Unveiling the Opaque World: How Index Investors can Aid in Accelerating the Net Zero Transition
The Institutional Investors Group on Climate Change (IIGCC) has emphasised the growing importance of index investing in net zero asset allocation, but also highlighted several challenges in decarbonizing portfolios through this approach.
One of the key challenges lies in achieving real emissions reductions rather than merely shifting investments from higher-emitting to lower-emitting companies. The IIGCC notes that the approach should not be solely about exclusion, but require a robust approach combining engagement, sophisticated measurement, capital reallocation, and transparency to drive real emissions reductions aligned with climate goals.
To address these challenges, the IIGCC offers several solutions. One such solution involves engagement over divestment, prioritising active dialogue with companies to encourage meaningful emissions reductions, particularly in listed equities, rather than simply divesting from carbon-intensive firms.
Another solution is integrated risk management, using tools like carbon footprinting, assessing fossil fuel exposure, and challenging asset managers on physical and transition climate risks to both manage investment risk and support real-world decarbonization.
Selective capital allocation is another strategy, with investors being selective in their investment choices by reallocating capital towards companies making credible efforts to transition, guided by industry engagement and tools such as the Net Zero Investment Framework (NZIF) developed by IIGCC. The NZIF helps investors evaluate companies' targets in line with science-based net zero pathways and sector-specific decarbonization trajectories, allowing for more informed portfolio construction.
Adoption of standardized frameworks like the IIGCC’s NZIF to measure and manage weighted average carbon intensity (WACI) in portfolios is also crucial, as it helps monitor progress and guide investment towards impactful decarbonization.
Warren Buffet, the Berkshire Hathaway boss, is a proponent of index funds. In 2007, he challenged a hedge fund manager to a decade-long outperformance duel, investing in an index fund. For nine of the ten years that followed, Buffet's index fund outperformed the manager.
Currently, 44% of the world's long-term assets and 60% of Europe's climate funds are invested in index funds and ETFs. The appeal of climate indices includes their use as policy benchmarks, supporting the design of climate-linked financial products, and lower costs.
However, the IIGCC warns that the low-cost appeal of climate index strategies could come at a high price if critical challenges are left unattended, potentially shifting focus away from real-world emissions reduction. The IIGCC suggests working with index providers to increase visibility and refine index alignment with objectives such as coal phase outs in emerging economies.
Notable examples of index investing for climate objectives include Ilmarinen, Finland's largest provider of private pensions insurance, which switched to the MSCI climate action index as a performance benchmark in early 2023. Nearly €33bn of Ilmarinen's listed equity assets are benchmarked against the MSCI climate action index. Similarly, Phoenix Group, the UK's largest savings and retirement business, launched a 'climate aware' index series alongside FTSE Russell in June 2024.
The IIGCC also highlights the approach adopted by Japan's Government Pension Investment Fund (GPIF), which pays its managers a separate fee for engagement and has found that index fund engagement is associated with improved financial and climate performance by companies.
In conclusion, the IIGCC research stresses that decarbonization in index investing is not simply about exclusion but requires a robust approach combining engagement, sophisticated measurement, capital reallocation, and transparency to drive real emissions reductions aligned with climate goals.
- The IIGCC advocates for a robust approach that combines engagement, measurement, capital reallocation, and transparency in index investing to achieve real emissions reductions, aligning with climate goals.
- One strategic solution for decarbonizing portfolios through index investing is selective capital allocation, where investors reallocate capital towards companies making credible efforts to transition, guided by industry engagement and tools like the Net Zero Investment Framework (NZIF) developed by IIGCC.
- Notable examples of index investing for climate objectives include Ilmarinen, Finland's largest provider of private pensions insurance, which switched to the MSCI climate action index as a performance benchmark, and Phoenix Group, the UK's largest savings and retirement business, which launched a 'climate aware' index series alongside FTSE Russell.
