Investing in a post-Paris world: pension funds rethink their approach to climate indices

Ten years ago, representatives from 196 countries gathered in Paris to commit to keeping global warming well below 2°C, and preferably to a 1.5°C scenario. Politicians sent a powerful signal, and investors responded. The subsequent years saw a mushrooming of climate-aware and Paris-aligned equity strategies, which today form the cornerstone of many institutional portfolios.

But a decade later, the actual progress made in reducing our global carbon footprint offers less room for optimism. The latest UN Global Stocktake speaks of a “glaring gap in emissions reductions” and warns that global emissions must be cut by more than 43% if the Paris targets are to be met. Some scientists now conclude it is impossible to limit global warming to 1.5°C.

The lack of discernible links between climate investing and climate progress raises uncomfortable questions. How effective have Paris-aligned strategies really been? Is it time to abandon the pretence that equity portfolios can mitigate climate change, or is a more holistic approach required?

An inconvenient truth

For now, few institutional asset owners see reasons to abandon their climate tilt. Some of the UK’s largest master trusts, including the People’s Pension and Nest, pride themselves on having their equities invested in climate-aware strategies. There is little appetite for change, not only because pension funds have signed up to net zero targets, but also because climate indices have, generally speaking, performed better than their benchmarks.

Over the past decade, the MSCI ACWI Climate Paris Aligned index has broadly outperformed the conventional MSCI ACWI index. Last year, the climate-tilted index returned 14%, compared with 17% for the mainstream benchmark. Does this mean that climate investing is in decline?

The truth may be more complex. One key performance driver for many climate-tilted indices has been their relatively high exposure to the US information technology sector rather than their green credentials. For example, tech firms account for more than a third of the MSCI Paris-Aligned index, compared with 27% in the mainstream version. 

The universe of Paris-aligned indices is surprisingly complex, as research by Lauren Juliff and Henrik Wold Nilsen for Storebrand Asset Management reveals: "There is no single way to define a Paris-aligned portfolio, which is generally counterintuitive to the mindset or goals of a passive investor". This means that some funds have strongly outperformed the benchmark while others haven't. 

But where funds did outperform the index, this was often due to higher exposure to US tech, rather than due to their climate credentials, the manager recognises. From a performance perspective, this has been positive—but has it led to real-world emission reductions? Perhaps not.

The evolution of index investing

It would be disingenuous to suggest that asset owners have not recognised the problem, but progress has been slow, warns Ana Harris, EMEA head of Sustainability and Climate Indices at MSCI. “While some of the largest French and German pension funds have started thinking about alignment, their approach is still very much focused on portfolio-level control. We are gradually seeing that change, but for many pension funds, it is still a journey.”

Over the past decade, climate indices have evolved significantly, adds Guido Giese, head of Sustainability and Climate Solutions at MSCI.

“Our products have evolved in stages. Five or six years ago, the focus for asset owners was really on carbon footprinting, getting Scope 3 in there and setting climate targets. From 2022 onwards, many asset owners told us: ‘We want to add something—we want transition metrics. Are climate targets credible? We want to invest in high emitters that are transitioning.’ That’s when we introduced alignment categories into our indices.”

However, the issue has grown more complex, he continues. “About 1.5 years ago, we realised that climate alignment is not a risk mechanism. I know it hurts, because in Europe a lot of companies are well aligned with climate targets—but that does not mean they will outperform the index.

“BMW may have a great climate target, but that doesn’t mean it will outperform BYD, which has no formal climate target but a business model that benefits from the transition. In Europe, we’ve made the mistake of thinking that a small carbon footprint is a good proxy for transition readiness. Unfortunately, it’s not—what matters is your ability to adapt, and that’s a very different metric from climate alignment,” he emphasises.

Beware the tracking error

For many asset owners, this offers an opportunity to rethink how they approach the energy transition in their listed equity portfolios—particularly if these are managed through index tracking. Dan Mikulskis, CIO of the People’s Partnership, stresses the need for indices to evolve. “One of our core beliefs is that our investment approach has to adjust to the conditions in markets.”

“Indices are great, but they can be quite a blunt tool, based on a certain view of the world. Five or six years ago, the view emerged that there could be a major policy shift in tackling climate change. That implied that the worldview embedded in standard indices might not reflect the future accurately. That’s when we started to develop Paris-aligned indices.”

However, investors now need to acknowledge that the world is not on track to meet its ambitions, he warns. “This inevitable policy response is not going to happen. That means trying to invest in a 1.5-degree-aligned world is increasingly hard to justify.”

From a long-term asset owner perspective, it may not be performance but tracking error that becomes hardest to sustain, he adds. “By trying to manage one risk, another is being created as portfolios become more concentrated—often in US technology companies. We’re already seeing that come through,” he warns.

Towards a more customised approach

Rather than abandoning climate ambitions altogether, a more customised approach is needed, says Harris—one that incorporates forward-looking data, green revenues, and more nuanced assessments of factors such as nature and biodiversity risks.

For Mikulskis, that means investors should move away from pooled funds and towards segregated mandates, enabling them to exercise greater influence over their allocations.

“I do think there is a positive way forward, and it lies in asset owners working in partnership with their data providers—and possibly with their asset managers—to develop better strategies. Index investing is great; it delivers real value for our members. But you do need to have the right partners,” he stresses.