Indexology^® Blog

After the launch of S&P GSCI Global Voluntary Carbon Liquidity Weighted, the first-to-market benchmark that seeks to track the current performance of global voluntary carbon futures markets, we thought it would be wise to go into further detail regarding the two main types of carbon commodity markets. These two markets are similar in that the most basic underlying component is one ton of carbon dioxide equivalent, but diving deeper, these two markets are strikingly different. The first significant difference is the price performance and history (see Exhibit 1). The much more established compliance markets have a number of years of available history, while the voluntary carbon markets are some of the newest commodity markets, with some contracts having only one year or less of trading history.

The carbon futures markets offer new alternative investment vehicles with robust potential interest across many different market participants. Physical carbon spot markets allow for direct carbon offsetting, while the development of futures markets encourages financial market participants to enter, increasing liquidity. Within the compliance carbon markets space, the Intercontinental Exchange (ICE) has been at the forefront, while the CME has led the charge in voluntary carbon markets. Recent news of exchanges, particularly in Asia, looking to enter or expand offerings in the carbon markets will likely enhance these new commodities’ price discovery and liquidity. Hong Kong Exchanges and Clearing (HKEX) was the latest to target voluntary carbon market trading, while Singapore Exchange backed a new carbon-focused trading venue.

What exactly are the differences between the two main types of carbon markets? Voluntary carbon markets differ from government-mandated compliance markets in several ways. Exhibit 2 breaks down the differences between both types of carbon markets. One main takeaway is that voluntary carbon markets are not fungible or interchangeable. Every individual project underlying the offset is unique, requiring the verification and validation mechanism. Compliance markets, which are much more established, simply permit an entity to emit 1 ton of CO2 equivalent and tend to be geographically based.

Carbon markets are a crucial piece of the energy transition puzzle needed to lessen the global economy’s reliance on fossil fuels to combat climate change. Many corporations and governments are stepping up to the challenge and reiterating their support for this colossal global effort to lessen the future catastrophic effects of climate change. The world will likely rely on carbon markets for efficiency and transparency in order to save the planet. These carbon markets are nascent and will surely grow as the world evolves. S&P Dow Jones Indices will be there to offer indices like the recent S&P GSCI Global Voluntary Carbon Liquidity Weighted to ensure benchmarks are available and designed to evolve as the market evolves. With the ability to add futures contracts from new exchanges and new offerings from current exchange partners, SPDJI is uniquely positioned to be the world leader in carbon markets. For more information, visit our Commodities Investment Theme Page and check out our sister company’s, S&P Global Commodity Insights, Energy Transition Resources.

Following a stellar Q1 in which the S&P Latin America BMI jumped 25%, the regional equity market fell back to Earth as second-quarter losses more than offset first-quarter gains. However, the region remained a relatively bright spot compared to global equities more broadly, as the S&P Latin America BMI was only down 3.5% YTD compared losses of around 20% YTD for the S&P 500 and S&P Global BMI.

Global inflation concerns, rising interest rates in the U.S., the Russia-Ukraine war and political uncertainty with new governments in Chile, Peru and, most recently, Colombia have finally caught up with the region. In addition, Brazil, the largest market in Latin America, will be holding presidential elections this year, contributing to further uncertainty.

From a country perspective, Chile had the best returns in Q2, with the flagship S&P IPSA gaining nearly 0.30% in CLP. The broader Chilean index, the S&P/CLX IGPA, did better with a 3.1% return for the same period. All other markets, in local currency, had negative returns for Q2 (see Exhibit 1).

No sector was unscathed in Q2. It is interesting to note that while Health Care (-42.1%), Consumer Discretionary (-40.0%) and I.T. (-39.1%) were the worst performers, they were not necessarily the main contributors to the quarterly losses. Exhibit 2 shows that it’s more likely that sectors with large representation in the region, such as Financials, Materials and even Consumer Staples, which were down 25.3%, 21.0% and 13.8%, respectively, had the most significant impact on the downturn of the equity market.

Similarly, most of the losses were driven by Brazilian and Mexican companies, which together represent about 88% of the S&P Latin America BMI. Exhibit 3 shows how the top 10 index constituents accounted for nearly one-third of the Q2 index decline. Brazilian companies Vale S.A., B3 S.A. and Itau Unibanco had the most significant impact on the index.

