Writing exclusively for International Investment, Julie Moret and Dina Ting argue that, despite the evolving opportunities to transition to a more sustainable future, drastic steps still need to be taken to formally address climate change.
In 2015, a collective commitment by the world's governments to combat climate change led to the United Nations' Paris Agreement to pursue preventing global temperature rise. The Paris Agreement provides an ambitious roadmap; if commitments, policies and action can deliver a 7% greenhouse gas (GHG) emissions reduction every year between 2020 and 2030, global warming can be limited to 1.5C, preventing the most catastrophic effects of climate change.
To reach these energy and climate goals by 2030, around €180bn in additional yearly funding will be needed. Policymakers, financial institutions, businesses and investors share a collective responsibility in driving these efforts.
To reach these energy and climate goals by 2030, around €180bn in additional yearly funding will be needed. Policymakers, financial institutions, businesses and investors share a collective responsibility in driving these efforts."
The EU's action plan
Through the EU Action Plan for Sustainable Finance, the European Commission (EC) has sought to hardwire sustainability considerations into the financial system and is seeking to channel public and private capital towards investments to meet the decarbonisation targets. As part of the Action Plan, the EC established the Technical Expert Group (TEG) on sustainable finance in 2018 to advise on the objectives and steps needed.
As detailed below, one of the steps was to develop sustainability benchmarks to promote Paris-aligned investments. The TEG set out minimum standards on two types of climate benchmarks that aim to provide clear rules that ensure the indexes are comparable and transparent: the EU Climate Transition Benchmark (EU CTB) and the EU Paris-Aligned Benchmark (EU PAB).
Specifically, the EU climate benchmarks seek to:
- Increase transparency on investors' impact, specifically with climate change and energy transition.
- Allow comparability between climate benchmarks while leaving benchmark administrators with flexibility in their methodologies.
- Reduce the risk of greenwashing through common standards, objectives and quantitative metrics.
A new class of benchmarks
Before the development of these new benchmarks, low-carbon index construction has focused on two principle approaches. One is "exclusions"-driven, namely identifying and removing those companies using fossil fuels, and the other is "carbon-tilted," with index weights adjusted positively toward companies demonstrating reduced emissions. The new climate benchmarks leverage the rapidly growing pool of available data and analytics, assessing how aligned each underlying company is to a 1.5 or 2C global warming scenario. Not only do they aim to hedge against climate transition risks (backward looking), but also to capture opportunities (forward looking). Research includes independently assessed science-based targets, CO2 emissions, and forward-looking product, strategy, emissions and policy plans.
As seen in Exhibit 2 below, while both climate benchmarks meet the minimum standards set out by the TEG, the PAB is the more stringent of the two. Compared to EU CTB, the EU PAB:
- Calls for a higher level of decarbonization versus the underlying investable universe.
- Has additional exclusions based on activities that lead to high GHG emissions.
Companies which are currently excluded from the index due to a high reliance on fossil fuels, should they transition their energy mix, could in the future be eligible to join the index.
With the PAB being more stringent than the CTB, several leading index providers have built indexes based off these standards, serving as a benchmarking tool for those looking to be at the forefront of climate transition investing. As an early entrant into the Paris-aligned space, Franklin Templeton has launched two UCITS exchange traded funds (ETFs) that are fully compliant with the PAB. The S&P 500 Paris-Aligned Climate Index and the STOXX Europe 600 Paris-Aligned Benchmark Index were selected as the underlying benchmarks.
What this means for investors
Our new Paris-aligned UCITS ETFs exemplify how the new EU climate benchmarks have spearheaded the development of flexible portfolio allocation tools that help investors transform their portfolio into an instrument for addressing climate change.
We believe that as investors seek to decarbonise portfolios and actively measure and manage climate risk in line with their investment liabilities, that they will seek proactive climate solutions. With the diversified structure of these funds, investors can move away from the notion that these are niche products and instead use them in a variety of ways.
Flows into sustainable ETFs more than doubled in 2019 and global ESG ETF assets are $88bn worldwide. We believe this momentum is likely to continue through a combination of changing investor preferences and regulation. European and Asian regulators increasingly seek demonstrable evidence of ESG integration and management of climate risk, while investor demand for sustainable investments looks set to continue its strong growth trajectory, across many investor types, from millennials and private wealth, through to insurance schemes.
Julie Moret is global head of ESG, and Dina Ting is head of global index portfolio management at Franklin Templeton