Our latest discussion paper outlines how index investing can effectively support the net zero transition by incorporating climate goals into the investment process. Reviewing challenges and practical considerations, it outlines how the Net Zero Investment Framework (NZIF) can help index investors align their strategies with these objectives, supported by case studies and setting out expectations for the investment ecosystem.
Index funds and Exchange-Traded Funds (ETFs) have become key building blocks and indispensable tools for institutional investors across asset classes. Their use has skyrocketed in recent years; index funds and ETFs now represent some 44% of total worldwide long-term assets, and 60% of total climate funds in Europe.
Yet despite their growing prevalence, index investors face hurdles in aligning their broad-based portfolios with net zero objectives.
Informed by our investor working group and aligned with the Net Zero Investment Framework, “Index investing for the net zero transition” aims to offer approaches for consideration to help those developing individual strategies. It seeks to:
The paper is supported by two investor case studies. One outlines how Ilmarinen, Finland’s leading pension insurer, has shifted most of its performance benchmarks to MSCI Climate Action indices and invested in ETFs in the same index to steer aggregate portfolio exposures to climate considerate allocation.
The second explains how Phoenix Group, the UK’s largest long-term savings and retirement business, has designed and implemented the FTSE All-Share Phoenix Group Climate Index to support its decarbonisation targets and inform a sustainable default investment proposition for its clients.
While the term index investing is often used interchangeably with ‘passive investing’, the former more accurately reflects the growing sophistication of quantitative systematic strategies that seek to track the performance of a specified index.
The rapid uptake in index funds and ETFs is driven by cost-efficiency, transparency and regulatory tailwinds, but also by continued innovation in product design. Increasingly, index funds and ETFs offer investors greater personalisation, allowing them to align portfolios with specific goals and preferences across asset classes, including on climate.
It is no exaggeration to say that sustainable investing is both shaping and being shaped by the growing shift towards index investing strategies. In one example, the FTSE 2024 Asset Owner Survey found that asset owners are now implementing sustainable investment more often through index strategy implementation than through active strategies.
However, barriers hinder net zero alignment within index strategies at scale. Backward-looking and incomplete data, unclear index provider methodologies, and the risk of divergence between climate-specific benchmarks and traditional market benchmarks all present challenges for investors. Index funds and ETFs are diversified, low-cost and broad-based by nature, which can limit effective individual corporate engagement.
Our investor working group agreed that financing reduced emissions in the real economy, rather than reducing financed emissions is another crucial consideration. This is especially true in the context of hard-to-abate sectors and climate solutions, which have high ‘up-front’ emissions but are nonetheless essential to the energy transition.
Similarly, emerging markets and developing economies account for two-thirds of the world’s energy-related CO2 emissions and 95% of the increase in emissions over the 2011-2018 period, according to a recent International Renewable Energy Agency report. Strategies that rebalance away from these regions risk slowing the transition.
Despite these challenges, our paper makes clear that index investors have a unique opportunity, and responsibility, to influence real-economy decarbonisation through portfolio construction, stewardship and policy engagement.
The Net Zero Investment Framework can help investors to support the climate transition using its suggested ‘levers of influence’. For example, investors can consider asset selection using climate indices that align the with widely used NZIF maturity scale and its 10 criteria to assess different stages of asset alignment with net zero.
Considering engagement and active ownership, the paper explores nuances in the index investing context. This includes a case study from Japan Government Pension Investment Fund, where the investor pays a separate fee to some asset managers to engage with portfolio companies. Reference to IIGCC’s Net Zero Stewardship Toolkit helps to outline what successful engagement might look like for index investors.
Separately, a detailed table reviews main approaches to climate index construction, considering their key features, advantages, challenges and considerations, and engagement potential.
Building on this potential, the paper outlines expectations for asset owners, asset managers, index providers, and policymakers to improve climate alignment in index investing. Points outlined include greater collaboration with index providers or asset managers to improve on methodology clarity and data transparency, as well as on index fund voting and engagement alignment.
Aligning stewardship and corporate engagement with index design, fund objectives and climate commitments can help investors looking to align their individual strategies with NZIF and scale transition efforts. Investors already value these approaches separately from portfolio construction, but tailored to index funds, they can help to ensure index climate criteria align with engagement prioritisation and escalation mechanisms. This includes considerations for securities lending programmes.
Our paper explores the landscape and the potential of index funds and ETFs to be net zero enabling solutions, supporting investors moving from commitment to implementation in line with their individual strategies and mandates.
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