Taking ESG beyond equities

Investors are increasingly looking to apply ESG analysis into asset classes beyond equities and corporate debt – and FTSE Russell is developing the tools to help them do so, says Sylvain Chateau, head of sustainable investment product management at its parent, the London Stock Exchange Group.

Sylvain ChateauEnvironmental Finance: FTSE Russell has recently launched the world’s first climate-related government bond index. Why have sovereign debt markets lagged equity markets in integrating climate risk?

Sylvain Chateau: New research is always aimed at equity markets before fixed income, and that applies to ESG as well as the wider market. This is why we were keen to embark on a new area of research that would be dedicated to fixed income and sovereign issues, because this is an area that was underserved by the market.

This is a paradox, given how large the sovereign market is and also because, when we deal with climate, it is first and foremost a government issue: governments take part in the international climate negotiations, and they put in place the policies and the regulatory framework in which corporate and other economic agents have to operate.

This is why, when we developed the FTSE Climate Risk-Adjusted World Government Bond Index, or Climate WGBI for short, we used a framework that characterises both how countries are actually exposed to transition and physical climate risks, but which also looks at what they are actually doing to prepare or to be proactive in this context. The index reweights countries based on both the level of exposure to climate risk but also the level of preparedness and proactivity that governments demonstrate in that regard.

EF: How have you sought to overcome challenges around inadequate climate data to construct the index?

SC: We have to be more specific about what we call climate data. If we look at the TCFD recommendations, they talk about transition risks, physical risk and resilience factors. Where we face challenges is around physical risks. For an index, we need robust data that is regularly updated, and which is available for all index constituents.

Regarding exposures to physical risk, there is still a lot of research to be done from a financial perspective. For the Climate WGBI, we decided to focus on a very limited number of indicators, for which there is continuity and clear differentiation between countries.

As an example, we built an agricultural production exposure indicator for the index, which looks at the volatility of production year-on-year for each country in the index. While it is difficult to estimate the financial consequences of a single climate hazard on agricultural production, when looking at overall production, you can argue the only reason for volatility of production is climate exposure.

EF: A frequent criticism of climate data is that it is backward-looking. How are you taking account of the future in your equity and fixed income climate indexes?

SC: That's a fair point. FTSE Russell’s parent company acquired my company, Beyond Ratings, last year and one of the intentions was to produce new KPIs that would be forward-looking. For example, one of the indicators that we've developed is around 2°C alignment for each country; it assesses the distance to target to reach the Paris agreement objectives. This is a very useful KPI for investors willing to align their portfolios with climate objectives.

Meanwhile, in the equity space we have launched, with the Transition Pathway Initiative, the FTSE TPI Climate Transition index. It uses data from the Grantham Institute and assesses the strategies of the largest and most carbon-intensive companies against climate objectives. This gives investors a good sense of how effective companies are in terms of responding to climate challenges.

EF: What about other asset classes outside equities and fixed income? How is investor demand developing for climate-aware investment tools?

SC: We designed a very interesting range of real estate indexes, the FTSE EPRA Nareit Green Indexes, which look at green strategies in the real estate business by weighting constituent real estate investment trusts and development companies based on green building certification and energy use.

Real estate and climate is a very interesting space. The major climate risk for the real estate sector is flooding. We’re exploring how to discriminate between real estate players based on their exposure to flooding risk. It’s a big challenge to map climate hazards and assets – it’s very data-intensive. While you might have high confidence on your asset data, you’re dealing with a lot of uncertain data from climate models. It’s not straightforward to build the links between climate data from these climate models and financial risk.

Real estate, because of the long-term nature of this sector, will increasingly need to assess existing and new projects against climate risk exposure. It’s an area where we’re keen to do more research.

EF: What is the future of ESG indexing in a post-Covid, low-carbon world?

SC: The current situation has really highlighted how non-financial risk can materialise in the financial world: ESG indicators matter in financial analysis. Governance indicators are commonly accepted as material; environmental issues are increasingly researched, especially around climate. The social pillar remains challenging when it comes to demonstrating materiality. However, the Covid pandemic has underscored the importance of being better able to demonstrate the connectivity between social indicators and financial risk. We believe that our ESG indexes and research can help investors better understand those connections, across environmental, social and governance factors, but, as the Covid pandemic has shown, those factors and connections are constantly evolving.

For more information, see www.ftserussell.com/sustainability-and-esg-data

Corporate Statements

Taking ESG beyond equities

Investors are increasingly looking to apply ESG analysis into asset classes beyond equities and corporate debt – and FTSE Russell is developing the tools to help them do so, says Sylvain Chateau, head of sustainable investment product management at its parent, the London Stock Exchange Group.

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