Many of our clients are considering using green or low carbon benchmarks in order to help them achieve their climate goals. Before allocating capital to low carbon benchmarks, it is important to be aware of their strengths and limitations. If the focus of using benchmarks is lower a portfolio’s carbon footprint, then green benchmarks are often a convenient way to go. In that way they contribute to shifting capital to lower carbon investments. However, if investors also expect green benchmarks to be the silver bullet for managing climate-related financial risks, then we have to disappoint them. They do not fully mitigate transition risks – as they do not mitigate all contagion and volatility associated with a disorderly transition. Also they don’t protect from physical climate-related risks.. Benchmarks are not mature enough to do that. And there are more challenges for using benchmarks as risk assessment tools along the way.

Operational

Do the current benchmarks really capture what activities are really green, sustainable or low carbon? We have set our hopes on the EU Taxonomy, but in the short term we still have some operational challenges how to map the Taxonomy’s to investible companies. The main issue is that the Taxonomy identifies low-carbon ‘activities’. However, companies are classified using systems such as the Global Industry Classification Standard (GICS), which defines sectors, industry groups, industries and sub-industries. How to map these categories to the Taxonomy’s activities remains unclear.

General versus Paris Aligned

Choosing the right benchmark is another challenge. Many investors already work with general ESG benchmarks (i.e. MSCI, S&P Dow Jones Indices, FTSE Russell and Bloomberg). Before choosing a benchmark, and more importantly, before choosing between a general ESG benchmark that takes into account more environmental, social and governance aspects than a Paris Aligned benchmark, an investor has to check the restrictions of the benchmark and potential tilts related to certain sectors and certain climate risks. A Paris Aligned benchmark may currently be too concentrated, leading to insufficient diversification.

Grey versus Green Risk Profiles

We have asked ourselves “how does performance of low-carbon benchmarks differ from ‘grey’ ones?” The answer is that our research shows that on a short-term horizon, moving to a greener portfolio protects investors from a portion of downside transition risk and volatility that related to a delayed disorderly transition scenario (but not all!). Also, it is important to know that using a green benchmark does not mitigate any locked-in physical risks associated with a Paris Aligned or Net-Zero scenario. If the world fails to act on climate change in a meaningful way and no real transition takes place, it is unclear if a green benchmark has any benefits over a grey one.

Work with an expert

One can compare using green or low carbon benchmarks with DIY. If you renovate your bathroom yourself, it can look great in the short term, but in the long term, you ask yourself if it would not have been better to have hired a professional. Difficult jobs, and adapting your investment portfolio to climate change and the risk and opportunities related to it, should be left to an expert.

Ortec Finance is proud to be able to model the risk-return characteristics of low-carbon benchmarks and fully integrate them into the strategic investment analysis and SAA advice we give our clients. We have integrated low carbon benchmarks in our standard ALM-SAA analysis tooling. This enables us to fully include them in in our strategic investment decision making and risk management tooling and advisory services.

Additionally we are working towards adding a temperature alignment score to standard benchmarks, so that we can combine both the climate-informed risk profile and temperature alignment scores in our SAA/ALM analyses. Because of our expertise, we are more able to assess the challenges of using benchmarks and can adapt to their flaws if necessary.

Using green benchmarks is only a starting point. If you are serious about climate change and contributing to mitigating and adapting to it, and rather would be prepared for a disorderly transition, grant yourself the convenience of an expert.

Responsible Investor Europe

Willemijn Verdegaal will discuss this topic in more detail during RI Europe in the session: Deep-dive 5 (June 16): What financial/environmental changes are Paris-aligned and Climate Transition benchmarks driving? Keep on top of one of the biggest ever moves in investment and business at the RI Europe 2021 conference. You can find the full agenda and the registration link here.

Would you like to get started on you Net Zero journey?

Don’t hesitate to reach out to us, or take a look at our Climate & ESG solutions page. Ortec Finance delivers state-of-the-art customizable solutions for climate resilient investment decision-making. We combine independent, research-backed climate change & ESG knowledge, advanced financial models and innovative technology for:
  • Climate scenario analysis
  • Climate-aware Strategic Asset Allocation & ALM
  • Alignment to Net Zero
  • Forward-looking extreme weather risk
  • TCFD & regulatory disclosure
  • AI driven ESG analytics
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