How well do two specific indices work for investors looking to integrate ESG guidelines into their portfolios?
Investment benchmarks that incorporate specific objectives related to greenhouse gas (GHG) emission reductions and the transition to a low-carbon economy are receiving more attention from investors and regulators alike.
How well, though, do two specific indices serve as benchmarks for investors who seek to integrate environmental, social and governance (ESG) guidelines into their portfolios? One, the MSCI World ESG Leaders Index, is a ‘best-in-class’ grouping that offers exposure to companies with the highest ESG in their respective sectors. The other, the MSCI World Climate Paris Aligned Index, is an EU-designated Paris-aligned climate benchmark that is most heavily tilted to the ‘E’ in ESG.
As Robert Berkhout, senior LDI specialist at NN Investment Partners (NN IP), explains, the designated EU climate benchmark, the MSCI World Climate Paris Aligned Index, meets the specific requirements of the EU benchmarks regulations for aspects such as decarbonisation and exclusion of activities carrying climate risk.
In contrast, the MSCI World ESG Leaders index selects – per industry sector – the top 50% market cap of companies in terms of ESG performance, based on its proprietary ESG models. This set-up provides a benchmark that is broadly diversified and still aligns with parent index, the MSCI World.
According to Berkhout, both indices are very closely aligned with the MSCI World in terms of risk and return while, in terms of universe, the number of companies are about the same. “The MSCI World Climate Paris Aligned Index applies a more dynamic benchmark methodology,” he continues. “As a result, annual rebalancing costs may be a few basis points higher. The EU climate benchmark is underweight in emission-heavy sectors while the ESG Leaders index is sector neutral.”
Nevertheless, Berkhout advises investors to monitor the future development of MSCI’s EU-designated climate index. “It maintains an annual decarbonisation target of 10%, which is higher than the 7% stipulated by the Paris agreement,” he explains. “Constituent companies that do not keep up with the index’s more ambitious target could be removed, resulting in a loss of diversification, as more weight is attributed to the smaller number of companies that do keep up.”
NN IP’s research indicates that, for the ESG risk score into each of the three components, the MSCI World Climate Paris Aligned Index better addresses environmental factors; while social and governance risks were lower for the MSCI World ESG Leaders Index. The MSCI World Climate Paris Aligned index also has the lowest average ‘controversy score’, reflecting the business practices of the index constituents.
For institutional investors with decarbonisation targets, an EU climate benchmark such as the MSCI Climate Paris Aligned Index could prove a practical solution. “It relieves investors of some of the burdens of creating their own Paris-aligned ESG guidelines and the extra monitoring of portfolio managers required,” Berkhout points out. “Because EU climate benchmarks are still new, the number of investment fund solutions are limited, but a discretionary investment mandate makes such a benchmark easy to implement.”
David Czupryna, head of ESG Development at Candriam, agrees there are some benefits offered by the indices but argues both fall short in important areas. “The ‘best in class’ index filters companies out but is still very diversified – and a good, generalised index,” he continues. “But it uses MSCI research, which is limited.
“The Climate index is more interesting as it is aligned to the Paris Agreement but the challenge lies in the data. There is not sufficiently high-quality data across industries and countries. Only one quarter of companies have a credible plan to tackle CO2 emissions; and many do not report on greenhouse impact at all.”
Czupryna acknowledges the ethos of the index as a yardstick in the passive investment world but reasons, that if investors use a particular passive index as a guide, they should be aware if it is imprecise or prone to misfire.
What, though, if the number of companies reporting on greenhouse gases and environmental impact increases – and the quality and quantity of data improves? Would that not boost the strength of ESG benchmarks? “You would certainly gain a more realistic view of a company’s impact on climate change,” says Czupryna. “As more companies disclose, however, so the data becomes more complex.”
To illustrate the point, he highlights the introduction of three ‘Scope’ categories identifying different kinds of carbon emissions a company creates in its own operations and wider value chain. ‘Scope 1’ covers direct emissions from the activities of an organisation; ‘Scope 2’ indirect emissions from electricity purchased and used by the organisation; and ‘Scope 3’ indirect emissions from sources the company does not own or control. The last of these usually comprises the greatest share of the carbon footprint.
Taking oil giant BP as an example, Czupryna goes on to explain where confusion could arise. For a company like BP, he says, most of the emissions come when the oil it produces is burned. As such, another company might buy and use the oil or gas from BP (categorised under Scope 1) while BP has also disclosed these emissions under Scope 3. “The real danger in a portfolio here is of double counting,” Czupryna warns.
“Yes, the indices do have practical uses but there are other ways to invest with an ESG focus – for instance, by taking a temperature alignment approach, or running a thematic portfolio where you invest only in companies that operate in a way that benefit the planet.”