The “lack of commonality” in benchmark selection makes asset owner assessments of performance more challenging.
UK pension funds need to apply high levels of scrutiny when evaluating climate-focused funds, due to the wide range of indexes they use for benchmarking purposes, according to a new report by Pensions for Purpose, an impact-focused investment consultancy.
The firm’s analysis of 108 climate-themed funds and 104 broader ESG funds from 24 asset managers found that 42% are using market capitalisation rather than climate-related benchmarks. Twenty-nine percent of funds use ESG thematic indices, 8% climate transition, 4% low-carbon, 4% positive impact and 6% Paris-aligned. Seven percent of assessed funds use no benchmark.
Further, almost half (49%) of climate-focused funds were found to be aligned with a market capitalisation benchmark, with 20% using a Paris-aligned benchmark (PAB) and 13% using a climate transition benchmark (CTB).
When asset managers present performance data relevant to a full market capitalisation benchmark, “it is then much harder to gauge whether their manager is doing a good job or not”, Karen Shackleton, Founder of Pensions for Purpose, told ESG Investor.
Active managers who participated in the research told Pensions for Purpose that benchmarking against a climate index would limit their investment universe and “potentially result in less favourable financials”, she noted.
Asset managers also cited difficulties selecting an appropriate climate benchmark, due to the vastly different methodologies, high licence fees, and wanting exposure to transition alpha.
“What we are suggesting is that investors point to the market capitalisation index for financial comparisons, allowing the manager to select from the full universe of opportunities, but that they are held to account on their carbon metrics by comparing against the carbon footprint that might be achieved from an indexed approach,” Shackleton said.
Shackleton added that financial performance and impact performance should be treated separately, noting that she sees no reason why a manager shouldn’t “take the carbon metrics of a climate index, and consider that to be a maximum carbon budget that can be spent wisely across the whole universe of stocks”.
Pensions for Purpose analysed actively managed bonds (31), equities (58) and multi-assets (7), as well as passively managed bonds (19) and equities (97).
Lack of commonality
A total of 142 different climate benchmarks are being used by the 212 funds to measure performance, Pensions for Purpose found.
“There is a lack of commonality in the choice of climate benchmarks and mixed views on whether there will be a move towards consensus benchmarks or a shift towards more tailored benchmarks designed to meet pension funds’ specific climate goals,” the report said.
Reasons given by passive managers as to why a large number of different indices are used included wanting specific exclusions, achieving the closest alignment to the manager’s climate goals, and wanting to benchmark against a bespoke index designed to suit their specific preferences, such as sector exclusions.
This makes it more difficult for investors to determine whether their asset manager is performing well in comparison to others.
The report includes an outline of the different kinds of climate indices these asset managers are using, and how each may be suitable for UK pension funds, depending on their own climate-related goals. Asset owners can then best identify funds using climate indices that align with their own targets.
Climate transition benchmarks (CTBs) and Paris-aligned benchmarks (PABs) were introduced into law by the EU in 2019, with strict criteria benchmark providers have to adhere to.
CTBs are suitable for pension schemes looking to protect their portfolio against investment risks related to the transition to net zero greenhouse gas (GHG) emissions, but that have not yet set net zero targets for their funds, the report said.
PABs are suitable for pension funds that have committed to becoming aligned with the Paris Agreement objective of limiting global warming to 1.5°C, the report added, noting that funds using a PAB benchmark will likely have a narrower universe of company holdings due to having more exclusions.
As asset owner and regulatory climate ambitions accelerate in the face of the growing environmental crisis, it is entirely possible Paris-alignment may be replaced with an even more ambitious goal, thus leading to more climate indices being published, Shackleton said.
“What is important is to recognise and understand why there is the lack of commonality, and to choose an index that is closely aligned to the pension fund’s own climate action goals,” she added.