Tag: Paris-Aligned Climate Indices

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Sustainability Thematics

As the UK Targets Net Zero by 2050, the S&P UK PACT Indices Can Too

The UK set goals of reaching net zero targets by 2050; these targets include transitioning to cleaner power and a more sustainable future, securing 440,000 well-paid jobs, and protecting the British consumer from global fossil fuels price spikes.1

The UK equity market certainly has some work to do, given its high weight in carbon-intensive sectors, compared with the rest of Europe and the U.S.

Larger weights in highly intensive sectors are reflected in the high weighted average carbon intensity across sectors in the UK (see Exhibit 2). This tests the efficiency and flexibility of the S&P PACT™ Indices (S&P Paris-Aligned & Climate Transition Indices) methodology, as many stocks must be removed due to the strict fossil fuel exclusions required by the EU’s minimum standards for Paris-aligned benchmarks.2

While net zero alignment may be a key target, it isn’t the only climate or ESG concern. Climate change potentially exposes market participants to transition and physical risks, while broader ESG factors may be ethically desirable, financially material, or both. Many of these ESG factors are uncorrelated,3 so gaining exposure to one likely doesn’t provide exposure to the others without explicit control.

S&P DJI offers two approaches that seek to align with a targeted climate scenario, alongside other ESG objectives: 4

  1. S&P UK Net Zero 2050 Paris-Aligned ESG Index
  2. S&P UK Net Zero 2050 Climate Transition ESG Index

The S&P PACT Indices represent a sophisticated strategy, targeting a 1.5°C scenario/2050 net zero compatibility. Additionally, the indices aim to meet the EU minimum standards for Climate Transition benchmarks (CTBs) and EU Paris-aligned benchmarks (PABs) and the Task Force on Climate-related Financial Disclosures (TCFD) recommendations as efficiently as possible, allowing for broad, diverse indices.

Undesirable exposures are excluded, then remaining constituents are reweighted (see Exhibit 3). This reweighting, framed within the TCFD recommendations on climate-related financial risks and opportunities, allocates toward companies that are more compatible with a 1.5°C scenario, green-revenue driven, science-based target setters, and have high ESG scores, while reweighting away from those with high greenhouse gas (GHG) intensity, potential physical risk exposure, and fossil fuel reserves—while maintaining high climate impact exposure.

The S&P PACT Indices are designed to be 1.5°C scenario and 2050 net zero compatible by reducing GHG emissions intensity against the underlying index (30% for CTB-aligned indices and 50% for PAB-aligned indices) and subsequently decarbonizing by 7% year-on-year. Additionally, a forward-looking academic model-based measure assigns companies their fair share of the global 1.5°C carbon budget, while incorporating companies’ forward-looking decarbonization targets.

How have they performed historically? Both the Paris-aligned and climate transition index variants have shown an excess return over the underlying index (see Exhibit 4), with lower volatility (see Exhibit 5).

Interestingly, the S&P UK Net Zero 2050 Paris-Aligned ESG Index has had a statistically significant and economically meaningful small size exposure, unseen in the climate transition index (see Exhibit 6). This can likely be explained by the extra exclusions the Paris-aligned index makes, which led to the removal of five of the nine largest companies, accounting for over 15% of the index weight. The S&P UK Net Zero 2050 Climate Transition ESG Index’s factor exposures have been more in line with the benchmark.

Overall, the UK equity market has been characterized by highly carbon-intensive sector exposures, a test of the S&P PACT Index methodology’s efficiency. The S&P UK PACT Indices have been up to the task, offering benchmark-like characteristics while aligning with net zero by 2050, TCFD recommendations, and broad ESG objectives.

 

1 This net zero target and the impacts are stated by the UK government.

2 Regulation (EU) 2016/1011

3 Exploring S&P PACT Indices Weight Attribution (Leale-Green & Velado, 2019)

4 We offer two approaches within the U.K. Other regional variants are also live.

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Sustainability Thematics

S&P PACT Indices Sector Weight Explanation in Europe and the Eurozone

In April 2020, we launched the S&P PACTTM (Paris-Aligned Climate Transition) Indices. The indices aim to align with a 1.5oC climate scenario, the EU’s minimum standards for EU Climate Transition Benchmarks and EU Paris-Aligned Benchmarks, and the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), while maintaining a broad, diversified exposure. The S&P PACT Indices consist of the S&P Paris-Aligned (PA) Climate Indices and S&P Climate Transition (CT) Indices. The index methodology excludes certain companies (exclusion effect), then reweights remaining constituents (reweighting effect) based on their climate performance (see Exhibit 1), as discussed in a previous blog.

We published a paper explaining the weight attribution of constituents in the S&P PACT Indices, where we isolated the transition pathway, environmental score, physical risk, and level of high climate impact revenue as important weight drivers. In this blog, we assess how sector allocations (see Exhibit 2) are driven by the climate factors and exclusions listed above within the S&P Eurozone PACT and the S&P Europe PACT Indices.