Though it is perhaps not surprising that the markets have taken a turn for the worse given the local political turmoil, rising inflation, the Russia-Ukraine war and the lingering effects of COVID-19, it is still disappointing to see the markets drop this sharply. While there is no telling where the bottom may be, volatility is likely to continue. Let’s hope the next turn will be an upswing.

For more information on how Latin American benchmarks performed in Q2 2022, read the latest Latin America Scorecard.

As financial conditions have tightened materially since the start of the year and pressure is mounting on the U.S. equity market, it is worth circling back to see how the “wisdom of the crowd” has held up. Specifically, does a sentiment indicator derived from Tweets on Twitter hold as an informative investable factor? It’s been over eight months since we launched the S&P 500^® Twitter Sentiment Index Series in November 2021. Since market conditions changed significantly following the launch, let’s take a look at how the indices have been performing.

Previously, using back-tested results, data showed the sentiment factor helped provide better annualized performance when markets turned down compared to the indices’ underlying benchmarks: the S&P 500 and S&P 500 Equal Weight Index.

When reviewing the performance data for the first two quarters of 2022, we see that U.S. equity markets have experienced a significant downturn, with the S&P 500 dropping 19.96% and the S&P 500 Equal Weight Index dropping 16.68%. During the same period, we have seen that Sentiment acted as a cushion, with the S&P 500 Twitter Sentiment Index dropping only 18.78% and the S&P 500 Twitter Sentiment Select Equal Weight Index dropping only 14.94%—ultimately offering some downside protection relative to their benchmarks.

Even though both indices showcased this outperformance, we saw it more readily in the S&P 500 Twitter Sentiment Select Equal Weight Index, which outperformed its benchmark by 174 bps over the first half of 2022. This index is more sentiment concentrated—it reflects the 50 most positively talked about companies on Twitter from the S&P 500 and is equal weighted, versus a market cap weighting of 200 stocks in the S&P 500 Twitter Sentiment Index.

Essentially what the indices have demonstrated is that in a downturn, the wisdom of the crowd seems to have held.

Since January 2021, the conversation about stocks and indices on Twitter has grown by 52% and the number of users Tweeting about stocks and indices on Twitter has increased by 30%.¹

“The finance community on Twitter continues to grow, featuring robust real-time discussion among a wide range of professional and individual investors. The S&P 500 Twitter Sentiment Index helps quantify the value of those conversations and gives people on Twitter an exciting way to measure the impact of their Tweets about publicly traded companies,” said Jared Podnos, Head of Strategic Market Development for Twitter’s Developer Platform.

An increased Tweet and user volume as a base for our indices, combined with a challenging two quarters for the U.S. equity market, provided a good test period for the S&P 500 Twitter Sentiment Indices, and they have managed to come out on top.

¹ Source: Twitter Internal Data. Stocks and Indices Conversation Dec. 31, 2021-June 23, 2022. Global. PT, ES, DE, JA, TR, EN, HI, AR language only.

DISCLAIMER

S&P® and S&P 500® are registered trademarks of Standard & Poor’s Financial Services LLC. Twitter® is a registered trademark of Twitter, Inc. These marks have been licensed for use by S&P Dow Jones Indices (S&P DJI) for use with the S&P Twitter Sentiment Index Series. The Indices are meant for informational purposes only and are not recommendations to buy or sell any securities. Any investment entails a risk of loss. Please consult your financial advisor before investing. S&P DJI and Twitter receive fees in connection with licensing and use of the S&P Twitter Indices.

The widespread global adoption of ESG and climate indices has created an accompanying need for better understanding regarding the performance impact of the various choices made in their design. As introduced in S&P DJI’s new Climate & ESG Index Dashboard, a Brinson-like “carbon attribution” teases out one particularly important source of returns.

Untangling the exact impact of individual goals on ESG and climate index returns can be a challenge, as sophisticated indices can incorporate a range of objectives. For example, the S&P PACT^TM Indices (S&P Paris-Aligned & Climate Indices) includes explicit carbon-reduction targets, temperature alignment goals and climate objectives such as mitigation and adaption, while an optimization process is used to target these multiple objectives simultaneously.¹ This can make the individual contributions hard to unpack.²

Conveniently, the impact of weighting to higher- or lower-carbon-emitting stocks may be assessed analogously to the way sector or country effects are measured by a Brinson attribution.³ To do so, first, we rank each benchmark security according to their weighted average carbon intensity (WACI),⁴ and then slice up the underlying benchmark universe into five quintile portfolios, from highest to lowest, each with an equal number of benchmark constituents. Then, for any index based on the same benchmark universe, we can simply apply the standard Brinson methodology (using the performance of our hypothetical carbon portfolios instead of the traditional sector or country portfolios) to measure the allocation effects of over- or underweighting each carbon quintile.

