Climate transition strategies involve challenging implementation questions. Among the most important: “Which index should we use?”
The choice of which index to use has important implications for investors. In this piece, we review:
- The indexes commonly used today by fixed income investors with climate objectives
- A comparison of standard market and climate indexes
- The benefits of using a standard market index
This note is the third installment of our 2023 Climate Transition series, following our “setting the scene” and “burning questions” papers. We hope you are finding this series timely and relevant, and we welcome your suggestions for future topics.
Climate investors focus on three indexes
When managing fixed income strategies with climate transition objectives, investors can choose a standard market index (such as the Bloomberg Global Aggregate Bond Index) or a more thematic, sustainability-focused index (such as a Paris-aligned or green bond index). Even if an investor has Paris-aligned ambitions, they may not require the use of a sustainability-focused benchmark. In fact, most investors opt to use a market index for reasons we will discuss below.
In Exhibit 1, we profile the three most popular categories of indexes used to benchmark climate fixed income strategies, based on a review of a range of climate offerings within the Morningstar Global Corporate Bond UCITS universe. More than 75% of these strategies are managed against a standard market index while the remaining use either a Paris-aligned or a green bond index. We limit our review to these three types of indexes, recognizing that there is a growing range of climate indexes available in fixed income.
Exhibit 1. A comparison of popular indexes used for climate fixed income strategies
|MARKET INDEX||PARIS-ALIGNED INDEX||GREEN BOND INDEX|
|Description||Standard market index||Index to pursue Paris-aligned emissions by excluding the worst emitters||Index of green bonds that adhere to the Green Bond Principles|
|Number of constituents||15,554||9,836||1,192|
|As % of market||100%||63%||8%|
|Yield to worst (%)||5.0||4.9||3.9|
|Inception date of index||09-Jan-00||01-Jan-20||01-Jan-14|
|Realized tracking error to market index||–||0.4%||3.0%|
|Weighted average carbon intensity (metric tons of CO2e/$1M revenue)||256||112||418|
The Paris-aligned index covers 63% of the market with limited differences in investment characteristics (such as yield and duration) versus the primary market index while achieving a much lower carbon intensity. Green bonds are a well-established category, and proceeds can have a number of specific uses ranging from renewable energy to energy efficiency, pollution prevention and control, sustainable water, green buildings, and climate adaptation. From an investment perspective, the green bond universe is only a small subset (8%) of the standard market index, with quite different investment metrics. Perhaps surprisingly, the carbon intensity of the green bond index is higher than the market’s, reflecting the fact that carbon-intensive polluters’ issues tend to dominate green bond issuance. In our view, the narrow focus of green bond indexes makes them impractical benchmarks for most institutions that invest in broader climate transition strategies. As such, we focus our discussion on the relative merits of Paris-aligned and broad market indexes below.
Exclusions-based approaches present trade-offs for investors
Exclusions can be helpful tools for building portfolios with low carbon intensity. A Paris-aligned index will effectively accomplish this through strict emission intensity caps. Exhibit 2 shows how the worst emitters contribute proportionally more to index carbon intensity. As a result, excluding the small number of heavy emitters results in large reductions. For example, excluding only the top 1% of emitters results in a whopping 22% reduction in carbon intensity. When the top quartile of emitters is excluded, the resulting portfolio achieves a 90% reduction in carbon intensity.
However, reported carbon intensity is a backward-looking metric. It doesn’t effectively capture an issuer’s forward climate profile. In fact, we expect to see the largest contributions to decarbonization from today’s high emitters that have convincing strategies and budgets committed to future decarbonization.
Our expectations were supported when we identified the largest contributors to decarbonization within the market index between the second and fourth quarters of 2022. The 10 companies that achieved the largest decrease in carbon footprint were all companies with high emissions: Each had an intensity of more than 500 metric tons of CO2e/$M revenue. This illustrates how the highest emitters today, that are also on a clear path toward decarbonization, can make outsized contributions to reductions in carbon intensity. Put another way, we should not focus investments solely on today’s lowest emitters.
As effective as exclusion-based approaches can be at reducing carbon intensity, we think they present some drawbacks that can ultimately favor the use of a market-based index to execute a variety of climate transition strategies. We outline some of these trade-offs here:
- Sector biases and tracking error. Banks comprise more than 30% of Paris-aligned indexes, creating the risk of over-concentration. Moreover, banks’ loan book disclosures are very limited. This creates uncertainty in what investors are actually funding when they invest in banks—their indirect emissions could be significantly higher than we expect. It’s likely banks will have to disclose more about loan book constituents in the future, creating event risk for climate-focused investors. Also, the Paris-aligned index is underweight energy and utilities (see Exhibit 3). Many of these firms are decarbonizing quickly while performing well financially. Excluding them could be a negative for performance. Finally, many investors measure their performance against traditional indexes that better align with their view of fiduciary duty and or strategic asset allocation goals. These investors may find it impractical or inconvenient to use specialized indexes when communicating with stakeholders.
- Engagement. Engagement with issuers on climate and other sustainability-related issues is a powerful lever for investors who want to drive changes in corporate behavior. Index choice doesn’t necessarily limit engagement opportunities for investors. But investors using broad indexes naturally tend to evaluate and engage with a broader range of firms. This more inclusive approach expands opportunities for investors to effect positive environmental and social change.
- Nuanced approach. Although indexes can be developed to allow for climate and social objectives, sustainable investing is nuanced and benefits from active, fundamental research and management. Thoughtful, active strategies that exploit a broad opportunity set can often benefit from more flexibility in pursuing sustainability goals over time.
- Alpha. While index choice doesn’t necessarily restrict the universe of securities that an investor might consider, in practice, a low-emissions index tends to make investors focus on issuers with low historical emissions. In this way, a more broadly defined market index can expand an investor’s opportunity set. Active management helps investors make the most of a larger opportunity set through rigorous, forward-looking analysis that identifies issuers poised to outperform in financial and climate terms. This ability can represent a valuable edge over passive strategies.
- Clarity.There is growing heterogeneity among climate-focused indexes, whether they are focused on climate change, emissions minimization, the European Union’s Paris-aligned and climate transition index rules, or green bonds. We believe the market’s thinking about each index’s pros and cons is still evolving. In our view, these indexes often rely on imperfect data and processes to determine index eligibility (due either to changing views about which types of firms are acceptable or to subjective interpretation of related metrics). For example, one of S&P’s climate indexes was recently criticized for including power generator Drax without a solid rationale. Although attitudinal changes like these are a normal part of the maturation of green financial markets, they also complicate portfolio management.
We have made the case for using a market index when managing climate transition portfolios. Our view may not be controversial: Most climate-aware fixed income strategies do this today. However, we observe that many equity investors who use climate-focused investment strategies use climate-focused indexes, as are an increasing number of fixed income investors. For reasons outlined above, we believe these investors should consider market indexes as viable alternatives.
Watch out for our next piece, “The Race to Net Zero,” which will consider ambitions for net zero by 2050, 2040, or even 2030.
Disclosure: Duration is a measurement of the sensitivity of a bond’s price to changes in Treasury yields. A fund’s duration is the weighted average of duration of the bonds in the portfolio. Duration should be interpreted as the approximate change in a bond’s (or fund’s) price for a 100-basis-point change in Treasury yields. Duration is based on historical performance and does not represent future results.