Benchmarks are highlighted in the CFA Institute paper, Net Zero in the Balance: A guide to transformational thinking as among the historical norms in finance practice that make investing in climate challenging. MSCI Institute’s Linda-Eling Lee talks to Top1000funds.com about the complexities and evolution of climate benchmarks including the use of balanced scorecard-toolkits that are improving the technology.
Benchmarks, incentives and time frames are highlighted in the CFA Institute paper, Net Zero in the Balance: A guide to transformational thinking as among the historical norms in finance practice that make investing in climate challenging.
The paper stresses the importance of mindset shifts and transformative thinking, highlighting some strategies for success, such as balanced scorecards, total portfolio thinking, universal ownership and stewardship.
In the five years to April 2023, investment in net-zero benchmarks increased from $10 billion to $100 billion, reflecting the growing alignment of investor portfolios to climate goals. This was driven in large part by the European Commission, which had set out the criteria for an official EU Paris-aligned benchmark focusing on emissions reductions. But one unintended consequence of that structure for investors was the potential for portfolios to reduce emissions on paper, while having no impact in the real world.
Linda-Eling Lee, founding director and head of the MSCI Sustainability Institute, says this remains a concern for investors, and the challenges of benchmarks and portfolio construction related to climate goals is not about performance or risk, but an ongoing determination to align portfolios to real-world outcomes.
“It’s not that hard to decarbonise your portfolio but it is difficult to see how that reflects the real economy around that,” Lee says.
“This has been a preoccupation and challenge everyone is trying to work through.”
To this end, last year MSCI developed an attribution tool and a framework to allow investors to better understand the changes in a portfolio’s carbon footprint and what was due to a company’s real world decarbonisation efforts, a portfolio manager’s investment decisions, or changes in the company’s financing.
Challenges of benchmarks
To comply with the EU focus on emissions reduction, benchmarks tend to overweight sectors such as communications, technology and healthcare, which are less material in the real world to reducing climate change. The simplicity of this approach overlooks the potential for high-emitting companies to deploy capital to low-carbon solutions, and the potential for investors to influence that transition through stewardship.
But Lee says benchmarks should be considered a tool, not a constraint.
There has already been “quite a lot of progress” in incorporating toolkits and balanced scorecard-type measures in benchmarks, she says, shifting the focus away from backward-looking data. One example is MSCI’s Climate Action Index series, which uses a balanced-scorecard approach.
“Climate benchmarks do prioritise forward-looking measures…and are about balancing the different objectives,” Lee says in an interview with Top1000funds.com.
“A lot of asset owners are moving towards variations of benchmarks and reflect quite different priorities.”
Some of this progress is related to the evolution of climate investing, from being focused on reduced emissions to a focus on transition finance.
“If you look at the newer transition-related benchmarks they use a balanced scorecard-toolkit way of looking at constructing the benchmark,” Lee says.
“In the conversations we are having, asset owners have been quite open to changes in benchmarks that incorporate these aspects. Like any technology, it will continue to get better.”
In addition, some level of standardised best practice, and groups like IIGC working with the industry on the principles of a climate or net zero aligned benchmarks, act as building blocks for index providers who can then customise to reflect different objectives and preferences of investors.
Beyond Europe
Europe’s leadership on climate investing is evidenced by the level of engagement from investors and the fact European companies are decarbonising quicker than those in other jurisdictions. MSCI data shows that 14 per cent of EU-domiciled companies are aligned to a net-zero pathway, compared with just 3 per cent outside the EU.
But Lee points out that Europe is only a small sub-set of the global conversation and, if alignment between the portfolio and the real world is the aspiration, investors also need to focus on where the decarbonisation needs to happen.
More than three quarters of the global coal-power generation capacity is in Asia Pacific, a region that also has less disclosure of transition plans by listed companies.
More than 90 per cent of large, listed companies in developed markets have disclosed their Scope 1 and 2 emissions, compared with 65 per cent in emerging markets. And about half of smaller listed companies have done the same. Transition capital flows to companies with better plans – typically, large companies in developed markets.
Lee says that both policy and capital needs to be focused on decarbonising the most impactful assets, and this will require an open mind and thinking beyond the norm – something that systems thinking can also provide, according to Roger Urwin, author of the CFA Institute report. Urwin says the features of climate risk present challenges to investors that their imaginations and toolkits have not previously tackled.
In part the problem lies in climate-focused capital chasing a dwindling number of fast-decarbonising companies, but these companies represent a smaller fraction of global greenhouse gas emissions. For example, an investment strategy designed to track a Paris-aligned benchmark must, by EU regulation, reduce average emissions by at least 7 per cent annually. This means only about one-third of the original investment universe of global companies are eligible to be included in such a strategy. And split by region, only 28 per cent of emerging markets companies are eligible compared to 62 per cent of companies in Europe.
“I worry about the movement towards more disclosure and more resourcing for disclosure,” Lee says.
“You will always have larger companies in developed markets benefit from that, and that gap is growing.”
The data challenge
The quality and volume of data has always been a concern for investors when it comes to climate. But investors need to understand that the data challenge is perennial, according to MSCI’s Lee.
“There has to be a recognition, and an embrace, of the fact that you will never get all the data you want. There is no data nirvana,” she says.
And while the amount and quality of information has improved, it is not keeping up with the demand for even more forward-looking data. The answer to that, Lee says, is for investors to look beyond company disclosures.
“I feel like in the beginning investors were asking companies for disclosure because it was a sign of transparency, but that assumes companies had the information and didn’t want to disclosure it,” she says.
“I feel like we have reached the limit of that.”
The second wave has been investors asking companies for information and data as a means, rather than the end of disclosure. This is a way of getting companies to think about their transition plans and how they can actually implement them.
“This works because it gets companies to do things that they would not normally do,” she says.
“But the disclosure itself is not that useful because it is not comparable.
“There is so much more technology and data about companies now, we can get things like asset locations and map them to different hazards or biodiversity risks. And we have the ability to model companies on emissions or water and project that forward, and this is what investors really need.
“There is a noise aspect to this data, but investors need to embrace that.”
The MSCI Sustainability Institute, which Lee founded about a year ago is driving better connections between capital market providers, academics, companies, and policy makers to help solve investors’ problems, including the need for more dynamic and more forward-looking data.
One clear initiative by the institute is bringing academics closer to the concerns of investors and focusing on the future, not on the past.
“We are trying to help them understand the real questions investors have today so academics can work on those that are relevant,” Lee says.
“Pricing and mispricing will evolve over time, and we have little information on that today.”
In helping academics solve these problems MSCI has given 300 academics licences to use all of its climate data. And just last month it launched the world’s first climate finance e-journal on SSRN, to be co-edited by Peter Tufano, Baker Foundation Professor at Harvard Business School, senior advisor to the Harvard Salata Institute for Climate and Sustainability and former Dean of the Said Business School at Oxford University.
