Passive vehicles can help investors reach climate targets, but are by no means perfect.
Institutional investors are increasingly attracted to climate-focused passive investment vehicles as a systematic and cost-effective way of transitioning their portfolios to net zero.
However, despite sharing a label, not all Paris-aligned products are calibrated in the same way to achieve the goals of the Paris Agreement, with some at risk of failing to complete the journey.
Recently, passive products that are ‘Paris-aligned’ – meaning they are decarbonising in line with a 1.5-2°C temperature pathway – have grown in popularity.
In May, 56% of 50 large pension plans said that they would scale up their use of Paris-aligned indices, according to a CREATE-Research report sponsored by German asset manager DWS.
Finnish pension insurance company Varma Mutual Pension Insurance has gone one step further, working to support the development and launch of Paris-aligned passive funds.
Most recently, Varma demonstrated its support for BlackRock’s new Corporate Bond ESG Paris-aligned Climate ETF with a €50 million seed investment. Tracking a newly designed Bloomberg MSCI index, the ETF aims to achieve a 50% reduction in absolute greenhouse gas (GHG) emissions and carbon intensity relative to the index and an additional annual 10% decarbonisation trajectory for both absolute emissions and carbon intensity.
“Passive products are efficient in reducing the climate-related risks in a big portion of your portfolio with relatively low costs,” Vesa Syrjäläinen, Responsible Investment Analyst at Varma, tells ESG Investor.
Varma manages statutory earnings-related pension cover for over 900,000 people in the private sector. Its investment portfolio reached €57.6 billion at the end of March.
The firm recently upped its climate ambition, pledging new absolute emissions reduction targets for its investment portfolio. This has required Varma to update the investment policies of its co-constructed US and European passive equity ETFs so they are Paris-aligned, excluding all companies producing coal and companies relying on oil for more than 10% of their revenue.
Developed and launched by Varma and Legal and General Investment Management (LGIM) in 2019, the ETFs are tailored to track the Sustainability Consensus index series designed by index provider Foxberry.
Foxberry ran screenings and optimisations to ensure its Sustainability Consensus range could become Paris-aligned, says David Sahlin, Co-Founder and Chairman of Foxberry.
“It became clear that Paris-alignment is the next step that needed to be taken, and Varma was a driver to getting this done and aligning [the range] with their own investment policies. Following a period of consultation, changes were made such the indices became Paris-aligned,” he says.
Drawing up guidelines
Policymakers have recognised the need for investors to have access to reliably Paris-aligned passive products.
As a whole, passive instruments are rapidly becoming a large part of the ESG fund market. In 2021, passively managed ESG funds represented around 40% of the US ESG fund market’s US$350 billion in assets, according to investment research provider Morningstar.
EU lawmakers introduced criteria for Climate Transition Benchmarks (CTB) and Paris-aligned Benchmarks (PAB) into law in 2019, outlining a baseline standard for index providers designing tailored indexes and benchmarks for passive products to track.
CTBs are designed to be used by asset owners that have yet to set net zero targets for their funds but are looking to protect their portfolio against transition-related investment risks. PABs are more suitable for asset owners that are committed to aligning their portfolios with the goals of the Paris Agreement and therefore willing to invest in a narrower universe of companies with credible emissions reduction strategies.
To meet the minimum requirements outlined in the EU PAB rules first published in 2020, any indices labelled as Paris-aligned must half the average weighted carbon intensity relative to the market and then continue to reduce emissions by at least 7% every year.
“PABs are more suitable as a long-term passive solution for an investor with ambitious climate targets and clear decarbonisation goals,” says Syrjäläinen.
He adds that the “built-in mechanics” to ensure decarbonisation in passive products – such as the guaranteed 7% annual reduction in emissions required under the EU directive – are “great for an asset owner’s plans for reducing its portfolio emissions”.
“CTBs have more exposure to fossil fuel and utility companies with higher GHG intensities. Unlocking the decarbonisation potential could be productive in terms of real-world impact and returns, but this requires engagement pressure from investors, which, in my opinion, is more impactful through direct investment,” he notes.
Out of alignment
A recent report published by the World Resources Institute has warned that rival Paris-aligned passive funds can look very different under the hood.
The paper set out to provide a robust framework for Paris-aligned passive investing, outlining guidance for investment criteria spanning climate mitigation and resilience, a just transition and do no harm. It then analysed how 35 sustainability-labelled passive funds and EU PAB-labelled passive funds available to US institutional investors performed against its criteria.
According to Lihuan Zhou, Associate at the WRI Sustainable Finance Centre, the study found “an investment space that is more grey than green”, with none of the assessed funds fully aligning with the WRI’s framework.
The majority of funds failed to incorporate climate mitigation and resilience into portfolio construction. Further, while a “considerable number” did include some form of fossil fuel exclusion, most did not exclude deforestation or anti-climate change lobbying. Few considered the importance of ensuring a just transition, the report said.
The results of the report are “not really surprising”, says Syrjäläinen, noting that European passive offerings are similarly broad, despite regulation.
“The wording in the [EU] guidance for constructing a Paris-aligned benchmark is relatively vague, which can result in very different products depending on the interpretation,” he says. “This is why it’s important to look at the underlying methodology for each Paris-aligned product. There are surprisingly many differences.”
