A passive solution that addresses climate change: MSCI Climate Paris-Aligned indexes

    Willem Keogh, Head Passive & ETF Investment Analytics, UBS AM
    Philippe Kybourg, Passive & ETF Investment Analytics, UBS AM

    Investment Objective

    The MSCI Climate Paris Aligned indexes aim to support investors in reducing their transition and physical climate risks, benefit from opportunities arising from the transition to a lower-carbon economy while aligning with the EU Paris-Aligned Benchmarks (PABs) minimum standards. To meet
    the minimum requirements, PABs must achieve a 50% reduction in carbon intensity (Scope 1+2+3 GHG emissions), while following a 7% year-on-year self- decarbonization trajectory.

    The index methodology (Figure 9) excludes companies involved in controversial weapons, having faced very severe ESG controversies, or linked to controversies pertaining to severe environmental issues as per the “do no harm principles”. Activity based exclusions are aimed at companies deriving revenue from tobacco, thermal coal mining, oil & gas related activities as well as certain kinds of power generation which accounts for more than 50% of revenues.

    To avoid divestment from high climate impact sectors, the weight of these sectors needs to be equal in an EU PAB as compared to the parent index. These exclusions and constraints complete the set of minimum criteria as set out in the legislation.

    An optimization-based approach

    The MSCI Climate Paris Aligned indexes follow an optimization-based approach (Figure 5) that not only meets, but exceeds the minimum standards for EU PAB. The approach aims to achieve the following objectives:

    • Align with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).
    • Align with a 1.5°C climate scenario using the MSCI Climate Value-at-Risk and a “self-decarbonization” rate of 10% year-on-year (as opposed to the minimum requirement of 7%).
    • Reduce the Index’s exposure to physical risk arising from extreme weather events by at least 50%.
    • Shift index weight from “brown” to “green” revenue using the MSCI Low Carbon transition score and by excluding categories of fossil-fuel-linked companies.
    • Increase the weight of companies which are exposed to climate transition opportunities and reduce the weight of companies which are exposed to climate transition risks.
    • Reduce the weight of companies assessed as high carbon emitters using Scope 1, 2 and 3 GHG emissions.
    • Increase the weight of companies with credible carbon reduction targets through the weighting scheme.
    • Achieve a modest tracking error compared to the Parent Index and low turnover.

    Alignment to TCFD Recommendations

    As outlined earlier, the MSCI Climate Paris Aligned indexes are aligned with the recommendations from the Task Force on Climate-related Financial Disclosures (TCFD). We spoke about the TCFD’s key goals to better disclose the financial impacts of climate-related risks and opportunities. If we focus on these in more detail, we can see in Figure 11 that the TCFD breaks down the risks into two sub-groups: transition risks and physical risks. We will see in the following sections how the index methodology addressed these two risk categories by leveraging the MSCI ESG Research’s Low Carbon Transition Score as well as their Climate Value-at-Risk. Focusing on opportunities, we will also outline how these two data sets allow the indexes to overweight companies likely to benefit from the transition to a lower-carbon economy.

    Transition Risk

    MSCI ESG Research’s Low Carbon Transition Risk assessment (Figure 12) is designed to identify potential leaders and laggards by holistically measuring companies’ current risk exposure to, and its efforts to manage the risks and opportunities related to the low carbon transition. The output of this assessment are two company-level factors:

    1. Low Carbon Transition Category: groups companies in five categories highlighting predominant risks and opportunities of transitioning.
    2. Low Carbon Transition Score: an industry agnostic score based on multi-dimensional risks and opportunities assessment considering predominant and secondary risks of transitioning.

    Using the output of this assessment, companies facing climate transition risks can be identified, and subsequently underweighted in the MSCI Climate Paris Aligned indexes, while firms with potential to benefit through the growth of low-carbon products and services are overweighted. If we link this with the TCDF recommendations, we can see how such a product can support in managing climate-related risk and opportunities. To support the use of this data in the index construction, MSCI has examined the performance impact of issuer’s climate transition risk profiles1. Interestingly, their findings show that the Low Carbon Transition Score provided a positive return when used in a GEMLT performance attribution (i.e., after controlling for the risk factors of the model), especially in the last 2 years. This suggests that climate-transition risk should be considered as an additional risk factor by investors as it already exhibits performance implications on their investments.

    Furthermore, the Low Carbon Transition score provides a quantitative and transparent assessment of how effectively firms have managed their climate-transition-related risk exposures2. Using this score, investors can identify portfolio companies that have lagged in their climate risk management and prioritize them for engagement through company-level structured talks or voting arrangements.

    MSCI Climate Paris Aligned Indexes also promote engagement indirectly by tilting from climate laggards toward climate leaders. Firms that are excluded or underweighted in the climate indexes may find it costlier to raise capital and take corrective actions to improve their climate profile. Such actions include investing more in green technology, making more informative climate disclosures and reducing their exposure to climate risk.

