Striving to make index strategies net-zero heroes
Index strategies can offer clearly-defined decarbonisation pathways that may help to avoid climate risks. We pull back the curtain on how they work.
Investors around the world are integrating climate considerations into their portfolios in the hope of avoiding worst-case climate scenarios. Many are seeking to do this via alignment to a net-zero trajectory.
Reaching net-zero emissions by 2050 is considered the safest way to limit global temperature rises to 1.5°C above pre-industrial levels, avoiding some of the worst impacts of climate change. As a result, many investors are looking to reduce the exposure to carbon emissions within their index strategies and align their portfolios with climate scenarios that may avoid the most severe impacts. This process requires a decarbonisation pathway that could align to a 1.5°C scenario.
There are different avenues to delivering a decarbonised index strategy with net-zero ambitions; in this blog post, we will focus on the exclusion and capital allocation methods, as well as a combination of the two.
For a more in-depth discussion of the subject, see our research paper.
Exclusions have a role
The exclusion approach, also known as negative screening, has been used to avoid having specific stocks or industries in an index. The most prominent exclusions have tended to be tobacco, alcohol, gambling, fossil fuels and controversial weapons.
Different exclusions can resonate with different types of investors and across different regions. Some prefer this approach as it is transparent, easy to communicate and offers peace of mind if an investor’s ultimate objective is to remove exposure to specific securities and sectors.
But aggressive exclusions may alter the portfolio’s profile quite significantly. As the level of exclusions increases, the adjusted index often strays from its parent benchmark, deviating from delivering a market-like, risk-return profile. The index may then incur unintended active risk as compared to its benchmark.
Two observations may be made from global market capitalisation indices. First, a stock can have a high-carbon intensity and contribute a sizable amount of carbon to the portfolio. Second, a stock may have a low intensity but if it is highly weighted in the benchmark it may still contribute heavily to the overall emissions of the index.
Figure 1 shows that by removing 30 securities (out of 2827) it is possible to achieve a 37% emission reduction in a global stock index from the Q1 2022 total emissions intensity level and a 50% emissions reduction from 2019 portfolio levels. This reduction can be achieved, typically, with a tracking error of less than 0.50% for a globally diversified strategy.
There is a role for exclusions in a net-zero approach, for example, to remove companies that are highly misaligned and have little likelihood of being willing or able to transition. Relying solely on an exclusionary approach to achieve net-zero portfolios, however, could be problematic. It may not always address the real-world needs for decarbonisation and may remove the possibility of the asset owner engaging with investee companies to change their behaviour and address specific sustainability risks.
Reallocation of capital offers different pathways
A common decarbonisation pathway, based on recommendations from the Intergovernmental Panel on Climate Change (IPCC) and the EU Paris-aligned Benchmarks (PAB), is to reduce carbon emissions intensity by a fixed percentage relative to a parent benchmark. The index portfolio would then continue to be decarbonised by additional percentage points year-on-year.
Figure 2 shows different decarbonisation objectives that investors may choose from to embark on a net-zero pathway. The middle line describes a pathway which reduces an index portfolio’s carbon intensity by 50% by 2030 before continuing with a carbon reduction trajectory of 7% year-on-year.
There is no universal application of the IPCC’s 1.5°C degree trajectories to achieve net zero, meaning we may see variations of the initial decarbonisation levels applied in aggregate to indices. The concept of 7% annual emissions intensity reduction in an index is based on the European Union’s Technical Expert Group on Climate Transition Benchmark and is consistent with the IPCC’s 1.5°C degree trajectory.
The goal here is to reallocate and adjust the exposure from high-carbon intensive to low-carbon intensive stocks, subject to various investment constraints which may include security or sector deviations from the parent benchmark. As a result, a decarbonised index may have different constituents and/or a different number of holdings than its parent benchmark.
Below, we provide an example of creating a holistic index solution for transitioning to a 1.5°C environment to aim to reduce potential climate risks. The starting stock universe is based on market capitalisation for developed and emerging markets. We can illustrate the tracking error implications for various degrees of decarbonisation rates subject to a range of investment constraints.
Figure 3 indicates that it could be possible to decarbonise a global index with a low tracking error, demonstrating that a 50% carbon intensity reduction can be achieved with about 15 basis points of tracking error. However, the tracking error rises sharply when the decarbonisation increases beyond 50%. The results may vary for specific regions and more concentrated indices. Furthermore, the construction of the example aims to mimic the market risk and return profile by applying various security, sector and geographical constraints.
Capital allocation and minimal exclusions combine for net-zero alignment
In our view, effective decarbonisation of index portfolios could involve a combination of minimal exclusion standards and greater reallocation of capital between winners and laggards. We expect to see continued demand from investors seeking to align portfolios with a net- zero pathway, who recognise that potential financial and climate risks are different across different regions and industry sectors.
We also expect that increasing investor attention may be paid to broader climate themes such as biodiversity, as well as social and governance factors, all of which may complement a net-zero index strategy.
Assumptions, opinions and estimates are provided for illustrative purposes only. There is no guarantee that any forecasts made will come to pass. The above information does not constitute a recommendation to buy or sell any security.
 Intergovernmental Panel on Climate Change: Special Report on Global Warming of 1.5°C (2018
 It is worth noting that in many jurisdictions’ utilities operate as regulated monopolies. This is an extreme example of a company that will continue to operate throughout the transition regardless of cost of equity capital, and where an engagement model could have more real-world impact.
 For example, the UN Intergovernmental Panel on Climate Change (IPCC) 1.5°C scenario is modelled as “no or limited overshoot” of carbon emission. AR6 Climate Change 2021: The Physical Science Basis — IPCC. Although, index strategies of listed companies do not fully reflect the world’s total emissions since a large share of global emissions are often from governments, individuals, and private companies.