Investors looking to apply the proposed EU climate benchmark in their strategies received good news from S&P Dow Jones Indices on Wednesday when it revealed a slight outperformance of its index concept over one year.
In a mock portfolio, the S&P Eurozone Paris-Aligned Climate Index Concept (Pac Concept) performed 22.4%, while the S&P Eurozone Largemidcap returned 21.5%, as of 1 January.
S&P commented that the concept outlines “how climate-related objectives can be met, due to the use of optimisation, while maintaining similar performance to the underlying index, with low tracking error”.
“This results in a broad, diversified index that should perform similarly to the underlying index.
“Factor analysis shows there to be unexplained alpha that may be driven by the climate strategy of the Pac Concept,” S&P added.
Over the period studied, starting from 30 December 2016 to 01 January 2020, the strategy had a 1% tracking error.
In order to limit global warming to 1.5°C, the EU Technical Expert Group (Teg) released a final report in 2019, in which it proposes two climate benchmarks.
S&P Dow Jones Indices has defined a benchmark concept according to the EU’s proposed requirements, which are still to be finalised.
Public companies account for around 47% of global carbon emissions, S&P said, which makes low-carbon indices an opportunity to increase investments in low-carbon companies.
“This new breed of sustainable climate indices will not only offer solutions that intend to be impactful, but equally aim to provide investors with reduced risks from transitioning to a low-carbon economy and the consequences of physical, environmental events while capturing financial opportunities that arise,” S&P commented.
S&P climate index
The Pac Concept applies to the eurozone region and goes beyond the requirements of the EU’s proposed Paris-aligned Benchmark by incorporating additional climate-related factors.
As set out by the Task Force on Climate-related Disclosures (TCFD), the concept addresses transition risk, physical risk and opportunities linked to climate change.
Despite reducing the transition risks of climate change, the Pac Concept shows a similar risk/return profile in the back-test as the underlying benchmark.
It reduces these transition risks by:
- Overweighting companies that are more aligned with a 1.5°C scenario based on using transition pathway methodologies, as endorsed by the Science Based Targets initiative, to encourage the index to organically decarbonise;
- Reducing the index carbon footprint by 7% year-on-year, to avoid overshooting;
- Overweighting companies with strong environmental policies;
- Reducing exposure to companies with fossil fuel reserves, which may pose stranded asset risk;
- Overweighting companies that have set science-based targets and meet specific criteria to avoid greenwashing; and
- Incorporating Scope 3 carbon emissions data, both upstream and downstream, to show a more complete view of a company’s carbon footprint on the world.
The Pac Concept also incorporates physical risk mitigation by reducing weighted average physical risks of climate change.
Climate opportunities are accessed via overweighting companies that have greater exposure to green sectors, such as renewable energy.
The Pac Concept uses ESG criteria to exclude companies, such as those:
- producing controversial weapons;
- showing a low UN Global Compact score;
- involved in controversies; and
- certain fossil fuel companies if they generate revenues from coal, oil and natural gas above determined thresholds.
At the November 2019 rebalance, 185 of 254 constituents of the S&P Eurozone Largemidcap were included in the Pac Concept and 23 companies were excluded due to exclusion criteria.
Going beyond EU regulation
The main areas where the index methodology goes beyond EU regulation are:
- Including physical risk mitigation to align with the TCFD model of financially material climate risks and opportunities;
- Using transition pathway methodologies, as endorsed by the Science Based Targets initiative, to weight constituents according to their level of alignment to a 1.5°C scenario;
- Ensuring stranded asset risk is minimised by reducing the fossil fuel reserve footprint of the Pac Concept;
- Minimising active share as the objective function allows the index to meet its objectives in the most efficient manner; and
- Incorporating Scope 3 data from inception.
The index concept uses forward-looking Trucost datasets to meet multiple climate objectives, aligned with a 1.5°C scenario and the TCFD recommendations.
It also incorporates the Science Based Targets initiatives-endorsed climate transition approaches and Trucost physical risk data.
A spokesperson at S&P said: “While we anticipate the EU to lean heavily on the Teg’s proposals in its final report, we will monitor and look to incorporate any changes or adjustments that could potentially impact the concept index and its performance.”