The EU developed rules for climate benchmarks in 2019. After a surge in uptake, investor sentiment is already cooling 

Key points

  • There has been widespread adoption of the EU’s climate benchmarks
  • Cracks are now starting to show, especially since the surge in oil prices 
  • There have been calls for new, more credible alternatives
  • One is to select companies on the basis of their climate transition plans or alignment with standards

The European Union’s climate benchmark labels got through political negotiations unscathed in 2019 – at least compared with the rest of the bloc’s sustainable finance regulation. 

From politicians shoehorning fossil fuels into the green taxonomy, to the recent watering down of corporate reporting rules, there have been major compromises across the EU’s package of ESG proposals – except for benchmarks.  

Some insiders say the regulation survived intact because most corporate lobbyists – and nearly all members of the European Council and Parliament – did not understand what was being negotiated.  

But, whether illiteracy in index construction contributed to the outcome or not, the final agreement was hailed as one of the European Commission’s biggest wins. 

The labels are ambitious. A Paris Aligned Benchmark (PAB) must start by halving the carbon footprint of its parent index, and then reduce it by a further 7% every year. Companies are excluded if they generate more than 1% of turnover from coal, 10% from oil, or 50% from gas. 

The Climate Transition Benchmark (CTB) label is less strict, but still requires an initial 30% carbon intensity haircut, followed by the same 7% annual reduction. No activities need to be excluded on climate grounds.   

Sentiment is changing 

Initially, investors piled into PABs and CTBs.    

Swedish pension fund AP2 has built PABs for SEK165bn (€14bn) of its fixed-income and global equities portfolios (see case study). In the UK, five pension funds run by Brunel Pension Partnership have shifted more than £3bn (€3.5bn) into PABs developed by FTSE. Last year, New Zealand Super allocated $15bn to PABs from MSCI. And earlier this year, four German states moved €11bn of assets from fossil-free indices to PABs created by Stoxx.

Lee Clements, head of applied sustainable investment research at FTSE Russell

“The PABs came along and raised the expectations. But now they’re being put to the test, and they’re struggling”

Lee Clements

Christine Chardonnens, head of climate indices at MSCI, says that benchmarks based on the CTB methodology have proved the most popular so far, as they are “less restrictive” than PABs. FTSE Russell, on the other hand, says most of its clients have plumped for PABs over CTBs. 

Building on their success, the European Commission is starting to sketch out similar rules for what it describes as “a new EU ESG benchmark label that would become a key lever to align investments with long-term sustainability considerations”. But before that new methodology has even been drafted, cracks are beginning to show in the PAB and CTB labels. 

“A lot of the initial interest in the EU labels is waning, or at least changing direction,” explains Lee Clements, head of applied sustainable investment research at FTSE Russell. He says there is still demand for the labels, but there is also growing “negative sentiment” towards them as they are implemented. 

In November 2022, the Net Zero Asset Owner Alliance put out a statement about the “shortcomings” of the rules, and called for new thinking around developing practical, credible benchmarks. 

“The EU labels kickstarted a wave of innovation when the industry was a bit stuck in that old-fashioned approach to low-carbon benchmarks,” says Clements, referring to the incumbent trend for strategies that promised huge portfolio-level carbon reductions while retaining sector neutrality and negligible tracking error. This made them incredibly popular with investors, but raised major questions about their ability to contribute to any meaningful change in the real world. 

“The PABs came along and raised the expectations,” Clements continues. “But now they’re being put to the test, and they’re struggling.”

The problems  

When they were being back-tested, many of the EU-labelled benchmarks outperformed the market, largely because they excluded much of the energy sector – a particularly beneficial move during the 2020 oil slump. 

But last year’s boom in energy prices had the reverse effect, compounded by the fact much of the capital taken away from fossil fuels was reallocated to big technology companies at a time when the sector has been performing badly.   

