index optimisation or tilts.
Investors and their managers should have a process to address trade-offs when targeting dual objectives. To tackle this, investors should clearly define three objectives for a strategy relating to:
- Risk and Return
Managers should help investors to assess potential trade-offs. Investors, on the other hand, should also be clear on whether their investment objective is to deliver a risk-return profile similar to the parent benchmark or to capture the risk-return of a specific sustainability theme. This will help determine an investor’s appetite for active risk against the parent benchmark and to prioritise objectives.
Dual objectives: climate solutions are not always low carbon
It is common for investors to target investments that have both lower carbon intensity and a higher share of climate solutions. However, these objectives are not necessarily compatible. To produce low-carbon solutions and build low-carbon infrastructure emissions are unavoidable. As shown in the table below, the sectors with the highest green revenues (GR) can also be ones which are more emissions-intensive.
Top GICS Sectors by Green Revenues*
Source: FTSE Russell (2023), *data only includes companies with green revenues. S1&2 = Scope 1 and 2 emissions.
There are strengths and weaknesses in applying both carbon and climate solutions objectives. What is critical is that managers and investors assess whether the benchmark design aligns with the intended outcome.
Traditional market benchmarks do not perfectly reflect the real economy
Climate benchmarks are anchored to their parent benchmarks as a starting point. However, the starting composition of a traditional parent benchmark rarely reflects the real economy and will differ from region to region. For example, the FTSE 100 has an energy sector bias with a weighting of 12.81% but with a very high stock concentration and with only two companies making up the energy sector1. This is very different from the composition of the S&P 500 which is more technology biased. Applying the same climate targets to both markets will have varying implications for investment outcomes such as tracking error, and stock and sector concentrations.
Translating Paris-alignment to benchmarks
Another issue to consider is how the parent benchmark will evolve over time. Inevitably their sector and stock compositions will change. Moreover, European Union climate benchmarks define Paris-alignment trajectories as an annual decarbonisation of 7% but in practice, a Paris-aligned decarbonisation pathway can vary over time. Using the Intergovernmental Panel on Climate Change’s (IPCC)scenarios, decarbonisation rates to 2030 that limit warming to 1.5°C vary considerably, and all these scenarios will use vastly different assumptions for technology costs, policy, and other socio-economic drivers.
Chart: IPCC 2030 Decarbonisation Pathways in 1.5°C Scenarios
2019 – 2030 Decarbonisation % vs Median Warming in 2100
Source: IPCC AR6 C1 1.5°C no or limited overshoot scenarios (2022)
Investors need to consider which scenario is most probable, how that scenario relates to the parent benchmark, and how the chosen decarbonisation pathway will meet both their climate and investment objectives.
Solutions for investors and asset managers to consider
- Investors and asset managers should agree clear objectives
- Clearly define both financial and sustainability objectives for a strategy.
- Assess whether these objectives come with potential trade-offs and understand the magnitude of these.
- Test objectives and trade-offs objectively and ensure that benchmark construction meets the criteria outlined below:
- Control for multiple carbon metrics
- Take an active approach to assessing the availability, quality and materiality of sustainability data
- Control for unintended consequences, for multiple carbon metrics, and for sector, country, style, and stock concentrations
- Test the implications of various rebalancing strategies to balance transaction costs with the impact of large one-off turnovers
- Integrate active corporate engagement to support real-world decarbonisation
1Factsheets | FTSE Russell (March 2023)