Climate benchmarks in practice: meeting evolving investor needs

Climate change has shifted from a long‑range environmental concern to a near‑term systemic risk that cannot be diversified away. A recent report from the Network for Greening the Financial System forecasts that a sudden policy shift to cut carbon could cut the gross domestic product by 1%–3% in hard-hit countries, while the International Monetary Fund and Fossil Fuel Subsidy Reform research show this triggers higher company defaults and sharp drops in stock and bond prices across carbon-heavy sectors, putting broad market portfolios at risk.

In 2019, the European Union introduced minimum standards for Paris-Aligned Benchmarks (PAB) and Climate Transition Benchmarks (CTB), creating the first standardised framework designed to measure portfolio alignment with the Paris Agreement’s 1.5°C objective. These benchmarks offer a systematic, rules-based approach for mitigating transition risk, communicating climate commitments, and aligning portfolio outcomes with investor expectations.

Over the past five years, practitioner and academic literature has debated how best to meet the regulation’s stringent requirements—including initial 50% (PAB) or 30% (CTB) carbon intensity reductions, a mandated 7% annual decarbonisation trajectory, exclusions, activity-based screens, and “do no significant harm” principles—while minimising tracking error and avoiding unintended sector or regional distortions.

Industry progress has been substantial, driven by enhanced environmental, social, and governance data coverage and quality and sophisticated optimisation frameworks that balance climate objectives against risk constraints like sector neutrality and turnover limits. Yet, challenges persist, notably the inconsistent integration of scope 3 emissions and the potential erosion of stewardship leverage from rigid activity-based exclusions.

This paper analyses the Morningstar EU Climate Enhanced Index Series, which includes PAB and CTB indexes across performance, volatility, factor exposures, and tracking-error drivers, highlighting key methodological choices and how they shape portfolio outcomes. This is especially relevant now as PAB and CTB exclusion criteria, alongside binding portfolio construction rules like weighted average carbon intensity reductions, feature centrally in the SFDR 2.0 product categorisation proposals currently under consultation.

Investors want climate alignment without losing beta exposure
Investor apprehension about ESG’s impact on returns has intensified. In Morningstar’s 2025 Voice of the Asset Owner Survey, the share citing "return drag" as the top barrier to considering ESG factors in the investment process rose from 38% in 2022 to 53% in 2025. That sentiment sets the backdrop for this analysis.

The EU Technical Expert Group on Sustainable Finance set minimum standards for PAB and CTB. PABs require a 50% lower initial carbon intensity than the parent index plus 7% annual decarbonisation. CTBs follow a less stringent trajectory toward well-below-2°C alignment or 30%, both preserving minimum exposure to high-impact sectors to encourage their transition rather than outright exclusion. 

PAB and CTB exclusions fall into two groups: baseline screens and activity‑based revenue thresholds. Baseline exclusions, which apply equally across both frameworks, reflect universal ESG safeguards required for EU climate benchmarks. The activity‑based exclusions introduce the climate‑specific differentiation between the exclusion frameworks. The PAB applies stricter revenue thresholds to ensure meaningful reductions in exposure to high‑carbon business models.

Data instability remains a challenge in managing carbon intensity reduction, especially with scope 3 emissions data. Reported scope 3 emissions in particular exhibit a high incidence of extreme year‑over‑year changes in reported totals, frequently driven by methodological updates such as category additions or financed emissions rather than real economy shocks. Practically, this raises turnover, stresses liquidity in narrower markets, and can push tracking error higher at the margin. Index optimisation mitigates but cannot eliminate the effect; persistent WACI drift driven by disclosure
changes tightens decarbonisation targets over time. Oversight and transparency are critical.

Index optimisation enables climate ambition with low tracking error
The analysis considered Morningstar’s PAB and CTB Enhanced Indexes over three‑, five‑, and 10‑year windows. The results are nuanced. Across markets and horizons, we observe modest excess returns in
many cases. Low tracking error and volatility broadly in line with their parent benchmarks evidence that climate alignment need not imply large deviations from core beta.

Performance highlights by horizon and market

10‑year view (2016-26)

• At the global level, both PAB and CTB Enhanced Indexes show slight outperformance versus their parent benchmarks.
• Developed-markets and emerging-markets variants also deliver positive but modest excess returns.

• Tracking error remains low, with Emerging-Markets PAB Enhanced Index the highest at 1.58%, while developed markets and global are less than 1.5%. In construction terms, that profile is consistent with optimisation that minimises the tracking error subject to binding climate constraints, especially in universes with broad diversificatio
  

Five‑year view (2021-26)

• Global and Developed-Markets CTB/PAB Enhanced Indexes underperformed modestly, the largest shortfall for Global and Developed-Markets PAB Enhanced Indexes at roughly negative 0.26% to
  negative 0.27%, while the Emerging-Markets CTB/PAB Enhanced Indexes outperformed, making emerging markets the strongest region in this period.