Performance is not the only challenge. The methodology for the EU benchmarks is complex; it does not use revenue as the basis for calculating emissions intensity, opting instead for more esoteric metrics (enterprise value including cash adjusted for inflation). This has been done to improve the stability of the calculations and link them to firms’ equity and debt funding, reducing room for gameable carbon intensity calculations, but it also makes it tricky for index providers and users to explain how constituents are ultimately selected.

And then there is the rate of turnover. Given how few companies are on track to reduce their emissions by 7% a year, it is unlikely that investors can simply hold the right firms to achieve the EU’s annual decarbonisation targets. Instead, they have to engineer the reductions by buying and selling stocks until they meet the thresholds. This can become a costly process in an asset class that prides itself on being cheap.  

Minimum standards of EU Climate Transition and EU Paris-Aligned Benchmarks | Source: EU Technical Expert Group on Sustainable Finance

Looking for alternatives

“We’ve reached a point where another wave of innovation is needed, and that’s not easy within this very prescriptive legislation,” says Clements. “So it’s beginning to happen outside of the benchmark labels.”

When the PAB and CTB labels were launched, they were praised for their focus on ratcheting up decarbonisation over time, as opposed to requiring one-off carbon footprint reductions. But there is talk about whether the emphasis on future progress should be measured differently. 

During a panel discussion on climate benchmarks at the University of Oxford in July, experts suggested that, instead of using a complex emissions trajectory, companies could be selected for net-zero benchmarks based on their climate transition plans or alignment with widely used standards like those developed by the Science Based Targets initiative. 

FTSE already has a suite of indices based on Transition Pathway Initiative analysis of how companies are managing the climate transition. The University of Cambridge is using information about how companies contribute to the phase-down of fossil fuels in a methodology it is developing for fixed income. S&P DJI has created an index family that assesses whether companies are using the appropriate amount of their annual carbon budget, based on figures from the Intergovernmental Panel on Climate Change. 

“Overall, we’re seeing growing client interest for more nuanced approaches to climate, taking into account forward-looking data that is increasingly available, and a greater awareness of the need to finance the transition,” says MSCI’s Chardonnens. 

Among the asset owners to snub the EU labels is €57bn Finnish pension insurance provider Ilmarinen

Having agreed to reach net zero by 2035, its board of directors called for a suitable benchmark that could serve as a reference for both active allocations and a passive index. 

“We needed something diversified, but the EU methodology creates a big risk [and] we won’t get that by forcing us to exclude so much of the energy sector,” explains Juha Venäläinen, a senior portfolio manager for cross asset allocation at Ilmarinen. He adds that stripping out so much of the energy sector also undermines the argument that investors should steer fossil fuel companies towards climate transition rather than ditching them.  

Climate index

Instead, Ilmarinen worked with MSCI to develop a best-in-class index, similar to the ESG one it was already using. Instead of using ESG scores to identify the best-performing companies in each sector, the new version uses MSCI’s climate ratings.

“We were looking for something that was transparent and easy to explain,” says Venäläinen. “So that when our team goes to meet with company management, they can explain why they aren’t in an index and their peers are and, most importantly, how they can improve their behaviour to make it in.”

In June, Ilmarinen moved a further €580m into a new ETF constructed by Amundi that tracks the benchmark, bringing the total amount it has allocated to the MSCI Climate Action indices to €5.4bn. 

Venäläinen says Ilmarinen is making two big bets with its climate index: “That this index will give us the climate performance we need to meet our carbon neutrality commitments, and that it will give us the financial outperformance that comes from being invested in companies on the right side of the transition.” 

It is a slow process, he concedes, predicting that it will take another five years to know whether those bets are paying off. 

“The caveat here is that the PABs have a glide path that is guaranteed to get them to net zero. We don’t know how our benchmarks will go.”

AP2 takes sustainable benchmarks to next level

Andra AP-fonden, better known as AP2, is one of the boldest and best-known users of climate benchmarks in the world.  

The Swedish pension fund was the first asset owner to adopt an EU Paris-Aligned Benchmark (PAB), committing to use the label two weeks before the rules fully entered into force in December 2020. 

