Building a climate transition equity index

Index Researcher & Designer at FTSE Russell, Hannah Layman, highlights how TPI scores can be used directly in index construction and the ways in which this can be done.

By providing an assessment ofhow ready a company is for the transition to a low carbon economy.TPI Scores provide a really useful tool for anyonewho's interested in supporting or benefiting from that transition.Alongside traditional uses like enhancing ESG scores,risk management, and engagement strategies,TPI Scores can also be used directly in index construction.There's a lot of different ways this can be done, and three waysinclude bucketing, screening or filtering techniques,targeting specific index outcomes, or a methodology called tilting.I'm just going to speak really briefly, at a high level about how TPI Scores can beused in each of these three different construction methodologies.So the first one I mentioned was bucketing screening or filtering techniques.The idea behind this methodology is that you take your universe of stocksand then you sort them based on the metric of interest,so in this case a TPI Score. You would then consider a threshold above or belowwhich you consider to be an acceptable level,and you can filter according to this threshold.So, for example, a climate transition leaders indexmight try to capture a subset of stocks that exhibitparticularly high management quality or carbon performance metrics.Or conversely, you might come up with a threshold for which a TPI score belowwhich is unacceptable, and you can filter or screen those stocks out.This type of construction methodology has the benefit of being really familiar to the market.And so it's really easy to communicate how your index was constructed.The second technique I mentioned is targeting specific index outcomes.This sort of methodology usesa mathematical technique, such as an optimiser or a solver to findthe index weights required to meet precise and predefined index outcomes.This is particularly useful if you need to meet precise sustainabilitygoals at an organisational level, or if you have prescriptive regulatory goals.The TPI Scores in this framework are particularly powerfulbecause you can target an uplift on a TPI score and therefore embedan uplift in a forward looking metric into your index construction.The third methodology that I mentioned is tilting.And this is a relatively simple methodology.You take all the stocks in your universe and you rank them according to their scoreon that particular metric of interest. So in this case, that would be a TPI Score.on that particular metric of interest. So in this case, that would be a TPI Score.You thenoverweight those stocks that have a high TPI Score,and you would underweight those stocks that have a lower TPI Score.You can then do this across several different metrics of interest,and then you can combine the multiplicatively.The key benefit of this methodology is transparency.Because you're maintaining the rank order within each tilt,you know that any stock that has a higher score will be rewardedmore than any stock that has a lower score.This transparency is particularly key for creating a narrativefor relative weight positions in your portfolio.An example of using TPI Scores in this sort of methodologywould be the FTSE TPI Climate Transition Index series.This series uses a combinationof tilts towards different climate metrics, but includesgetting extra exposure towards companies that have a high management quality score,and also those are aligned with lower carbon performance scenarios.If you want any more information on TPI Scores or the methodology,you can get that on our website. Thank you very much.

Hannah Layman, Index Researcher & Designer, FTSE Russell