Recalibrating investment strategies for climate risk

Addressing climate risk is prompting investors to recalibrate long-term investment strategies – and poses novel challenges.

The transition to net-zero emissions has become one of the key drivers that will define the global economy over the decades to come. Even as investors respond to energy crisis, resurgent inflation and the reshaping of supply chains, they are increasingly looking to incorporate climate change into their long-term view. This is prompting some fundamental recalibrating of investment strategies – and is surfacing complex new risks.

At FTSE Russell, we have been considering climate risk and opportunity as part of our wider work on sustainable investment since the turn of the century. In recent years, however, the issue has moved from a niche interest among specialist investors squarely into the investment mainstream. Many investors – such as those members of the $130 trillion Glasgow Financial Alliance for Net Zero – have committed to entirely decarbonise their portfolios by 2050.

In responding to climate risk, investors can choose from a number of approaches. One strategy is simply to exclude those sectors responsible for much of the problem – energy companies, heavy industry, transport etc. – and instead focus investments on the technology and service sectors. While such an approach instantly flatters an investor’s carbon footprint, it also introduces substantial tracking error against measures of the broader market. Furthermore, it eliminates exposure to and capital support for those emitters that are seeking to sustainably transition to low-carbon business models.

In short, it does not address the economy’s climate transition challenge, introducing investment risk while seeking to reduce a portfolio’s climate risk.

Instead, the Paris Agreement and national climate change plans anticipate a gradual transition to a low-carbon world – not an overnight switch to zero emissions. Broad-based investors need to participate in this transition, supporting those emitters who are responding to the low-carbon imperative, while gradually reducing exposure to those that are not.

This is an approach endorsed by regulators within the EU. In putting forward minimum requirements for benchmarks that are aligned with the low-carbon transition, the EU Benchmark Regulation requires climate indexes to have, in aggregate, the same weighting of sectors highly exposed to climate change as the benchmark. This avoids the creation of climate indexes that exclude large swathes of the economy and requires index designers (and investors) to identify climate leaders within every industry sector.

At FTSE Russell, we have applied the EU’s rules relating to Climate Transition Benchmarks (CTB) and Paris-Aligned Benchmarks (PAB) to develop our FTSE EU Climate benchmarks. These aim to achieve a reduction of 50 percent in carbon emissions against the benchmark for PAB-aligned indexes, or 30 percent for CTB indices, as well as a 7% year-on-year self-decarbonisation rate, meeting requirements set out by the EU’s Benchmark Regulation. Not only do these indexes deliver high climate performance and higher exposure to green revenues, they also offer sector exposure and returns which remain as close as possible to the broader market.

The indexes combine data and analysis from the Transition Pathway Initiative (TPI), set up by the Church of England Pensions Board, London School of Economics and the UK’s Environment Agency Pension Fund in 2017. The TPI assesses how the world’s largest emitters are positioning themselves for the low-carbon transition, including by considering forward-looking metrics, such as emissions goals. It also assesses companies’ management and governance systems to address the climate transition.

We have used the outputs of the TPI Global Climate Transition Centre to inform a series of indexes that weight constituents against measures such as carbon emissions and targets, fossil fuel reserves, exposure to green revenues, and climate governance. The indexes deliver significant improvements on these measures compared with the benchmark, while managing tracking error.

We are seeing a growing number of asset owners – large pension funds, in particular – undertaking a shift of considerable proportions of their portfolios into strategies that address climate risk. For example, Brunel Pension Partnership Limited, which pools several UK local government pension funds, has switched more than £3bn to index funds that track FTSE EU Climate benchmark indexes. 

But this evolution is not without friction. Investment performance is typically measured against a market benchmark. However, when conventional benchmarks do not take into account a critical driver of returns – in this case, the externalised costs associated with carbon emissions and the climate transition – managers are at risk of being penalised if their performance diverges too widely from the benchmark.

Investors are therefore beginning to grapple with the implications for their climate-orientated investments in a world that is not decarbonising as fast as it needs to. The Paris Agreement, and the net-zero ambitions of most governments, anticipate a substantially decarbonised global economy by the middle of the century. That implies annual emissions reductions of around 7%, which, as noted, is the goal required of indexes seeking to align with the EU’s Paris-Aligned Benchmark Regulation.

However, should climate policy and technological innovation not keep up with climate science, the broader economy will decarbonise at a slower rate. Over time, this would mean that an index comprised of companies that are managing to decarbonise in line with Paris would become increasingly unrepresentative of the broader economy. This would begin to introduce unwelcome levels of tracking error and thus investment risk.

The solution is to build resilience to the implications of a more slowly decarbonising economy into climate indexes. This requires the creation of a review and governance process that enables the indexes to evolve – should they need to – as regulations change, and to match the changing appetites of investors to market risk versus climate risk.

Central to understanding and managing these risks is collating and analysing climate data and incorporating the resulting insights into investment processes. Whether it is understanding the evolving green economy, tracking current carbon emissions and performance against future targets, or knowing which metrics provide a window into company management quality, we have applied our robust and transparent methodologies to data collection and dissemination. Our data, and the insights it provides, can help our clients understand how climate change and the race to net zero are likely to drive the global economy and investment performance in the decades to come.

Find out more about the FTSE Russell sustainable investment index framework.