Index investing and encouraging real-economy decarbonisation

Combatting climate change and its associated risks is likely to require trillions of dollars of investment, known as transition finance. This can take many forms, including both public and private funding, across asset classes and investment strategies. A new consultation paper from the Glasgow Financial Alliance for Net Zero (GFANZ) looks at how index investing can support the energy transition. LGIM, with our acknowledged expertise in index investing and investment stewardship on climate risks, co-leads the workstream that produced the paper, Index Guidance to Support Real-Economy Decarbonization.[1] We helped launch it at a roundtable during the October PRI in Person conference

GFANZ identifies four key transition finance strategies. Climate solutions is one, where companies or projects are identified with products or services that are likely to lead to lower greenhouse gas (GHG) emissions than would otherwise be the case. An example might be battery technology. Other strategies support companies or activities which are assessed as aligning or aligned with a pathway towards net zero; such companies might have net zero commitments, targets, and credible transition plans. A fourth strategy is called 'managed phaseout' whereby companies receive funding that will accelerate the winding down of high emitting activities, such as coal-fired power generation. Some potential investments may not fit into these categories but will be close to aligning and therefore regarded as being 'in development'. A key characteristic is that from the perspective of the financing institution or investor, transition financing may result in an increase in reported emissions initially, because it is often targeted at high emitting activities.

'Transition-informed' index investing can often focus on the carbon emissions intensity of a portfolio (or index) rather than the transition status of the individual holdings. Paris Aligned Benchmark (PAB) and Climate Transition Benchmark (CTB) funds are good examples. They begin with a much lower portfolio carbon emissions intensity than comparable unconstrained flagship benchmarks and reduce emissions intensity from there, towards net zero. This can be achieved via different combinations and weightings of holdings. These are appropriate strategies for some investors. For other investors, the focus on emissions intensity at the overall portfolio level emphasises historic emissions over specific companies’ decarbonisation on a forward-looking basis. Also, the GFANZ paper notes that in some cases such strategies may experience tracking error compared to flagship indices  

The GFANZ paper makes the case for an index investing approach focused on individual companies or issuers and the extent to which they are net zero aligned, informed by benchmark principles outlined by the Net Zero Asset Owners Alliance and the Institutional Investors Group on Climate Change. Holdings can be classified along the lines of the GFANZ transition financing strategy definitions (particularly aligning and aligned). In addition, companies may be regarded as being 'in development', where, for example, perhaps an overall commitment to align with net zero by 2050 has been made, or they could have the 'potential' to be aligned given their current emissions reporting or performance.

In the consultation paper we suggest that 'transition-potential' indices could help encourage real-economy decarbonisation. These indices would include companies in the relevant market (or equivalent flagship benchmark) that are categorised as potential, in development, aligning, aligned, or which are already operating with net zero emissions. 'Transition-aligned' indices would be similar but not include companies with only 'potential' to be net zero aligned. The time-bound nature of any category is important; a company could not remain classified as 'potential' indefinitely, for example. A third type of index would include only companies that were already at net zero.

Index rules would operate so that over time changes in weightings would increase the proportion of the index containing companies that were aligning, aligned, and at net zero. Fixed income index funds could also set limit on the maturity dates of individual bond issues included, and/or balance maturity exposure, linked to the extent of net zero alignment. For example, a fund might hold 15-year bonds from an issuer that was clearly aligning or aligned, but only shorter maturity bonds from issuers that were classified as 'potential' or 'in development'.

Engagement would focus on encouraging companies to adapt fast enough to ensure they remained in the index as the weightings shifted more towards aligned companies, or to ensure their longer-term bonds qualified for inclusion in a fixed income index. The interaction with index rules would mean that engagement was time-bound; change would be expected by a certain time. Engagement tools include voting at the general meetings of equity holdings. Fixed income index funds can provide different engagement channels, for example, through exposure to the primary bond market (i.e., new issues of debt). Engagement with policy-makers and regulators is also important, to make the case for more action to help enable a transition to net zero.

There are challenges, which the paper identifies and asks questions about. Determining in which transition finance category a company belongs is a matter of judgement but for index investing the definitions need to be distilled into rules driven by clear metrics which can be applied across the global investment universe. The type and availability of data are important. Demand for such strategies will be driven by the extent to which they meet investors' investment objectives.

The publication of the GFANZ consultation paper on index investing is an exciting development. It is also an example of how LGIM is helping lead thinking on index investing, investment stewardship, and mitigation of systemic climate change risks.

There is now a consultation period until 9 January 2025 – we are looking forward to sharing our thinking and hearing reactions and contributions from asset owners and others.

[1] Our fellow co-leads are SGX Group and PKA.