Aligning with the Paris Agreement: An Index Approach

Institutional investors are under pressure to align their strategies with a maximum global temperature increase of 1.5^oC targeted by the Paris Agreement. We examine how they can approach this while respecting other investment constraints.

By Stuart Doole, Neeraj Kumar, Veronique Menou

Climate-related risks, whether physical or related to a transition to a lower carbon economy, are changing the risk-return profile of individual companies and entire industries, leading to new and increased risks in investors' portfolios¹. In turn, institutional investors are under pressure to align their strategies with a maximum global temperature increase of 1.5oC as targeted by the Paris Agreement, raising questions about how to do so while respecting other investment constraints.

Companies in carbon-intensive sectors are increasingly facing challenges due to lower demand for fossil fuel or their carbon-intensive products. Extreme weather events are damaging companies' assets and operations in high-risk regions (and those regions are growing). In addition, regulators and civil society are pushing investors to act. In 2017, the Task Force on Climate-related Financial Disclosure (TCFD) released its recommendations to companies and investors, stressing the need for climate scenarios. In July 2020, the EU Commission proposed regulations² to set minimum standards that indexes must meet to be labelled as EU Climate Transition Benchmarks (CTB) and EU Paris-Aligned Benchmarks (PAB)³.

Some investors have already started this climate-change investment journey by adopting low-carbon strategies that have enabled them to reduce their exposure to carbon stranded-asset risks. Others have addressed transition risks more broadly by shifting capital from "brown" to "green" assets. How can climate indexes fit into this fast-evolving picture? Whether they are used as a benchmark for active managers or the basis of investment products, climate indexes may need to extend beyond solely addressing stranded-asset risk and instead be efficient and comprehensive in how they reduce climate risk and reweight in favor of companies whose activities or operations support economic transition or a positive impact on the environment.

To reflect this shift, we have launched the MSCI Climate Paris Aligned Index, which is consistent with this holistic view of climate change risks and opportunities. The index is aligned with TCFD recommendations, substantially reduces the index carbon footprint (including Scope 3 product and supply-chain emissions), elevates the weights of companies with substantiated reduction targets and reduces physical climate risk exposure (based on the MSCI Climate Value-at-Risk (Climate VaR) model). Finally, the index will reduce its carbon footprint by 10% year-on-year ("self-decarbonization")⁴.

How Can Climate Index Objectives Reflect Investor Needs?

How Can investors Assess the Temperature Alignment of a Decarbonizing Investment Strategy?

What does portfolio alignment mean if there is a plan to decarbonize an investment strategy over time? The MSCI Global Warming Potential aims to answer this questions by measuring how a given portfolio (or company) contributes to a projected global temperature rise above the pre-industrial average using company climate targets, scope 1, 2 and 3 emissions and estimates of current and future green revenues as inputs into climate pathways. Understanding the calculated warming potential of a broad and diversified portfolio is not easy as relatively few companies have sufficiently ambitious and credible targets and hence few are currently aligned with 1.5°C (based on the MSCI Global Warming Potential framework).

We illustrate how to assess alignment in the presence of decarbonization using the MSCI Climate Paris Aligned Index. The index's core exclusions and reweighting may be useful for indexed investors to support their active ownership but, like the physical risk reduction, are insufficient in themselves to achieve a 1.5°C warming potential. The key element is self-decarbonization. MSCI ESG Research has tested a range of company-level self-decarbonization rates between 5% and 15%, which is the range of global carbon emissions reduction required year on year to be net zero between 2050 and 2100⁵.

Ignoring self-decarbonization, the basic warming potential calculation says, for example, that the MSCI World Climate Paris Aligned Index has a temperature of 2.9°C, as shown in the exhibit below. We cannot easily embed the decarbonization in the warming potential model directly, but — as a shorthand — if we suppose every stock decarbonizes at the index methodology rate, then the current index is indeed 1.5°C aligned. By applying a 10% self-decarbonization shock through 2030, we have achieved a consistent picture: a warming potential of 1.5°C for the MSCI World Climate Paris Aligned Index alongside a positive 1.5°C Climate VaR. If some companies fall short of such upgraded targets and lag this climate pathway over the next 10 years, the index may naturally become more concentrated around the climate solutions companies.

Self-Decarbonization Drives Index Temperature Alignment

As investors adapt their climate-aware investment strategies to cope with the physical, social and economic challenges of climate change, a holistic approach that embeds forward-looking measures of climate risk and return may help on their journey to decarbonizing their portfolios. The MSCI Climate Paris Aligned Index is a complementary tool for such institutional investors as a benchmark and as the basis of indexed allocations.