June 2022
ICE Data Services
Investing towards net zero should be simple – for all the sound and fury, the goal is unambiguous, and the necessary timeframe widely agreed.
But despite acknowledgment that greenhouse gas emissions must be urgently cut to limit the impact of global warming, there is dispute about the right approach. At the core of the problem is measurement: the data of climate change is notoriously difficult.
Even companies with the best of intentions can struggle to get their heads around how best to measure carbon emissions, plan reduction pathways and assess climate risk.
Europe is a leader on ESG and its regulation in this area is being watched globally. The EU has adopted a regulatory framework designed to improve transparency and comparability, encourage investment flows to climate solutions, and to prevent greenwashing by index providers by introducing two new types of benchmarks – the Paris-Aligned Benchmark and the Climate Transition Benchmark and providing for sustainability-related disclosures for all benchmarks. These standards work as part of the EU’s investment goals aimed at meeting the area’s objective to be net carbon neutral by 2050.
The minimum standards for both the Paris-Aligned and Climate Transition benchmarks aim towards net zero in 2050, and both target an annualized 7% reduction trajectory. There are two key differences between the two types of benchmarks. The Paris-Aligned approach excludes fossil-fuel exposure, and requires a more aggressive 50% minimum carbon reduction relative to the market index, as compared to the 30% reduction required for the Climate Transition approach. .
The variations reflect the different ambitions of the two types of benchmarks.
In response to market demand for investment in benchmarks that take account of climate factors, ICE Data Indices has launched the Corporate Bond Climate Indices (“Climate Index Series” or “Climate Indices”), a new series that includes six alternative climate index variants for each of 23 standard corporate bond parent indices, offering 138 indices in total.
For bond fund managers, the Climate Indices allow them to benchmark themselves to indices that are on a decarbonisation trajectory aligned with the global warming target of the Paris Climate Agreement. In this way, the Climate Indices help investors pursue low carbon investment strategies and decarbonize their investment process, while aligning risk and performance against a fair benchmark.
The Climate Index Series, built on Sustainalytics data, has some important differences from other index providers.
For starters, ICE’s Climate Index Series take account of Scope 3 emissions data, up and down the entire corporate value chain, as well as direct Scope 1 emissions and indirect Scope 2 emissions.
For many industries – not least the fossil fuel corporations – Scope 3 emissions are the most important because they include the carbon emitted by the users of a company’s products. Measuring Scope 3 emissions is a difficult thing to do. As part of the requirements for Paris-Aligned and Climate Transition Benchmarks, the regulations specify a gradual move towards Scope 3 in the coming years. We have launched the Climate Index Series fully incorporating Scope 3 emissions data from the beginning.
The Climate Index Series also takes an inclusive approach to carbon reduction.
In meeting the carbon reduction targets the Climate Indices retain all qualifying securities, but assign weighting factors to issuers that are ranked on carbon metrics including absolute emissions and carbon intensity, relative to enterprise value and revenue.
Low carbon companies are initially weighted at up to twice their market capitalization while high emitters are weighted as low as half their market capitalization. If the reduction target is still not met, these weight factors are then incrementally adjusted within a range until the carbon target is reached.
And how about performance?
To be fair, it is a little early to say with confidence. Limited back test data means it is tricky to draw too many conclusions and the recent distortions in the fossil fuel markets add a lot of short-term noise.
The ultimate goal for investors is an index that delivers benchmark-aligned carbon reduction and yet delivers diversification, risk and performance broadly in line with its market-representative parent index.
For the Climate Indices based on the high-grade Euro Corporate and US Corporate indices as an example, the limited history on the Climate Indices suggests they are representative of their market segments and can even deliver positive incremental return. Based on the last 17 months ended May 31, 2022, in which the parent indices were down more than 10%, the average outperformance of the climate variants was between 0.20% and 0.30%. That was accomplished with an average monthly performance differential of 0.02%.
In these examples at least, the Climate Indices are delivering the upside of emissions reductions and there doesn’t appear to be a high cost-downside to get there relative to the market-weighted parent index. But the history is very limited, with the available observation period a tumultuous one. Using the Global High Yield index as a counter example, the Climate Index variants lagged the parent index an average of about 0.10% per month over the same 17-month period.
It’s still early days in the march to net zero. But progress is being made. The new Climate Indices are designed to help investors align with two of the most credible climate-related benchmarks - as they look beyond corporate promises of change, to the actions companies are taking to achieve their emission reduction goals.
Takeaways