The Energy sector was allocated zero weight in the S&P Eurozone LargeMidCap PA Climate Index and the S&P Europe LargeMidCap PA Climate Index, largely due to the methodology’s exclusion of companies that participate in oil operations. Meanwhile, Energy companies were eligible, but still underweighted in the S&P Eurozone LargeMidCap CT Index and S&P Europe LargeMidCap CT Index, as all companies were misaligned with their 1.5oC budget (see Exhibits 7 and 9). Within the S&P Eurozone LargeMidCap CT Index, one Energy company was overweighted. This company showed a strong environmental score, low physical risk, and was the closest to the 1.5oC compatibility goal of all the Energy stocks. Within the S&P Europe LargeMidCap CT Index, another Energy company was overweighted—this was the second-closest stock to the 1.5oC compatibility requirement.

Unlike the S&P Europe LargeMidCap CT Index, no Utilities companies were excluded from the S&P Eurozone LargeMidCap CT Index due to power generation revenues, but many were excluded for gas operations in both indices (see Exhibits 4 and 5). Among the S&P PACT Indices in Europe and the Eurozone, Utilities received an underweight within the PA strategy, but an overweight within the CT series, largely due to differences in exclusion requirements. Energy and Utilities are generally considered among the highest-emitting sectors. Some Utilities companies are on a trajectory in line with the 1.5oC regulation, resulting in a vast weight improvement relative to Energy companies within the CT indices.

Financials was overweighted within the S&P Europe and Eurozone LargeMidCap PA and CT Indices. This is due to Financials being the largest sector within these indices—it was not affected by exclusions, which accounted for 16.5% of excluded weight from other sectors. If this weight is added to each constituent on a pro-rated basis (in line with the index’s objective function), then Financials would receive an overweight by having no excluded companies (represented by the yellow bars in Exhibit 2). We see that Financials receives less weight than a simple redistribution of eligible weight would suggest, due to Financials having a lower climate impact (see charts on the right in Exhibits 2 and 3). This reflects a positive redistribution effect overall, with the climate factors negatively affecting the weight of Financials in the indices.

Consumer Staples was strongly overweighted in both the S&P Eurozone LargeMidCap PA and CT Indices. This is likely due to there being no exclusions for the sector, as those companies are closer to their 1.5oC budget (below 102 as seen in Exhibits 6 and 7) and have high climate impact revenues.

We will follow up with another blog on the S&P 500 PACT and S&P Developed PACT Indices.

Categories
Sustainability Thematics

What Drives the S&P PACT Indices’ Weights?

In April 2020, we launched the S&P PACTTM Indices (S&P Paris-Aligned & Climate Transition Indices). The indices aim to align with the following: a 1.5oC climate scenario, the relevant aspects of the EU Low Carbon Benchmark regulation (BMR), and recommendations from the Task Force on Climate-related Financial Disclosures (TCFD), while maintaining a broad, diversified exposure. The S&P PACT Indices consist of the S&P Paris-Aligned (PA) Climate Indices and S&P Climate Transition (CT) Indices.

In this blog, we try to answer a simple question: what drives the S&P PACT Indices’ weights?

First, companies are excluded (exclusion effect) due to business activities, public controversies,1 and a low alignment score with the principals of the UN Global Compact—these companies receive zero weight.

Second, companies that remain are reweighted (reweighting effect) to achieve climate-related objectives.2 Companies that perform well from a climate perspective receive an overweight, while those that perform poorly receive an underweight or zero weight, as shown in Exhibit 1.

The S&P CT Indices (i.e., the indices that align with the EU’s minimum standards for EU Climate Transition Benchmarks) have fewer exclusions than their PA counterparts (i.e., the indices that align with the EU’s minimum standards for EU Paris-Aligned Benchmarks), with fossil fuel-based exclusions being the difference. Oil operations are particularly impactful in excluding companies. The additional exclusions are evident in the excluded columns in Exhibit 2, where the S&P PA Indices show more of their market cap is excluded.

When reweighting eligible companies to meet the climate objectives, we observe (see Exhibit 3) company performance on four climate metrics to have the largest and most significant impact on the change of company weights, across regions:

  • S&P DJI Environmental Score;
  • 1.5oC alignment via the transition pathway dataset;
  • Physical risk score; and
  • High climate impact revenues.

So how can companies improve the climate metrics that have the largest influence on their S&P PACT Indices weight? Ineligible companies can reduce undesirable exposures (e.g., public controversies and UNGC misalignment [as measured by the Arabesque GC Score]). Eligible companies can gain increased weight in the S&P PACT Indices by significantly reducing carbon intensity year-on-year (to improve their 1.5oC alignment), disclosing more information regarding environmental policies and metrics (to improve their S&P DJI Environmental Score3), improving performance against environmental policies and metrics (to improve their S&P DJI Environmental Score), divesting assets in locations highly exposed to physical risks and reduce assets’ physical risk sensitivity factors (to improve their physical risk score).

For further detail, please see our paper on S&P PACT Indices weight attribution.

 

 

 

 

1 Public controversies are judged by the SAM, part of S&P Global, Media Stakeholder Analysis (MSA), which monitors ongoing controversies from companies.

2 Climate-related objectives include the 7% year-on-year decarbonization, carbon intensity reduction, 1.5oC alignment using the Trucost, part of S&P Global, transition pathway dataset, S&P DJI Environmental Score improvement, green-to-brown share control/improvement, physical risk mitigation, high climate impact revenue constraint, carbon disclosure overweight cap, Science-Based Target overweight, and fossil fuel reserve exposure control/reduction.

3 The environmental score is the environmental pillar from the S&P DJI ESG Scores.