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No Time to Rest in Passive ESG Market

Asset owners are looking for greater comparability across climate benchmarks, while providers respond to increasingly sophisticated demands.

To say that ESG investment benchmarks have come a long way in a short space of time would be an almost heroic understatement. To take one UK-based example, when FTSE4Good was launched in 2001, a pioneering benchmark for socially responsible investing (SRI), the focus was on carbon emissions. Today, concepts such as ‘just transition’ have moved into the spotlight as SRI has given way to ESG – and investors have developed higher expectations of investee firms’ decarbonisation strategies.

Efficient, reliable and trusted benchmarks can cut the cost of sustainable investment, as they allow passive, index-based strategies to support sustainable investment objectives. In April this year, Manisha Ali, Portfolio Specialist at Neuberger Berman, calculated that, while the whole ESG investing market was growing rapidly, passive strategies in the US were increasing at four times the rate of actively managed assets.

Passive funds, she said, account for roughly 40% of all US sustainable investment assets under management.

The market for green benchmarks is getting crowded and it’s no longer confined to equities. In recent weeks, Bloomberg has announced the launch of the Bloomberg Global Aggregate Green, Social, Sustainability Bond Indices, while MSCI unveiled a suite of indices under the Climate Action banner. Not to be left out, S&P Global launched “a new family of climate-focused market benchmarks”.

Then SGX Group, Singapore’s multi-asset exchange, announced a futures product related to the Nikkei 225 Climate Change 1.5°C Target Index, designed to have 50% lower emissions than the parent, Tokyo’s benchmark Nikkei 225.

EU benchmarks “have shortcomings”

In short, it is a busy time in the ESG index sector.

For asset owners, there has never been a richer array of benchmarks from which to choose. But abundance brings problems, not least that the more factors a benchmark considers, the greater the risk of tracking error, the straying of a portfolio from the performance of its benchmark.

More on that in a moment.

First, there was something of a stock-take on the whole subject in November, in a report from the Net Zero Asset Owner Alliance, the 80-strong UN-sponsored group with US$11 trillion under management. The alliance conceded that “benchmarks are efficient and practical tools for integrating decarbonisation objectives into the investment process and for supporting net-zero portfolio alignment”, but highlighted areas where improvement is needed.

One such relates to non-equity investments. “To date, the focus of index providers has been on equity climate benchmarks, while indices in other relevant asset classes – such as fixed income – have been lagging.”

Then there are the guidelines adopted by the European Union in 2020, which the report sees as a positive development, before adding: “However, the alliance believes these benchmarks have some shortcomings.”

The two standards enshrined in the EU guidelines are the Paris-Aligned Benchmark (EU PAB) and the Climate Transition Benchmark (EU CTB). But while the Alliance described these as comprising a “welcome and important addition to the index universe”, both benchmarks pose potential challenges for users, it added.

First, the asset owner could be managing assets for a policyholder who expects more traditional, broad-based returns. Second, the EU benchmarks may have a large tracking error “which may or may not grow over time”.

Third, members of schemes or mandates are likely to have different time horizons, risk/return expectations and de-carbonisation targets.

In short, said the alliance, the EU benchmarks are best suited to specific circumstances, such as where there is less concern about market volatility or the complete exclusion of some sectors. Elsewhere, it added, index providers should supply net-zero aligned benchmarks and asset owners should use them.

Sindhu Krishna, Head of Responsible Investment at pensions provider Phoenix Group, and a spokesperson for the alliance working group that produced the report, said: “ESG benchmarks have definitely come a long way. There has certainly been evolution, guided to an extent by regulations that have come in, such as those from the EU.”

But she added: “Asset owners are constantly looking at benchmarks. Every asset owner is different in terms of objectives, so we discussed what are the principles that should underly benchmarks in order better to help asset owners navigate and make their decisions.”

Krishna said asset owners needed first to have a clear idea of where they are going and then find the right benchmark to measure progress.

Innovation and competition

Sustainable investing was initially seen as a boon for the active manager, but today passive investment solutions claim to go well beyond managing ESG risks.

A report in September by asset manager DWS and independent research boutique CREATE-Research found 22% of pension funds surveyed are implementing, or have already implemented, impact investing as part of their passive investment strategies. DWS added: “Impact investing is set to penetrate capital markets, and passive investments such as exchange-traded funds (ETFs) and mandates will be an important driver of this development.”