• Sector dynamics matter. Energy, notably in 2022, alongside industrials and consumer defensive, explained much of the global PAB shortfall.
• Emerging-markets tracking error again is the highest (1.45%), in line with the pattern that smaller or less-diversified universes amplify tracking error when climate criteria are applied.
  
  Three-year view (2023-2026)
• Global CTB/PAB Enhanced Indexes underperformed slightly. Developed markets were mixed, with the
• CTB negative and PAB marginally positive.
• Emerging-Markets CTB/PAB Enhanced Indexes continued to outperform modestly.
• Emerging-markets tracking error peaked around 1.63%–1.64%, versus less than 1% for global and developed markets, again consistent with universe breadth and the cumulative decarbonisation gap that must be closed at each rebalance.
  
  Volatility
• Over 10 years, Global PAB and CTB Enhanced Indexes delivered annualised standard deviations of 12.79% and 12.65%, respectively, near the parent benchmark's 12.56%, despite approximately 50% lower carbon intensity and nontrivial exclusions.
• Over three years, dispersion widens slightly, for example, global CTB annualised standard deviation notching at 9.84% versus its parent benchmark's10.02% but remains modest.
• This is the construction story. The index optimisation uses Morningstar's Global Industry Standard Risk Model to preserve core factor exposures while enforcing ESG exclusions and climate constraints
• Global and Developed-Markets CTB/PAB Enhanced Indexes underperformed modestly, the largest shortfall for Global and Developed-Markets PAB Enhanced Indexes at roughly negative 0.26% to negative 0.27%, while the Emerging-Markets CTB/PAB Enhanced Indexes outperformed, making emerging markets the strongest region in this period.
• Sector dynamics matter. Energy, notably in 2022, alongside industrials and consumer defensive, explained much of the global PAB shortfall.
• Emerging-markets tracking error again is the highest (1.45%), in line with the pattern that smaller or less-diversified universes amplify tracking error when climate criteria are applied.

How minimal requirements are achieved
The PAB and CTB Enhanced Indexes employ convex optimisation with Morningstar's Global Standard Equity Risk model to minimise tracking error while hard‑coding climate constraints (initial approximately 50% PAB or 30% CTB reduction and 7% annual glide path) plus sector and country, diversification, and turnover guardrails.

Optimised variants cut turnover and ex‑post TE versus tilt constructions in developed markets and developed Europe. The strength of index optimisation is disciplined control of active risk: The risk model
prices each active weight so that the portfolio can target the required ESG improvement while holding sector and country exposures close to the parent and keeping turnover within guardrails. Its main limitations are complexity and input dependency, since outcomes can be sensitive to model specification, covariance estimates, and ESG data quality. Robust governance, periodic model
recalibration, and transparent disclosure are essential to sustain its reliability.

Rright‑skewed carbon intensity also plays a role. Carbon intensity distributions are heavily right‑tailed. Large reductions in portfolio WACI can be achieved by down‑weighting a relatively small set of high‑intensity outliers, allowing most market weights to remain close to the parent and keeping tracking error contained.

CTB/PAB through a factor lens
Factor lenses help explain the Morningstar CTB versus PAB Enhanced Index differences observed in the data. The use of binding decarbonisation, plus sector representation, leads to underweighting large,
carbon‑intensive leaders. Index weight is commonly reallocated to smaller, lower‑intensity names that meet climate thresholds. The Morningstar Global CTB Enhanced Index tends to show stronger momentum, higher volatility, and higher liquidity tilts, consistent with lighter exclusions and a lower initial intensity reduction. The Morningstar Global PAB Enhanced Index is more growth‑oriented and more defensive on volatility and shows a higher dividend bias and deeper quality underweights. Both share a similar small‑cap tilt relative to the broad market.

In aggregate, an examination of the Morningstar EU Climate Enhanced (PAB and CTB) Indexes shows that investors can obtain material decarbonisation with low tracking error and benchmark-like risk, but should expect some periodic dispersion tied to scope 3 data instability, universe breadth, and market leadership cycles.