The S&P 500^®-based S&P 500 Net Zero 2050 Paris-Aligned ESG Index offers a case study. Exhibit 1 shows the weights of the index and its underlying benchmark, as well as the active weight of the index, in each S&P 500 carbon quintile as of June 30, 2022.

The results of the subsequent return attribution by carbon quintile portfolio—as measured over the prior three months—are shown in Exhibit 2.

Together, Exhibits 1 and 2 measure the extent and impact of carbon-based weights over the period: the High Carbon Quintile 1 outperformed the S&P 500 by 6.1% (see Exhibit 2), and the S&P 500 Net Zero 2050 Paris Aligned ESG Index underweighted this carbon quintile by -6.9% (see Exhibit 1), which detracted from the relative index performance. Conversely, the overweight in the Low Carbon Quintile 5 contributed positively to the relative index performance.

Repeating and cumulating such analysis over multiple periods offers a longer-term perspective, as shown in Exhibit 3 for the five-year period ending in June 2022. Over this longer-term period, an underweight in the High Carbon Quintile 1, and an overweight in the second-least carbon intensive quintile, contributed the most to the index’s overall outperformance.

By quantifying the links between index design choices and index performance, a carbon-based attribution analysis such as that in Exhibit 3 can offer insight and perspective that may prove useful in assessing the merits of one index over another. Investors seeking similar attributions for a range of our flagship indices are now able to find them in S&P DJI’s newly launched Climate & ESG Index Dashboard.

Register here to receive quarterly insights and performance attributions for our range of flagship ESG and climate indices.

¹ For more details, see the full index methodology, available at www.spglobal.com/spdji/en/documents/methodologies/methodology-sp-paris-aligned-climate-transition-pact-indices.pdf

² www.ssga.com/content/dam/ssmp/library-content/pdfs/insights/reducing-carbon-in-equity-portfolios.pdf

³ https://jpm.pm-research.com/content/11/3/73; https://www.jstor.org/stable/4478947

⁴ https://www.spglobal.com/spdji/en/documents/additional-material/faq-sp-paris-aligned-climate-transition-indices.pdf

With the first half of 2022 in the books, commentators have noted that this year’s -20.0% total return for the S&P 500® is the worst January-June result in more than 50 years. Painful as the first six months were, what might they tell us about the rest of the year?
History gives us both bad news and good news. Bad news first: the correlation between the past six months’ return and the next six months’ return is vanishingly small. Predictions are problematic. Exhibit 1 illustrates this for the S&P 500; results for the S&P MidCap 400® and S&P SmallCap 600® are comparable. (The data here encompass not just the first six months of the year, but every six-month period from 1995 onward.)

In general, knowing how well or poorly an index did in the past six months tells you nothing about how well or poorly it will do over the next six months.

But…with a little legerdemain, we can tease out some good news as well. The fact that returns have been above average, or below average, does not help us forecast what returns will be going forward. This means that regardless of what has already happened, the next six months’ return is best regarded as a random draw from the same distribution that generated the last six months’ return.

We can use this insight by sorting the data points in Exhibit 1 into deciles based on the last six months’ performance. Within each decile, we can measure the average monthly performance in the last six months and the next six months. The difference between the next six months and the last six months represents the improvement (or worsening) of performance by decile and is graphed in Exhibit 2.

On one level, Exhibit 2 is just a demonstration of mean reversion in action. But it also has a practical implication: if historical returns have been especially good, future returns are likely to be worse, and if historical returns have been especially bad, future returns are likely to be better. At the end of June 2022, historical results across the capitalization range were indeed especially bad, as Exhibit 3 illustrates.

There are no guarantees, but history tells us that when returns are as bad as the first half of 2022’s have been, improvement has been much more frequent than continued decline. When returns have been especially bad, patience tends to be especially valuable.