Simon Klein, Global Head of Passive Sales at DWS, said ETFs and passive investing could make all the difference in helping impact strategies to break through on a large scale. “We are already seeing high demand from private and institutional investors for index concepts that formulate concrete goals, and we will be further expanding our efforts in this area,” he added.

Aled Jones, Head of Sustainable Investment and Product Management for EMEA at indexes, analytics, and data solutions provider FTSE Russell, identified a key issue in the construction of reliable ESG-related benchmarks. “The main limiting factor is availability of data. Is there enough data to fulfil the requirements of asset owners?”

Thomas Kuh, Head of ESG Strategy at Morningstar Indexes, acknowledged the challenge but said the situation is improving over time. “Part of the improvement process is getting it out there and used, and then listening to feedback.”

He added: “We asked the same question when we launched the first low-carbon indices about ten years ago. More effort is going into improving the data.”

The proliferation of benchmarks in the last decade or so inevitably raises the question of whether there are too many and whether some consolidation may be beneficial. At this stage, the forces of innovation and competition should be allowed to play our, suggested Kuh.

“We should let as many benchmarks flourish as are needed. There is a high degree of difficulty for benchmarks tracking de-carbonisation and improvements here are helped along by competition between benchmark provider,” he said.

“The market will send a signal if it gets to the point that there are too many.”

Jones noted: “We have about ten core ‘index families’ within which are different ‘tweaked’ versions. It looks like a lot but underneath the tweaks they are the same products.”

Phoenix Group’s Krishna was more circumspect, saying the Net Zero Asset Owner Alliance working group had discussed more disclosures with regard to the benchmarks, finding that there was a case for rationalising some of the different methodologies and metrics used in different indices. “It would be good to have more comparability among benchmarks,” she added.

The first of the ten key principles laid down in the alliance’s report is transparency in the methodology and design of benchmarks.

A linked question is whether the large number of indices could provide cover for greenwashing by unscrupulous businesses or asset managers. Concerns have been raised that sustainability-branded passive investment vehicles can be too broad-based to eliminate ESG risks.

“That should not happen,” said Jones. “Companies are included or excluded against objective criteria. There are always gaps in company disclosures.” He added that anyone wanting to assess a company’s commitment to Paris alignment should use both the company’s reported information and more independent views as to what the company is doing in practice.

“For example,” he said, “FTSE Russell integrates assessments from the Transition Pathway Initiative into the methodology governing some of its climate indices. This offers a forward-looking view from independent analysts.”

Kuh said that the issue of greenwashing is being addressed. “Deception is going to be increasingly difficult to get away with for any length of time. As things progress, we are going to see benchmarks that don’t measure up being shown up.

“New and better data are coming on-line all the time.”

Review, renew

The Net Zero Asset Owner Alliance blueprint for benchmark construction makes two points on the exclusion of various assets. The first is that de-carbonisation should be measured from the inception of the fund in question rather than from some point in the past when it is, wrongly, assumed that the process had begun.

This can lead to the exclusion of companies in ‘hard to abate’ sectors.

The second is that, with the exception of thermal coal, there should be no automatic bans on corporate activity. It said: “Exclusions of high-emitting sectors or constituents are not necessary to achieve de-carbonisation objectives. Rather, benchmarks should tilt the weights in favour of the de-carbonisation leaders.”

Writing for ESG Investor, John Willis, Director of Research at Planet Tracker, warned that established index providers would face increasing competition from innovative new market entrants. He said: “Profitability attracts competition, of course. So, while the index majors may resist change, new entrants will be only too willing to meet demand.”

He added: “Self-indexing – whereby an asset manager maintains ownership and control of the index and the related intellectual property – also poses a threat to the index majors.”

Looking to the likely next developments in benchmarking, FTSE Russell’s Jones said: “The debate on climate change has become more sophisticated. A few years ago, we looked just at the carbon emissions aspect. Now other aspects such as the just transition have assumed great importance, as well as a focus on other asset classes like fixed income.”

He added: “We are always looking at new things. It is important to review and refresh things over time as new data emerges. We look at our indices once or twice a year.”

Kuh said: “One of the things we are hearing about from asset owners is the growing importance of what may be called climate-adjacent issues, such as biodiversity, species loss and the need for sustainable food and agriculture. These issues are not new, but how do you take account of them in an index tracking progress towards net zero?

“It is a challenge to find ways of including a wider range of factors without introducing higher tracking error.”

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

Copyright © 2023 ESG Investor Ltd. Company No. 12893343. ESG Investor Ltd, Fox Court, 14 Grays Inn Road, London, WC1X 8HN

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