ESG

Low-Carbon Indices 101

Low-carbon indices are becoming a fixture on the investment landscape, as the intensifying drive to address climate change compels investors to address risks entailed for financial assets. There is, however, no uniform way of providing such indices or understanding their benefits. The following outlines what low-carbon indices are, how they diverge and what their place in the bigger picture might be.   

Low-carbon indices have emerged over the past few years to help cope with the challenges of climate change and supplement the transition to a low-carbon global economy. More specifically, they exist to help track the impact of carbon emissions – both current and potential future emissions embedded in fossil fuel reserves – and the associated risk on financial assets.

For example, constraints on carbon emissions via technological innovation or government regulation in the future could cause current assets to lose value, presenting an apparent risk to investors. Carbon indices primarily take three forms: broad-market-optimised, best-in-class, and fossil-free. They employ different methodologies and cater to separate concerns and types of investors altogether.

Index Categories

As their name suggests, broad-market-optimised indices are designed to track broader market indices. They overweight investments with lower-carbon footprint offering potential outperformance if, for instance, policy measures develop which reward lower-carbon activities. MSCI Low Carbon Target and FTSE UK Carbon Optimised are typical examples of such programs.

These indices are likely to appeal to investors without an exclusion or divestment policy in place, as the construction methodology is consistent with how an investor would apply a Responsible Investment approach more generally across its investments. Typically, such investors are seeking reductions in their exposure to carbon emissions and carbon reserves.

Best-in-Class indices, such as those provided by MSCI Low Carbon Leaders and S&P500 Carbon Efficient Index, exclude worst performers in terms of carbon emissions/reserves from each sector and then re-weight across the sector. Investors using these consider carbon efficiency across all industries, rather than solely focusing on those with the highest carbon emissions. This strategy has the effect of explicitly signalling to stakeholders that the worst carbon emitters are not present in the portfolio.

Considering the relatively low cost of both broad-market and best-in-class indices, their clarity in delineating steps taken towards carbon reduction and their relatively simple implementation, these can provide the first measures for investors to reduce the carbon intensity of their portfolios. As the tracking error of these indices is usually small relative to the broader market index, they provide a viable alternative to passive investors who do not want to venture too far from their current allocation.

Fossil-free indices, in contrast, are expected to show significant deviation from broad market indices. MSCI ex Fossil Fuel and MSCI ex-Coal, or FTSE ex Fossil Fuel and FTSE ex-Coal belong to this category. As their name suggests, they are exclusionary by definition and focused on sector- or factor-based selection. They are therefore appropriate for asset owners already committed to divesting from fossil fuels. They may also be suitable as a benchmark for active management. Fossil-free indices have performed well in the current environment of falling oil prices, for example, but could underperform should the trend reverse.

Methodologies and limitations

As just some of the tools available for tackling climate change risk, low-carbon indices most often do not by themselves offer exposure to investment opportunities aligned with the shift to a greener economy. Such indices are primarily focused on risk management, and thereby do not capture the “opportunity” side of the equation – such as exposure to companies leading on technological innovation and the development or provision of products and services best positioned to succeed in a lower-carbon environment.

For example, a recent white paper by global consultancy Mercer, warns investors to beware of factor-based indices using “simplistic or naïve metrics.” These can be dangerous, Mercer suggests (referring to index providers such as FTSE Russell, MSCI and S&P), due to static designs that could “lead to an inability to address concentrations of risk, valuation bubbles or crowding.” Meanwhile, the same white paper finds that factor investing strategies, smart-beta, and particularly “active multi-factor” approaches can offer superior risk management and portfolio evolution over time.

Index construction methodologies and outcomes of specialist indices vary, sometimes quite substantially. For example, the term “fossil-free” does not have a consistent definition across asset owners, index providers or investment managers. Other categories of indices for their part remain subject to concerns about data availability and transparency, due to the relative inconsistency of carbon emissions reporting. In addition, different construction approaches may lead to varying degrees of tracking error.

Methodologies understandably develop over time to account for previous oversights or new knowledge, while periods of extreme market stress or dislocation can cause the performance of carbon indices to deviate considerably from mainstream benchmark indices.  In determining the correct approach for them, investors should ask: what risks does a low-carbon index protect against, can there be unexpected consequences from the construction methodology, and could the investor be taking undesired biases as a result?

One part of the equation

The use of low-carbon indices is not a substitute, either, for actively managed equities with a high level of ESG integration. These often do not have exposure to high-carbon sectors in the first place as a result of their portfolio construction process and are also able to capitalise on investment opportunities explicitly addressing climate change and low carbon. Such strategies stand in contrast to the type of risk management integrated into low-carbon indices.

Some companies provide a low-carbon index as part of a broader overall sustainability strategy. UK multinational financial services company Legal & General, with £1 trillion in assets under management, of which half is equity, employs a multi-dimensional holistic approach to ensure its low-carbon strategy is on par with the company’s sustainability standards. The firm has set up a low-carbon index to capture green transition, employing a methodology different from what it has observed in the market.

“We propose a factor-based index, not a market-cap based one,” L&G Head of Sustainability Meryam Omi told NordSIP. “A lot of the climate-themed funds only address the risk side of the carbon and end up excluding companies that are producing solutions, like renewables. We tilt away due to emission, but tilt back in due to green opportunities, [where the] whole point is to capture the transition.” Climate problems can’t be solved merely by looking at data, Omi explains, so the company employs an active approach to key industries, divesting from those who fall behind in green transitioning, which also enables it to keep a very small tracking differential which makes a negligible difference to its performance against the index. Finally, it uses active voting in some of the biggest companies in the world across key sectors to oppose the election of managers who do not take ESG sufficiently seriously.

Low-carbon indices are an evolving part of addressing the risk management of carbon emissions that not only haven’t been standardised in any broadly agreed sense (and possibly cannot be), but also are just one utensil in the investor’s toolbox for the integration of sustainability with maximising returns. Indeed, the various ways in which investors themselves conceive of employing low-carbon indices will play a central part in their continuing evolution and their contribution to the effort to meet the carbon-reduction objectives set out by the UN Sustainable Development Goals and the Paris Climate Agreement.

 

Picture © Sanit-Fuangnakhon – Shutterstock

Kames Capital
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  1. Pingback: Green Indices Sprout Again | NordSip

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