Variation is inevitable when index providers all use different methodologies and different data providers to inform their index composition.
For example, an index provider’s decision to reduce just Scopes 1 and 2 emissions versus another committing to reducing all scopes “leads to very different index compositions based on how Scope 3 emissions are phased in”, says Syrjäläinen.
It’s also an issue for asset owners investing in bonds, according to Ann Brännback, Senior Portfolio Manager at Varma.
“In fixed income, you also need to consider duration and yield, not only the issuer and sector,” she says. “The index design is important to have a scalable and cost-effective solution. We welcome the launch of credit PAB ETFs and hope to see them grow into products with good liquidity.”
However, without visibility of the underlying methodology of the Paris-aligned indexes on offer, asset owners will continue to struggle to understand which are truly Paris-aligned, says Syrjäläinen.
“Currently, there isn’t any independent third party that will verify is an index or product is actually in line with the [EU] guidelines. Anyone can claim that a product is Paris-aligned,” he says.
Financial regulators should continue to “take steps” to further encourage growth and improve the transparency of sustainable investing, especially in the US, the WRI report said, noting that regulators can require firms using ESG-related fund names to disclose the criteria used in choosing these labels.
The US Securities and Exchange Commission is currently consulting on extending its so-called ‘Fund Names’ rules to a wide variety of sustainable funds to ensure that at least 80% of the contents matches the label.
The second part of the EU’s Sustainable Finance Disclosure Regulation will also tighten up fund labelling in Europe, requiring asset managers to provide comprehensive underlying information that will justify their categorisations of funds as Article 8 or 9.
The market is becoming almost overripe with tailored Paris-aligned indices.
Launched in 2021, the Morningstar EU Climate Indexes series helps investors target companies within broad market indexes that are Paris-aligned, drawing on carbon emissions data and carbon risk ratings from subsidiary Sustainalytics. The benchmarks manage transition risk by underweighting high emitting companies across Scopes 1-3 emissions and ‘tilting’ exposure towards companies making demonstrable efforts to reduce emissions and have set credible decarbonisation targets.
“Our conversations with investors often start with interest in CTBs and typically end at PABs,” says Thomas Kuh, Head of ESG Strategy at Morningstar Indexes. “While EU regulators did create two standards, the market does seem to be gravitating towards PABs.”
Swedish insurance and pensions company Länsförsäkringar recently reindexed two of its passive funds so they incorporated the EU’s PAB framework. The Länsförsäkringar Global Indexnära and Länsförsäkringar Sverige Indexnära now track custom Paris-aligned indices from Morningstar that build on the EU directive.
In 2021, FTSE Russell launched the FTSE EU Climate Benchmarks index series – a suite of climate-themed equity indexes that are aligned with limiting global warming to below 2°C by 2050. Also applying a tilt methodology, the benchmarks base their degree of exposure to companies on factors such as fossil fuel reserves, carbon reserves, green revenues and net zero transition strategies.
“The series uses two different scores drawn from Transition Pathway Initiative (TPI) data, which are a forward-looking assessment of what companies do to transition towards the objectives of the Paris Agreement,” says Solange Le Jeune, Director of Sustainable Investment at FTSE Russell.
TPI, an investor-led organisation, last year partnered with the London Stock Exchange Group (LSEG) to expand its assessment capabilities. Its Global Climate Transition Centre will increase TPI’s assessment coverage from 479 to 10,000 companies across a broader range of asset classes, providing insights into the credibility and progress made by companies transitioning to net zero.
The Brunel Pension Partnership, a local government pension scheme pool, has transitioned over £3 billion in passive investments to the FTSE Russell Paris-aligned benchmark series, which it helped to co-develop.
Talking about Paris
Active engagement is one of asset owners’ most powerful tools to hold companies accountable and ensure they are transitioning to net zero.
However, engagement and stewardship “can be something that is lacking in a passive portfolio”, Varma’s Syrjäläinen notes.
An active fund may hold anywhere between ten to 40 companies – a passive fund can run into the hundreds. Keeping track of every company’s progress to net zero is more challenging.
“Active investors have natural access to company management and therefore are able to form a more qualitative understanding of what’s going on,” acknowledges FTSE Russell’s Le Jeune.
“But the argument that investors cannot engage within a passive strategy is wrong,” she says. “They may be less qualitative and less in-depth, but investors can draw lines in the sand, based on data used in index construction, and determine at what stage they need to engage with these companies one on one.”
Asset owners can do this by adopting a passive engagement strategy, setting trigger points that will allow them to identify when company engagement is needed.
As asset owners often engage through asset managers, it’s also important that asset owners make sure their managers’ engagement priorities are aligned, experts say.
But only six of the 21 asset managers running the 35 funds assessed in the WRI report had specifically outlined that companies are expected to align with a 1.5°C trajectory in their stewardship policies.
In the latest AGM season, a number of large passive houses, including BlackRock took a cautious approach to backing climate-related resolutions.
“It’s important to complement all passive products with good stewardship practices, engaging companies, industries and the market, and voting in favour of decisions that are in line with the Paris Agreement,” says Syrjäläinen.
Ultimately, while a useful and popular tool in the asset owner’s net zero toolkit, “passive products are not alone the best solution for positive real-world impact”, he says.