The world of sustainable investing, better known for incorporating environmental, social and governance (ESG) criteria into what was before mostly financially driven investment decision-making, seems to be here to stay. As ESG index investing continues to evolve, so does our suite of ESG indices—expanding both in terms of methodologies and regions covered. Australia is no exception. In a recent paper, we looked at how a hypothetical ESG index of indices could provide tangible ESG benefits while not deviating much from a hypothetical baseline index of indices. Let’s see how.
How Were the Baseline and ESG Indices of Indices Constructed?
We can think about these as a collection of indices, with the baseline comprised of traditional market-cap-weighted indices and the ESG one made up of their respective ESG counterparts. Weights were assigned based on the latest Australian asset allocation data.1 The underlying ESG indices include a broad-based Australian ESG index, international carbon control indices, a global ESG real estate index and a global net zero 2050 infrastructure index. Each of these ESG index series were created to serve different investment and ESG objectives.
A Closer Look at the Underlying Indices
Exhibit 2 highlights how all of the ESG index variants have historically closely tracked their benchmark indices2 (annual tracking error ranging from 1.0% to 2.6%), while Exhibit 3 reflects the relationship between ESG gains and level of tracking error.
Most ESG indices displayed both S&P DJI ESG Score improvement and carbon intensity reductions at the index level (see Exhibit 3). The S&P Carbon Control Indices led for carbon intensity reduction, followed by the Dow Jones Brookfield Global Infrastructure Net Zero 2050 Climate Transition ESG Index. This is in line with both the indices’ objectives—to minimize carbon intensity and be compatible with a 1.5°C scenario, respectively. As for S&P DJI ESG Score improvement,3 the winners were the S&P ASX 200 ESG Index and Dow Jones Global Select ESG RESI, which were designed to raise index sustainability performance measured by the S&P DJI ESG Scores and the GRESB Scores, respectively.
Combining Underlying Indices into Baseline and ESG Indices of Indices
The ESG index of indices shows reductions in carbon intensity and fossil fuel reserve emissions close to 50%, as well as enhancements in the S&P DJI ESG Score and its dimensional environmental, social and governance scores, relative to the baseline index of indices (see Exhibit 4). All these ESG gains were attained for a low level of tracking error (0.81% annualized; see Exhibit 5).
We highlighted how a collection of ESG-focused indices could reflect substantial ESG improvements, from lower carbon intensity and minimized fossil fuel reserve emissions to improved S&P DJI ESG Scores, as well as dimensional E, S and G score enhancements, while closely tracking the baseline collection of indices. The variety of underlying sustainable indices used reflects the diverse nature of investment and ESG needs. Combined into a holistic strategy, ESG indices could present an effective, sustainable alternative to traditional cap-weighted benchmarks, helping drive sustainable strategies forward.
1 Based on back-tested data for the period analyzed.
2 Sourced from the Australian Prudential Regulation Authority (APRA). Available here.
3 S&P DJI ESG Score improvement is calculated as the difference between index-level ESG score of the ESG index and its benchmark.The posts on this blog are opinions, not advice. Please read our Disclaimers.