Are You a Climate Investor or Growth Investor?

Key Points

  • Low carbon equity benchmarks developed by European regulators may maintain unintended factor exposures and characteristics investors should consider when choosing climate reduction strategies.

  • Our analysis shows that these benchmarks, especially Paris Aligned Benchmark (PAB) strategies, carry a growth tilt that make them vulnerable to changes in market sentiment and drawdowns in value markets.

  • The RAFI Multi-Factor Climate Transition Developed Index, which integrates carbon intensity reduction with a balanced multi-factor approach, offers investors an alternative to style-tilted low carbon benchmarks with a potential for outperformance across a greater range of conditions.

Ari Polychronopoulos is the corresponding author.

First-generation low carbon equity benchmark indices were developed almost a decade ago with the goals of mitigating climate risk and preparing for the transition to a low carbon economy. These indices aimed to simply have lower carbon intensity than the market within a given tracking error. As interest and adoption of low carbon benchmarks increased, so did the proliferation of new approaches with varying objectives related to climate measures.

In an effort to mobilize investment toward sustainable goals in a consistent manner, the European Commission published its Sustainable Action Plan in May 2018, which integrated sustainability risks, opportunities and targets into a regulatory framework. The Action Plan had several key initiatives with one being the development of low carbon investment benchmarks. To help assist in these initiatives, the Commission created the EU Technical Expert Group (TEG) on Sustainable Finance with representatives across financial services and academia.