Build it and they will come: the climate index market heats up

In 2015, MSCI committed to reporting the carbon footprint of its flagship indices, a process that was driven by investor demand, the index provider said. What followed was unprecedented visibility over carbon intensity of MSCI’s indices, their exposure to high emitters and downside risk exposures to changes in extreme weather or climate policies.

Over a decade later, investor interest in the climate risk embedded in indices is on the rise once again. This time, the search is on for climate indices that serve as not only credible low carbon benchmarks but also investible tools for allocators to onboard.

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Physical risk

Earlier this year, Standard Life – one of the UK’s largest asset owners – released a transition plan outlining the group’s on-going net zero activities. Amongst the mix was the launch of climate-aligned benchmarks. Partly, the group says its decisions were motivated by physical risks that were becoming more apparent, frequent and costly.

Cascading physical risks and their financial materiality has shaped demand for climate indices. “Physical risk is moving up the agenda”, says Shahyar Safaee, deputy chief executive officer at Scientific Climate Indices (SciX), a newly formed provider of equity climate indices.

One of SciX’s offerings is a climate index series specifically centred around physical risks. “In its core version, the series targets an average 15% reduction in long-term physical climate risk for around one percentage point of tracking error relative to the benchmark”, SciX said in a statement.

Shahyar says the physical risk focus in intentional. “The financial literature indicates that these risks already affect markets but may not yet be reflected reliably in equity prices”, he says, “their long horizons, inherent uncertainty and complex transmission into company cash flows make them particularly difficult to assess. For long-term investors, physical climate risk is therefore a fiduciary matter rather than simply an ESG consideration”.

Passive plays

A renewed focus on physical risk sits alongside an interest in passive transition investing. LSEG’s FTSE TPI climate transition index series is a case in point.

The series underweights fossil fuel reserves, overweights companies generating green revenues and takes into account a company’s emissions reduction commitments.

LSEG’s approach has thus far attracted investor attention from the New York State Common Retirement Fund, Phoenix Group, Brunel Pensions Partnership and the Church of England Pensions Board.

Amongst its latest adopters is Taiwan’s Bureau of Labor Funds. In July this year, three of Taiwan’s largest public pension funds selected five investment managers for a $3bn passive mandate focused on listed transition infrastructure securities. The benchmark of choice was part of the FTSE TPI climate transition series.

Index development has also stretched beyond equities. Last year, researchers at the University of Cambridge teamed up with Bloomberg’s index designers to develop a fixed income index that favours companies phasing down fossil fuel activities. The ‘fossil fuel phase out’ bond index, which is now live, is the first of its kind.

Regulatory benchmarking

Investor interest in climate indices also has policy tailwinds. Most notably – the push for performance benchmarks. Britain’s Value-for-Money framework and Australia’s Your Future Your Super performance test are examples of that trend.

In the case of the latter, a short-term, benchmark-hugging performance test had resulted in the unintended consequence of inhibiting investments in climate solutions. The test has been the subject of industry and policy debate lately. The government’s latest consultation proposes a ‘CPI + x’ benchmark approach to fit the profile of alternative investments – the kind that climate solutions strategies are characterised by.

Conversations over the UK’s VFM framework have brought up similar concerns.

“UK pension funds may on the other hand deem the Value for Money (VFM) initiative a disincentive to ambitious climate strategies because of the tracking error the latter introduce, although this should not penalize financially disciplined and benchmark-aware climate solutions”, Shahyar reckons.

While these factors might have reinvigorated investor interest in climate indices, the interest itself goes back a few years. Shahyar points to 2020, when the European Commission set out the criteria for Paris-aligned benchmarks.

“Nowadays, demand is evolving with asset owners reassessing first-generation low-carbon and PAB indices because of their high tracking error, sector concentration and weak connection to real-world decarbonization”, he explained.

Shahyar reckons demand for indices is now focused on making these investible. That would mean combining climate objectives with fiduciary constraints, whilst preserving methodological credibility and financial discipline.

Since 2015, investors have demanded access to indices that account for climate objectives. Now, their demand is deepening. A decade on, the quest for investible climate indices is alive and well.