Not all sustainable ETFs are created equal. Zeb Saeed, senior product specialist at DWS Group, examines how passive approaches can assist investors in their net zero transition.
A warning that climate change could cut global gross domestic product (GDP) by $23 trillion by 2050 is a stark reminder of the importance for organisations to remain on the path to net zero.
The alarm bell, rung by insurance behemoth Swiss Re in a report published last year entitled, ‘The economics of climate change: no action not an option,’ would result in world economic value dropping by around 10%.
While the potential consequences of failing to adopt carbon-friendly practices have been recognised for some time, this latest research shines a further light on the speed at which action is necessary.
As the report notes, a collaborative approach is required, with different nations and industries all doing their bit.
It states: “The impacts of climate change can be lessened if decisive action is taken to meet the targets set out in the Paris Agreement. This will require more than what is pledged today, with both the public and private sectors working together to accelerate the transition to net zero.”
The investment sector has a vital role to play. Growing numbers of consumers are seeking to invest their money in solutions which place the planet’s future front and centre, with this demand being met to some degree by a proliferation of ESG-focused products.
Despite its rapid rise to prominence, however, the concept of sustainable investing remains in relative infancy compared to the more traditional approaches. This means product manufacturers must continue to find ways of considering climate impact within investment portfolios.
Room for improvement
Investment solutions that focus on decarbonisation have come on in leaps and bounds in recent years, yet there is room for improvement. As we are beginning to learn, tackling climate change is far from a one-dimensional pursuit. There are many factors, from regulatory reporting to stewardship, that determine whether a company is making positive change.
In addition, with growing awareness around greenwashing, investors are starting to pay closer attention to what’s underneath the bonnet of solutions which claim to be ESG-friendly. They are no longer taking sustainability claims at face value.
The upshot is product manufacturers have a significant responsibility to make sure the companies within sustainable funds and indices are genuinely making a difference rather than just claiming to.
The ETF market is no exception. Here we look at the current market, identify some of the problems and suggest what needs to change.
The 2015 Paris Agreement is central to the sustainable investing landscape, forming the basis for the Paris-aligned benchmarks, established in May 2019. Across Europe, around 75 funds and share classes are aligned with climate-focused benchmarks, with these solutions administering around €10 billion in assets, according to Bloomberg Data at the end of 2021.
Before going any further, it makes sense to take a whistle-stop tour of the benchmark’s aims. Amongst other things, Paris aligned benchmarks must satisfy three key metrics:
- A 50% reduction in carbon intensity relative to the investable universe.
- A minimum 7% year-on-year reduction in carbon intensity.
- Screen out companies involved in certain controversial business activities, including those concerning fossil fuels.
Although these Paris-aligned benchmarks have ushered in many positives, there are drawbacks.
Most notably, they do not explicitly cater for engagement to materially help push those companies key to the net-zero transition to a green pathway.
Other problems exist, and after analysing the market and speaking to our clients, we found one overarching concern – many existing indices are largely powered by complex, risk-based optimisation engines. This is a problem because the index or manager is afforded little to no control over how individual stocks are weighted, running the risk of large allocations or overweights ending up in controversial names.
Practical recommendations by climate initiatives such as the Institutional Investors Group on Climate Change (IIGCC), which we will come onto shortly, aim to address some of these drawbacks.
Developing the framework
As well as the Paris-aligned benchmarks, other initiatives are proving important. The IIGCC, which describes itself as “the European membership body for investor collaboration on climate change and the voice of investors taking action for a prosperous, low-carbon future”, has proposed a net-zero framework for investors to follow.
The framework contains two core objectives. First, to decarbonise investment portfolios in a way consistent with achieving global net-zero greenhouse gas (GHG) emissions by 2050. And second, to increase investment in the range of ‘climate solutions’ needed to meet that goal.
Although firms are afforded some discretion over how these objectives are met, the IIGCC’s framework offers some clear expectations, including criteria at asset class level. For passive investments, this most notably recommends avoiding an approach focused on excluding carbon-intensive companies. In contrast, the key is for managers to take a positive approach, with a clear strategy on engaging with companies and using votes to help them improve, and the use of selective divestment for those companies with no credible pathway to net zero that are resistant to engagement.
This is crucial for investors to consider. Not all investment solutions aligning to the Paris benchmarks are making the same difference. We feel it is crucial to invest in companies taking active steps to tackle climate change and not just paying lip service to it.
Changing the landscape
We wanted to develop a sustainable investment solution where the index has some form of control over the weighting of individual stocks, rather than simply having an overall objective of meeting the Paris-aligned benchmark requirements.
The key aspect of our Xtrackers Net Zero Pathway Paris Aligned ETFs is that they adopt a tilting approach prior to optimising for the Paris-aligned benchmark requirements, offering underlying companies an incentive to take steps towards net zero. To do this, our solution seeks to overweight companies with strong net-zero key performance indicators, as recommended by IIGCC in its framework, and removes those with the worst performance. The indices focus on three key climate-related metrics: green revenue shares, climate disclosure standards and the adoption of science-based targets, all areas that can be improved through successful engagement and voting strategies.
Using the initial weights, a positive tilt based on the three key metrics is applied, increasing the company’s weighting as much as fourfold. This may well involve capturing and investing in companies making the biggest difference, be it those with the greenest revenues or hitting the highest standards of climate disclosure and most ambitious targets.
This marks a crucial step in moving towards an ETF landscape that invests in a Paris aligned approach which is engagement-friendly and consistent with the recommendations outlined by the IIGCC. With the move towards passive investing showing little sign of abating, we must continue to meet the changing needs of our clients. And as we are finding out, when it comes to sustainability, there is more at stake than purely short-term profit margins.
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