New climate indices will help direct investments to tackle climate change
While many parties have started to offer low-carbon benchmarks to shape passive investment products, it can be hard to compare the different methodologies employed.
Varying types of reporting can hamper an investor’s ability to choose adequate benchmarks for respective strategies. The lack of clarity around the impact of an investment on global warming could also affect the reliability and ultimately the adoption of low carbon indices.
As the market signals increased demand for low-carbon, fossil-free, and clean-energy investment products, the introduction of new EU climate benchmarks this month is well timed.
According to analysis from Bloomberg Intelligence, a large amount of capital, especially given the COVID-19 crisis, has found its way towards ‘greener’ and more sustainable investment vehicles. ESG and value-based ETFs had net inflows of $29 billion in 2019, tripling 2018 values. Passive low-carbon strategies attracted significant asset growth from 2018 with over $1 billion invested in U.S. based ETFs, and continued to rise in 2019 with flows of nearly $3 billion globally.
However, it remains difficult for investors to ensure that what they are financing is truly climate-aligned. Current index offerings tend to apply to three broad categories:
- Market optimization: catering for those looking at lower carbon investment strategies
- Best in class: typically focusing on carbon efficiency and energy transition
- Fossil-free: based on excluding key characteristics from an investment strategy
The European Commission’s Technical Expert Group for sustainable finance has recognized the need for more strategies. According to Andreas Hoepner, Professor of Operational Risk, Banking & Finance at University College Dublin: “Benchmarks currently offered in the market do not necessarily align with the financing needs implied by the limitation of global warming to well below +2°C.” Until now, there has been no formal framework to guide investors on temperature scenarios. Investors are therefore cautious of “greenwashing,” in which the qualifying characteristics for inclusion in these indices may be poorly measured or based on heavily estimated data.
The two new EU benchmarks that were introduced in April 2020 should help clarify this issue. These include a Climate Transition and a Paris-Aligned methodology, to follow a decarbonizing investment strategy. For a benchmark to qualify, it needs to comply with the minimum technical requirements set out by the European Commission’s delegated acts.
The constituents of each index will need to be assessed in terms of a reduction in their carbon footprint. Expectations for a benchmark’s year on year decarbonization will be stringent: at least 7% on average per annum. This trajectory follows the Intergovernmental Panel on Climate Change (IPCC)’s 1.5°C scenario, for alignment with the Paris Agreement. Failure to meet this trajectory over a two-year period will result in the withdrawal of the EU label.
Both indices also set ambitious targets for emissions reduction relative to investment universe or parent index, with the Paris Aligned Benchmark expected to achieve a 50% reduction. These measures keep the methodology true to the IPCC’s overarching ambition and encourages organizations to reduce their carbon footprints, ensuring that those who do not will have a harder time accessing capital.
The clear guidance and framework for benchmark providers will offer greater assurances for investors. The greatest impact is expected to fall on passive managers keen to meet the demands of pension funds, as ESG ETF demand surges in the current downturn.
Climate change is clearly a hot topic and the European Commission’s proposal will have an important impact on the flow of future investment, with the EU climate benchmarks playing a crucial role in delivering on carbon neutral ambitions by 2050. The Commission’s final report, released in September 2019, served as a foundation for draft delegated acts, which were adopted at the end of 2020.
By Nadia Humphreys, Business Manager for Sustainable Finance solutions and Chris Hackel, Index Product Managerat Bloomberg.
How Europe is leading the way in reshaping global green bonds
The euro-zone is setting its sights on standards for green bond issuance -- a move that could boost a rapidly expanding market worth nearly $1 trillion.
Published 2 October, 2020
Four months of European Commission consultations with insurance companies, academics and others ends Friday, aimed at agreeing by next year what really counts as “green” in projects funded by such debt. That’s needed as the bloc itself is set to unleash as many green bonds as the world issued last year, and the risk of “greenwashing” rises amid the rush to tap surging demand for clean finance.
“A widely-accepted standard is good for any financial market,” said Richard Gustard, head of European securities trading at JPMorgan Chase & Co.
“The signs are that both issuers and investors are fully on board with green bonds and it’s going to be an increasingly important part of the market.”
Richard Gustard, head of European securities trading at JPMorgan Chase & Co.
It wouldn’t be the first time the European Union led the charge. Data protection, financial research, chemicals and the climate are examples of areas where the world’s largest trading bloc implemented rules that countries and companies in other parts of the globe adopted.
The EU needs to create a framework before it begins offering its planned 225 billion euros ($264 billion) of green securities. Even though it’s late to the game, with governments and companies selling a record amount of debt last month, it’s set to be the biggest issuer.
Green bonds are defined by proceeds being ringfenced for environmental projects, but there’s been debate in Europe over whether that should include investment in the nuclear industry. For corporate bonds, concern about the standards were raised in 2017 when Spanish oil company Repsol SA became the first major refiner to sell the securities.
And then there’s the matter of “greenwashing,” when a climate-friendly tag on debt doesn’t necessarily live up to the hype. One solution may be to give such securities ratings that gauge their environmental credentials. The Bank for International Settlements recommends rating the companies themselves.
“The risk of greenwashing exists until that taxonomy becomes fully operational,” said Imogen Bachra, European rates strategist at NatWest Markets Plc, adding that the European Central Bank will also be paying close attention given its own commitment to buying green assets.
While this may be more of a problem for emerging markets than Europe, with Sweden’s bonds rated as “dark green,” the bloc faces challenges to wean itself off coal. Dutch investor NN Investment Partners said last month it ditched its holdings of green bonds from Poland, citing an unclear climate policy by the EU’s most coal-reliant nation.
It underscores the need for standards in the industry. There are dangers too though, by possibly removing the emphasis on investors doing their own analysis in much the same way that finance became too reliant on ratings agencies before the financial crisis, according to Ronald van Steenweghen, a money manager at Degroof Petercam Asset Management.
“It should be avoided that the standard becomes a tick-the box exercise,” he said.
"It would be unfortunate if investors would focus too much on these standards, like they did on ratings in the past"
Ronald van Steenweghen, money manager at Degroof Petercam Asset Management
An EU technical expert group report last year recommended that any criteria should be voluntary to start with. JPMorgan’s Gustard said similar standards for trading credit defaults swaps “revolutionized” those markets.
“Ultimately, it’s going to stand or fall on investor behavior and issuer behavior,” Gustard said, adding that green bonds could increase exponentially if the guidelines are widely accepted.
By John Ainger, With assistance by Jill Ward, and Nikos Chrysoloras for Bloomberg Green