What to think about Climate Benchmarks?

In a world grappling with climate change, climate benchmarks have emerged as easy solutions for passive investors looking to align their equity portfolios with a sustainable future.

In a world grappling with climate change, climate benchmarks have emerged as easy solutions for passive investors looking to align their equity portfolios with a sustainable future. They integrate objectives related to greenhouse gas (GHG) emission reductions and the transit to a low-carbon economy through the selection and weighting of portfolio holdings. The two most prominent versions are the EU Climate Transition Benchmark (CTB) and EU Paris-Aligned Benchmark (PAB). Both have similar criteria focussed on decarbonisation, and the PAB is aligned to the Paris Agreement goal of limiting global average temperatures to well below 2°C above pre-industrial levels. The aim of the CTB is to protect assets against investment risks related to climate change and the transition to a low-carbon economy, while a PAB is intended to be at the forefront of the immediate transition towards a 1.5 °C scenario.

Sounds amazing you say, not so fast. Contrary to what the names indicate, they’re not really benchmarks in the traditional meaning of the word, rather a set of rules. And those rules give a lot of leeway as seen by the different implementations by MSCI, Scientific Beta, S&P, and other data providers. With more rules comes a larger active share. The iShares MSCI World Paris-Aligned Climate UCITS ETF has an active share of >25%. It is not your typical passive investment, even if the ETF structure might nudge you away from noticing that fact.

Problematically, the idea of self-decarbonisation of a portfolio is not the same as decarbonising the real-world economy, as it pushes capital to be re-allocated to lower-carbon companies, rather than decarbonising or solution-oriented companies. Consider a simplified ideal world where all companies are decarbonising at a rate of 7%. Intuitively, any portfolio should be fine. However, suppose I’d like to replace an investment in some tech company with a renewable utility that is more carbon intensive. Suddenly, my portfolio has a self-decarbonisation rate that’s worse than 7%, even though my investment is more relevant for a low-carbon future. Because of this, looking at decarbonisation rates at a portfolio level with changing holdings does not make any sense. Even less so to enforce a portfolio decarbonisation rate or comparing carbon intensities with a broad-market index. In the simplified example, any portfolio is acceptable because regardless of the holdings and the trading, the portfolio is aligned with the Paris agreement.

When investing, one should not only focus on companies with low emissions, but on companies that must decarbonise and that have credible transition plans, with intermediary targets in place. Or companies that provide solutions to successfully decarbonise a part of the economy. Does a PAB or CTB from an index provider accurately capture the preferences you have as an investor? Are those rules transparent enough and does the final portfolio properly reflect the input or are the holdings untraceable? Or is this the time that actively managed funds get a second look?

Climate benchmarks are mere rules yet aspire to be tools for change. Their effectiveness depends on our ability to understand their nuances, customize them to fit diverse preferences and use them as catalysts for meaningful climate action. Doing so requires active decision making, not passively following some rules. Only so can we steer or planet towards a brighter, more sustainable future.

 
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