Insight

Five principles to improve the next generation of net zero benchmarks

23.05.23

How can index providers better align benchmarks with net zero? More than 30 investors share their findings in our latest report, which assesses the net zero offerings of eight leading index providers together with the impact of EU regulation. The result is five key principles to consider.

Read: Enhancing the Quality of Net Zero Benchmarks

Many investors have committed to aligning their portfolios with a net zero target. Meanwhile, a significant and growing portion of capital invested in public markets is allocated to strategies that track or seek to outperform a net zero benchmark.

In 2019, the European Commission set out the criteria for an official EU Paris-Aligned Benchmark (PAB) or Climate Transition Benchmark (CTB), which complements Europe’s wider Sustainable Finance Disclosure Regulations (SFDR).

As a result, between Q1 2017 and April 2023, investment in net zero benchmarks increased from USD $10.2bn to USD $100bn, driven mostly by passive investment strategies in EU PAB and CTB electronically traded funds (ETFs).

Though a welcome signal, investors point out that the EU focus on emissions reductions poses unintended consequences – risking decarbonisation on paper rather than in the real world.

Our working group set out in June 2022 to assess the impact of current EU regulations and suggest ways to improve the next generation of net zero benchmarks. They also analysed the current market, inviting eight index providers to present their net zero offerings.

Overlooked sectors

Benchmarks and market indices describe the performance of a security market, market segment, or asset class. Index providers create them by aggregating sets of securities and (or) assets based on pre-set criteria, and they often act as a performance measure for an investment strategy and portfolio manager.

The market share of investment vehicles that track a benchmark has grown steadily over the past three decades. As of 31 March 2023, more than 30% of the estimated USD $15.5trn invested in global public market assets are invested in passive strategies tracking a pre-specified benchmark.

This, together with the EU’s emphasis on emissions reductions is encouraging. However, to comply with those regulations, net zero benchmarks tend to overweight less-material sectors to climate change: such as communications, technology, and health care to achieve emissions reductions.

This trend neglects the fact that excluded high-carbon companies may be deploying capital towards tomorrow’s low-carbon solutions. It also overlooks the influence an investor has to support these companies in decarbonising at the necessary pace.

The five principles

To build on this momentum, our investor working group defined five key principles which should be integrated into the construction, maintenance, and reporting processes of net zero benchmarks to enhance real world emissions reductions.

These are aligned and compatible with the Net Zero Investment Framework, the most widely implemented methodology for investors who have set a net zero commitment today.

The first principle is overarching, with the next four working together to enable it.

The report offers detailed recommendations to support each principle. It also explains that there are nuances to different asset classes that investors and index providers should consider.

Encouragingly, the index providers were largely supportive of prioritising real world emissions reductions, though some feedback varied for each principle.

The providers also contributed to a comparison table which allows investors to compare the core characteristics of their net zero offerings. This includes details on the benchmark methodology, asset class covered, and whether it is compliant with the EU regulations.

Read: Enhancing the Quality of Net Zero Benchmarks

Iancu Daramus, Director of Climate-aligned Investing at Fulcrum Asset Management said: “Many net-zero solutions risk hitting the emissions target whilst missing the impact mark. What matters is not to reduce, on paper, an index’s average carbon footprint, but to unlock capital for companies showing ambition and progress in decarbonisation.

“Achieving these real-world outcomes requires transparent data, backed by engagement and reflecting the nuances of sectors and regions. Fulcrum was delighted to contribute to the working group for this report, which provides a much-needed intervention around net-zero investing.”

The five key principles

Prioritise real world emissions reductions.

 Benchmark design should be informed by the incentives they would create in practice. To the extent possible, net zero benchmarks should favour avenues to enhance real world ’organic’ emissions reductions, over ’paper decarbonisation’.

Ensure transparency of benchmark rules and their consequences.

 Index providers should grant full disclosure on how constituents of a benchmark are selected and weighted and disclose any unique features to limit the ‘black box’ nature of the methodologies.

Incorporate a sectoral and regional based approach.

Benchmarks should recognise that different speeds of adjustment are required for different sectors and regions. They should adopt a science-based approach to emissions reductions in high-emitting sectors to ensure a just transition.

Prioritise publicly available data and integrate alternative alignment metrics.

Net zero benchmarks can make use of a range of alternative metrics that better reflect the transition potential and enhance real world emissions reductions. Incorporating forward-looking metrics can facilitate lower and more predictable portfolio turnover relative to an index using financed emissions alone.

Facilitate engagement to improve issuer behaviour.

Net zero benchmarks should maximise their opportunities for engagement to improve issuer behaviour. While these would differ across asset classes, this can be done, for example, by embedding climate performance-related signals into the construction methodology and communicating these to potential benchmark constituents.

If you’d like to take part in our working groups and be the first to see insights and analysis, why not speak to our investor relations manager today to find out more about becoming a part of IIGCC.