Since then, it has rolled the model out across its SEK80bn (€6.7bn) developed markets and SEK49bn (€4.1bn) emerging markets global equities portfolios, in addition to SEK36bn (€3bn) of corporate bond investments. Its quantitative active strategies are run on top of the indices, with portfolio managers expected to ensure compliance with the methodology.  

The PABs were developed in-house to help the buffer fund meet its commitment to become net zero by 2045. They replace multi-factor benchmarks that AP2’s quant team constructed in 2018. 

When it comes to upfront decarbonisation, they were even more ambitious than the EU’s rules require. While the regulation calls for an initial reduction in carbon intensity of 50%, AP2 says it achieved 70% for global equities and 75% for corporate bonds when it launched.

AP2 key data

  • Total assets: SEK 407.1bn (€36.5bn) 
  • Equity portfolio: 40.5% of total assets (9% domestic, 21% developed markets, 10.5% emerging markets)   
  • 2022 return: -6.6% 
  • Location: Göteborg 

That reduction was largely possible because the benchmarks excluded around 250 high-emission companies in the energy sector.    

Peter Mannerbjörk, a quantitative portfolio manager for fixed income at the fund, acknowledges that this under-exposure to oil and gas has hurt performance during the recent boom in energy prices. But he says it is still early days when it comes to assessing both the financial and climate performance of the benchmarks.  

“As of today, we cannot see that PABs are limiting us in terms of exposure towards risk premiums or sustainability dimensions, nor towards regions, countries or industry groups,” Mannerbjörk says. However, he points out that AP2’s choice to use a multi-factor approach skews the fund away from North America and big tech – which has nothing to do with the PAB methodology.  

Peter Mannerbjörk, quantitative portfolio manager for fixed income, AP2

PABs, like any other net-zero initiative, will fail if the companies do not decarbonise” 

Peter Mannerbjörk

Because the private sector is not decarbonising at scale, AP2 is achieving much of the 7% annual carbon reductions required under the EU rules by reweighting constituents, rather than retaining companies on steady net-zero pathways.  

Claes Ekman, another quantitative portfolio manager involved in constructing the indices, says the fund hasn’t experienced any significant costs as a result of this increase in turnover. This is because the methodology includes a model to optimise trading costs, points out Ekman. 

“However, if companies don’t begin to decarbonise their activities in the long run, we can expect higher trading costs,” he notes, adding that this kind of reweighting might also “lead to unwanted and sub-optimal exposures towards regions, sectors and other risk factors”. 

He says: “Sooner or later, under such a scenario, there’s a risk we’ll be in a situation where we have a conflict between the targets in PAB and other portfolio characteristics valued by AP2.”  

Mannerbjörk agrees, saying the annual decarbonisation target isn’t “fully within the control of the benchmark constructor”.  

“If all companies have and maintained exactly the same intensity in the future, we couldn’t do anything to decrease our intensity in line with the rules,” he says.  

“We don’t need the whole world aligned with Paris, but we do need some. PABs, like any other net-zero initiative, will fail if the companies do not decarbonise. We’ll have to wait and see how it plays out.” 

In the meantime, the big project for AP2 is including more Scope 3 emissions into the benchmarks, to stay compliant with the regulation. 

When the EC launched the methodology for the PABs, it knew it was too early in the development of Scope 3 emissions data to include it as a requirement. Instead, the rules stated that benchmarks initially only needed to calculate the Scope 3 emissions of energy and mining companies. By the end of 2022, that needed to be expanded to include transportation, construction, buildings, materials and other industrial sectors.  

By next year, all companies will fall under the Scope 3 requirements. Ekman describes this as “the greatest challenge for PABs”.  

“The current lack of standards and differences in estimation methods can have a huge impact on the emissions datapoint for a given company in a given fiscal year,” he explains. 

“This is not least the case when comparing Scope 3 emissions from different data vendors.” 

The pair said there were no plans to expand AP2’s PABs further, or to make any significant changes to the methodology beyond what is required by the existing regulation.