The German state of North-Rhine Westphalia (NRW) has opted to use a global “fossil free” ESG index – which excludes companies active in the extraction of fossil fuels – in the state’s Pensionsfonds’ global equity portfolios, a spokesperson for the state has told IPE.

The index – STOXX ESG Countries World ex Eurozone – tracks companies in Australia, Canada, Japan, Switzerland, the US and the UK.

It excludes companies whose activities, such as the extraction of fossil fuels, account for at least 5% of turnover, with the exception of natural gas.

NRW currently uses the standard version of the STOXX ESG index, without the exclusion of fossil fuels, for euro-zone countries. STOXX, a subsidiary of Deutsche Börse, designed the index for the Pensionsfonds of the four federal states: Baden-Württemberg, Brandenburg, Hessen and North-Rhine Westphalia.

The states were looking for a sustainable index solution with reduced CO2 emissions, according to Deutsche Börse.

The construction of the index, selection and weighting of the individual stocks, is based on a combination of exclusion criteria, best-in-class approach and the rules guiding investments for the Pensionsfonds in NRW.

Exclusion criteria apply to companies dealing or producing weapons, or weapons systems, prohibited by the Rome Statute of the International Criminal Court.

It also excludes companies generating 5% of their turnover through the production of nuclear energy or specific components of nuclear power plants, unless companies’ share of turnover in the renewable energies sector exceeds the share from the production of atomic energy or specific components of nuclear power plants, coupled with a corporate strategy to increase the use of renewable energy sources.

The production of specific components of nuclear power plants also includes the enrichment of uranium, but not the production of power plant components, which are not specially designed for nuclear power plants and that are not central components to generate electricity by nuclear power, STOXX said.

The index also excludes companies generating at least 5% of the turnover by producing products and services with pornographic content “portraying individuals or the sexual act in a degrading way” and firms that severely violate the principles of responsible corporate governance part of the UN Global Compact.

Only companies classified as leaders in environmental, social and corporate governance (ESG) in their industries and respective region are considered for the index under the best-in-class approach.

The 60 most liquid stocks are ultimately selected as a result of best in class and exclusion criteria.

A case study for bespoke ESG index

STOXX used a methodology to control implicit risks, such as industry, regional or company-specific risks to design the index, according to Deutsche Börse. The methodology also determines the exclusion criteria.

The index had to address sustainability and climate risks, while achieving an attractive risk-return profile, he added. It applied filters relating to business activities and products, for example controversial weapons, thermal coal, controversial weapons or companies that produce nuclear energy or essential components for the production of such energy.

The data on CO2 data originated from STOXX’s partner CDP, a charity that runs the global disclosure system to help investors manage their environmental impact.

Data is important to develop an ESG index for institutional investors, “that’s why we work with data providers including Sustainalytics, Institutional Shareholder Services ESG (ISS ESG), CDP, ENTIS, and Clarity AI,” the spokesperson said.

The data is used typically to exclude certain companies and weight based on ESG or climate criteria. The essential elements of the index designed for the four German states are the selection only of companies with a good ESG score and the exclusion of controversial activities.

“We are able to manage liquidity constrains,” the spokesperson said, “while controlling exposures (industry/country) and keeping the risk/return profile of the index attractive”.

STOXX or DAX indices, whether ESG, climate or broad benchmark, rely on a transparent set of rules.

“This way, all market participants always know where they stand. They then have a choice: pure exclusions, inclusions, a mix of both, a selection of ESG and climate leaders, or even solutions tailored to individual needs, as we developed two years ago with the four German states,” the spokesperson said.

By using an ESG index, investors can manage their reputation and cover legal requirements, which are likely to get stricter in the future, the spokesperson said.

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