ESG Club The role of exclusions
Fadi Zaher is head of index solutions and investment specialist at Legal & General Investment Management
STRIVING TO MAKE INDEX STRATEGIES NET-ZERO HEROES
Index strategies can offer clearly defined decarbonisation pathways that may help to avoid climate risks. We pull back the curtain on how they work.
Investors around the world are integrat- ing climate considerations into their port- folios in the hope of avoiding the worst- case scenarios for global warming. Many seek to do this via alignment to a net-zero trajectory, across a variety of investment styles and strategies. Reaching net-zero emissions by 2050 is considered the safest way to limit global temperature rises to 1.5-degrees above pre-industrial levels, avoiding some of the worst impacts of climate change.¹ As a result, many investors are looking to re- duce carbon emissions exposure within their index strategies. This process re- quires a decarbonisation pathway that could align to a 1.5-degree scenario. There are different avenues to deliver- ing a decarbonised index strategy with net-zero ambitions. Here, we focus on the exclusion and capital allocation methods, as well as a combination of the two.
The exclusion approach has been used to avoid having specific stocks or industries in an index. The most prominent exclu- sions have tended to cover companies involved in tobacco, alcohol, gambling, fossil fuels and controversial weapons. As the level of exclusions increases, how- ever, the adjusted index often strays from its parent benchmark, deviating from delivering a market-like, risk-return pro- file. The index may then incur unintended active risk as compared to its benchmark. There is a role for exclusions in a net-zero approach, for example, to remove compa- nies that are highly misaligned and have little likelihood of being willing or able to transition. But relying solely on an exclu- sionary approach to achieve net-zero port- folios may not always address the real- world decarbonisation requirements and may remove the possibility of the asset owner engaging with investee companies to change their behaviour and address specific sustainability risks.
Re-allocation of capital
A common decarbonisation pathway, based on recommendations from the Intergovernmental Panel on Climate Change (IPCC) and the EU Paris-aligned Benchmarks (PAB), is to reduce carbon emissions intensity by a fixed percentage relative to a parent benchmark. The chart below shows different decarbon- isation objectives that investors may choose from to embark on a net-zero pathway. Depending on the initial decarbonisation rate, the integration of the yearly carbon- reduction mechanism should bring con- vergence between the different portfolios by 2050.
The goal here is to re-allocate and adjust
Our research paper on decarbonisation strategies for indices explores this topic in more detail and can be accessed at
www.lgim.com. The above information does not constitute a recommendation to buy or sell any security.
Key risks: For illustrative purposes only. The above information does not constitute a recommendation to buy or sell any security. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested. Past performance is not a guide to the future. Views expressed are of LGIM as at 01 September 2022. The Information in this article (a) is for information purposes only and we are not soliciting any ac- tion based on it, and (b) is not a recommendation to buy or sell securities or pursue a particular investment strategy; and (c) is not investment, legal, regulatory or tax advice. Legal & General Investment Management Limited. Registered in England and Wales No. 02091894. Registered Office: One Coleman Street, London, EC2R 5AA. Authorised and regulated by the Financial Conduct Authority, No. 119272
38 | portfolio institutional | October 2022 | Issue 117
PI Partnership – Legal & General Investment Management
the exposure from high-carbon intensive to low-carbon intensive stocks, subject to various investment constraints which may include security or sector deviations from the parent benchmark. As a result, a decarbonised index may have different constituents and/or a different number of holdings than its parent benchmark.
Decarbonisation rates versus tracking error
It is possible to decarbonise a global index with a low tracking error; our analysis indicates that a 50% carbon intensity reduction may be achieved with around 15 basis points of tracking error. However, the tracking error rises sharply when the decarbonisation increases beyond 50%. The results may vary for specific regions and more concentrated indices.
Capital allocation and minimal exclusions In our view, effective decarbonisation of index portfolios could involve a combina- tion of minimal exclusion standards and greater re-allocation of capital between climate ‘winners’ and ‘laggards’. We expect to see continued demand from investors seeking to align portfolios with a net-zero pathway, who recognise that potential financial and climate risks are different across different regions and industry sectors.
1) Intergovernmental Panel on Climate Change: Special Report on Global Warming of 1.5°C (2018)
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