SFDR 2.0 makes CTB/PAB indexes a natural building block
The Sustainable Finance Disclosure Regulation (SFDR) or the EU's framework that requires financial market
participants and advisors to disclose sustainability-related information in a standardised way is being
overhauled. SFDR 2.0 aims to streamline sustainable finance classifications, curb greenwashing, and
sharpen comparability by forging tighter links between portfolio sustainability outcomes and mandatory
disclosures. The overhaul was driven by evidence that the original regime was too complex, hard to
compare, and vulnerable to greenwashing. SFDR 2.0 simplifies product categories, tightens minimum
standards, and aligns disclosures more closely with the wider EU sustainable finance framework
(taxonomy, Corporate Sustainability Reporting Directive, Markets in Financial Instruments Directive,
benchmark rules). These changes will reshape the roughly €1 trillion in European passive sustainable
fund assets (Q4 20257), positioning PABs and CTBs as cornerstone tools for meeting elevated standards.

The PAB and CTB framework gains heightened relevance as SFDR 2.0 mandates universal exclusions, which include controversial weapons, tobacco, and breaches of UN Global Compact/OECD principles— across all product categories, while sustainable products face the full fossil fuel exclusions mirroring EU PAB rules. This regulatory convergence effectively funnels managers toward CTB/PAB frameworks to achieve "Article 8+" or "Article 9" status with minimal methodological friction, prompting a potential reshuffle in fund lineups as providers recalibrate for compliance and disclosure readiness.

In light of this reality, we expect investors will have an increased interest in how these exclusions impact a global portfolio and some of the differences between developed and emerging markets in this context.

Using the past five years of Morningstar’s Emerging Markets and Developed Markets Target Market Exposure Indexes, which together represent the top 85% of free-float market capitalisation, we examined the average number of excluded securities and the portfolio weight associated with each exclusion category across both baseline and fossil fuel activity exclusions. The review considered both securities explicitly removed for violations of baseline criteria and those omitted because of insufficient data.

Key findings

• Global standards and norms noncompliance, or companies Sustainalytics identifies as involved in

breaches of international norms based on their stakeholder impacts and links to violations of globally recognised standards, is the most significant driver of baseline exclusions across both universes, although the magnitude differs substantially.

• For emerging markets, “baseline exclusions” behave more like a material active bet given the weight

impact, which can meaningfully affect regional exposures and tracking error.

• Severe controversies are meaningful in both, but in emerging markets, they are more often the same

names, which suggests emerging markets’ most severe controversies are more concentrated and correlated—the same companies often trigger multiple baseline screens.

• Oil and gas weight is similar across developed markets and emerging markets, but coal and power

generation are not. Emerging markets show much higher coal extraction and coal‑linked power generation exclusions, indicating transition constraints in emerging markets are more infrastructure‑embedded, which may create country/sector distortions.

There are a few areas for further exploration and debate where the new SFDR 2.0 product categories differ from the CTB/PAB framework. The SFDR 2.0 Category for Sustainable Products (Article 9) introduces stricter exclusions on new fossil fuel projects and coal/lignite phase-out plans that notably go beyond CTB/PAB requirements. This signals that regulators may view CTB/PAB as a floor for benchmark design but want higher ambition for labeled sustainable products, even if it fragments the market and complicates stewardship in high impact sectors.

The option to use a 15% EU Taxonomy alignment acts as a "safe harbor" shortcut to meet SFDR 2.0's 70%
sustainability/transition thresholds for the new product categories. Coverage of EU Taxonomy‑aligned
capital expenditure within the Morningstar Global All Cap Target Market Exposure Index has already
improved as mandatory CSRD reporting comes into force, with the weight of companies reporting rising
from 6% at the end of 2024 to 10% by mid‑2025, and the reporting population increasing from 570 to
more than 740 companies. Although future coverage is expected to stabilise, this step change provides a
clearer data foundation and supports the Commission’s calibration of the 15% threshold as broadly
attainable. For index‑tracking strategies, including PAB and CTB funds that already exhibit meaningful
exposure to Taxonomy‑aligned activities, this strengthens the case that the safe harbor is a practical
compliance mechanism rather than a theoretical one.

Climate benchmarks are becoming essential tools for managing transition risk as investors seek meaningful decarbonisation without sacrificing core-beta exposure. Morningstar’s PAB and CTB Enhanced Indexes use optimisation to meet stringent emissions reduction and exclusion requirements while keeping tracking error and volatility close to the parent benchmarks. The accelerating evolution of European regulation reinforces this relevance. SFDR 2.0 elevates minimum sustainability standards, introduces universal exclusions, and sharpens the link between portfolio outcomes and product classification, effectively positioning PAB and CTB frameworks as foundational reference points rather than optional overlays. Together, these developments position climate-aligned benchmarks as practical building blocks for sustainable portfolios in Europe and beyond.

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