    By way of a practical example, let us consider Figure 13. In the example of the MSCI EMU and MSCI EMU Climate Paris Aligned indexes, this regional exposure does not contain any companies classified under “Asset Stranding”. On the other end of the spectrum, there are some companies classified under “Solutions”, for example Verbund AG and Siemens Gamesa Renewable Energy SA. When we focus on the differences in terms of weight between the two indexes, we can clearly see that “Solution” are overweighted (6.88% to 19.58%), while the “Transition” part is underweighted both from a “Product” as well as “Operational” perspective.

    Physical Risk

    The Climate VaR model developed by MSCI aims to measure the potential impact of different climate scenarios on individual securities’ valuations. Climate VaR indicates, in percentage points, what could be the potential impact on the market value of a security because of the effects of climate change.

    The MSCI Climate Value-At-Risk measurement helps investors to assess future costs related to climate change and understand what those future costs could mean in the current valuation of securities. The premise of Climate Value-At-Risk is to aggregate costs related to specific climate risks over the next 15 years and calculate what these costs might signify about financial performance into the foreseeable future. Using the Extreme Weather Climate Value-at-Risk in its optimization, the MSCI Climate Paris Aligned indexes target a reduction of at least 50% in the exposure to physical risk arising from extreme weather events. In addition, the methodology also leverages Policy Risk and Technology Opportunities Climate Value-at-Risk to align the portfolios to a 1.5°C climate scenario.

    Looking at Figure 15, we can see how the MSCI EMU Climate Paris Aligned index reduces its economical exposure to Physical Climate scenarios as compared to the parent MSCI EMU index. In addition, the MSCI Climate Value-At-Risk also quantifies how current and forthcoming climate policies could financially impact companies within the portfolio, but also how these corporations could profit from their low carbon innovative capacities. The index captures these aspects in its methodology, as the Climate Paris Aligned index reduces its policy risks while increasing its exposure to technology opportunities arising from the transition to a low carbon economy. We again clearly see how the methodology aligns with the TCFD recommendations in this instance by addressing physical and transition risks while also considering opportunities’ financial impact.

    Looking at the Aggregated Climate Value-at-Risk to summarize how significant these improvements are, we can see that the MSCI EMU index could lose up to 22.15% of its value in the next 15 years due to climate change, whereas the Climate Paris Aligned index would even slightly benefit from it, with an upside of +0.39%. It is interesting to note how the policy risks account for most of the downside risks. It will be costly for companies included in the MSCI EMU index to meet reduction targets embedded in policies that have been proposed in the Nationally Determined Contributions (NDCs) of the Paris Agreement. On the other hand, since the MSCI EMU Climate Paris Aligned index diverts its weights towards companies better positioned for the transition, the policy risks are extensively reduced for that portfolio and are more than compensated by the financial opportunities the transition will bring to the companies forming the index.

    The challenge of 1.5°C alignment

    As we have alluded to earlier, the transition to net zero emissions will require substantial efforts from investors, as their investment portfolios will need to achieve drastic reductions in carbon emissions. As a first step, it is important to assess the actual carbon intensity of a given portfolio. To achieve this, investors must not only consider Scope 1 and 2 emissions, but they also need to incorporate Scope 3 emissions in their analysis. If we investigate the weighted average carbon intensity by sector in the MSCI ACWI index, we can see in Figure 16 that most of the emissions are related to Scope 3 emissions. While sectors like Utilities and Materials display a higher proportion of Scope 1+2 emissions relative to other sectors, the emissions in other sectors are mostly driven by Scope 3 emissions. It is therefore natural that the European Commission in the minimum requirements for Paris-Aligned benchmarks requires that Scope 3 emissions be phased-in in the coming years. The MSCI Climate Paris Aligned indexes go beyond these minimum requirements, as they already include Scope 3 emissions since June 2020.

    The current carbon intensity of a portfolio is only part of the challenge. Next, we also need to understand the carbon emissions reduction targets planned by issuers and assess whether these targets are credible. As we noted earlier, companies globally are still vastly misaligned with 1.5°C scenarios. There again, MSCI Climate Paris Aligned indexes can support investors in overweighting companies setting credible emissions reductions targets by at least 20% compared to their corresponding parent indexes. However, the key to aligning the MSCI Climate Paris Aligned indexes to a 1.5°C scenario remains the 10% self-decarbonization per annum which goes beyond the 7% decarbonization rate prescribed by the EU PAB minimum requirements. Applying a 7% decarbonization on the investable universe would only be sufficient to limit global warming to below 2°C; only by performing a more stringent reduction of 10% can we aim to achieve the 1.5°C global warming potential.

