Rethinking net-zero equities benchmarks

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.

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.  

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.”