Navigating the climate index jungle

Climate change has become the largest dedicated investment theme within the ESG universe. This reflects a shift from ESG investing which focuses on assessing issuers’ risk exposures to certain ESG factors and moves into climate investing which aims to hard-wire specific climate ambitions into the investment strategy.
To satisfy this investor demand and, in certain geographies, to meet minimum regulatory requirements, a range of climate index benchmarks have been developed. These are typically a function of carbon footprint, self-decarbonization, fossil fuel exposure, business sector activity exclusions and green revenues or a combination of all five.
These carry distinct characteristics for example in terms of country and sector exposures, decarbonization pathways and portfolio tracking error (TE) implications. For instance, the higher the degree of carbon intensity reduction, typically the larger the tracking error. This translates into TEs which are lowest for Climate Transition Benchmarks (CTB) and highest for Climate Action and Low Carbon SRI benchmarks.
In this paper, we explore this climate index jungle to help investors understand the trade-offs and ensure index selection meets specific portfolio objectives.

Introduction

Climate indexes have come of age. In the past, most tended to focus on climate risk mitigation, which often exclusively involved fossil fuel sector exclusions. Now, climate benchmarks are able to achieve multiple goals such as reducing the carbon intensity of an investment portfolio, allocating to climate investment solutions or aligning to a specific climate pathway. These innovations are timely since heightened geopolitical risk and record temperatures on land and sea^[1] are strengthening investor ambition and regulatory action when it comes to climate.

This paper consists of five sections: the first, explains the momentum behind climate investing; the second, examines the construction of the most prevalent climate benchmarks in the marketplace; the third assesses the characteristics of the various climate benchmarks; and along with our conclusion we include a glossary detailing terminology relevant to climate investing.