    Green Opportunities

    There is a strong focus on green versus brown revenues with the aim to have a four times higher ratio in MSCI Climate Paris Aligned Indexes as compared to the parent index. This is achieved by reducing and excluding exposure to fossil-fuel-linked activities, while increasing exposure to sustainable activities related to green revenues as shown in Figure 17. It is interesting to note that the percentage of green revenues have increased, while the percentage of brown revenues have decreased. This led to a green versus brown revenue ratio of 40.89 times, which is a substantial improvement above the aim of four times.

    Do we meet the PAB Minimum Standards?

    As displayed in Figure 18, using the MSCI EMU Climate Paris Aligned index as an example, we can see how the index meets the PAB minimum standards, for example the minimum 50% reduction in carbon intensity as compared to the parent index. Moreover, the index also meets objectives that are not included in the regulation but that help the portfolio to reduce its exposure to climate change risks.
    More specifically, the index can reduce its exposure to extreme weather events by reducing its Climate Value-At-Risk by at least 50% compared to the parent exposure, while the green to brown revenues ratio is also well above the aim of a four times improvement.

    In addition to these objectives, the MSCI Climate Paris Aligned indexes have also achieved their first annual self-decarbonization of a minimum of 10%. In Figure 19, we can see that all exposures have achieved this objective which started in June 2020 with the inclusion of Scope 3 emissions in the index methodology. Interestingly, for broader exposures like ACWI, EM or USA, the indexes have even achieved a higher self-decarbonization.

    Performance Analysis

    From a performance perspective we can see in Figure 20 that the MSCI EMU Climate Paris Aligned Index has a better performance compared to the parent benchmark. This outperformance is particularly noticeable in 2019 and 2020. The drivers of the outperformance in 2020 have been both a smaller maximum drawdown at the peak of the COVID-19 outbreak, as well as a stronger recovery in the second half of 2020. One further observes how this excess return is achieved with lower volatility, which results in an overall improvement in the risk-return profile of the benchmark. This finding is confirmed when looking at metrics such as the Sharpe and Sortino ratios. When looking at the tracking error versus the parent benchmark, it can be termed as a “good” one, because as shown in Figure 21 the higher tracking error translated to higher performance versus the parent benchmark.

    Performance Attribution

    To understand what is driving the recent excess returns of the MSCI EMU Climate Paris Aligned index over the parent MSCI EMU index, we ran a performance attribution using the GEMLT factor model from MSCI Barra (Figure 22). Over the last 24 months, we can see that the GEMLT factors (-3.28%) and the country active exposures (-0.46%) caused a performance drag, while the active sector weights (-0.65%) also negatively impacted returns. Interestingly, the specific returns which is the portion that cannot be explained by the model, was the largest positive contributor to performance with +468bps. This result might suggest that overweighting companies that are well positioned to benefit from transition opportunities while underweighting stocks with physical and transition risks was performance accretive for the Climate Paris Aligned benchmark.

    One way of dissecting returns a step further is to look at individual stocks and their respective contribution to the 4.68% of specific returns based on their weight allocation. As shown on Figure 23, we can see that 219bps out of 468bps are linked to stocks that are underweighted or excluded, whereas 249bps can be attributed to companies being overweight compared to their weight in the parent index. This result is in line with our expectations: increased exposure to companies providing green revenues and well placed to benefit from the climate transition are improving returns, while being less exposed to stocks having climate or transition risks was also beneficial in terms of performance.


    As a passive solution to address climate change, the European Union has created a legal framework which defines the minimum requirements for climate benchmarks. The strictest benchmark defined under this framework, the EU Paris Aligned Benchmark, can serve as an instrument for investors at the forefront of the transition, favoring today the players of tomorrow’s low carbon economy. The MSCI Climate Paris-Aligned indexes not only meet, but exceed the minimum requirements for EU Paris-Aligned Benchmarks. Their methodology integrates a 50% carbon footprint reduction, together with a 10% year-on-year self-decarbonization glidepath, with the aim to achieve a 1.5°C pathway by 2030 and support investors in meeting their net zero commitments. In addition, these indexes are fully aligned with the recommendations from the TCFD, assessing and subsequently reducing transition and physical climate risks, while increasing exposure to potential opportunities arising from the transition.

    For more information, please contact

    Florian Cisana
    Head UBS ETF & Index Fund Sales Nordics
    UBS Asset Management
    E: [email protected]

    1. Giese, G., Z. Nagy, and B. Rauis. 2021. “Foundations of Climate Investing: How Equity Markets have Priced Climate-Transition Risks.” The Journal of Portfolio Management, 47 (9).
    2. MSCI. FAQ-Understanding MSCI Climate Indexes. November 2021.

    Image courtesy of Alto Crew on Unsplash

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