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:
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.
