A Far from Passive Approach to Paris-alignment

The distinction between active and passive investment strategies needs to be redefined for sustainable investments, argues Henrik Wold Nilsen, Senior Portfolio Manager at Storebrand.

The past decade has seen an increasing shift from active to passive investment strategies, which are viewed as a low cost, low governance option for investors.

This trend is also gaining traction in the sustainable space, as institutional investors look to replace broad market capitalisation indices with climate-led benchmarks in their passive portfolios. According to FTSE Russell’s 2024 sustainable investment survey, asset owners are now implementing sustainable investments more often through passive than active investment strategies for the first time.

As of 31 December 2023, US$856 billion in assets were benchmarked to MSCI ESG and climate indices, compared to MSCI ACWI Index’s US$76.4 trillion total.

However, the subjective, opaque and inconsistent metrics used in creating climate indices – due to the absence of a universally accepted method for assessing company or portfolio climate risk – has led Henrik Wold Nilsen, a Senior Portfolio Manager at Storebrand Asset Management, to conclude that the choice of a climate benchmark is very much an active decision.

He believes that the evolving nature of climate science, policy and data availability means that delivering a systematic portfolio aiming for alignment with the Paris Climate Agreement requires specialist expertise, oversight and accountability to appropriately manage emerging sources of risk.

A different approach

Wold Nilsen created Storebrand’s ESG Plus climate fund range strategy in 2016. The funds aim to track market cap indices, such as MSCI World, with alignment to the Paris Agreement by excluding fossil fuels and other environmentally-harmful sectors, allocating 12-15% of the portfolios to climate solutions companies, and optimising the remainder of the fund to reduce carbon intensity versus the benchmark, while keeping tracking error relatively low (1.0-1.5%).

“Following the signing of the Paris Agreement in December 2015, we wanted to understand the implications for those investors who were used to market cap investing and appreciated the attractive properties of passive investing,” he said. “Our goal was to create an alternative lens which takes climate into consideration.”

In contrast, many of Storebrand’s competitors opted to track newly developed climate indices, typically prompted by the EU Paris-aligned Benchmark (PAB) regulation. Following the regulation’s implementation in 2020, intended to bring a level of standardisation to the market, Storebrand took a closer look at how these indices might be adopted into passive investment strategies.

In its 2022 whitepaper, ‘Climate change benchmarks: The passive pretenders’, Wold Nilsen and co-author Lauren Juliff argued that there is no such thing as passive Paris alignment and that ‘index-tracking’ is not equivalent to ‘passive’ due to the degree of subjectivity involved in climate index construction.

As Wold Nilsen explained to ESG Investor, “Passive investing works for market cap equity benchmarks because index selection within a specific geography makes little difference to the investor’s risk/return profile. The basic equation is the same: multiply the equity price by the number of shares available in the market and adjust for free float.”

While there may be some nuances – between A and B shares in an initial public offering, for example – these finer details do not make a big difference to the outcome, he added.

However, when comparing indices designed to target risks associated with the transition to a low carbon or ‘Paris-aligned’ economy, the tracking error range could be several hundred basis points because of the plethora of methodologies or approaches available.

“The EU guidelines mandate specific sustainability and climate metrics, but don’t provide instructions regarding portfolio construction,” Wold Nilsen said. “Most of the important choices for risk and return are still open to interpretation, and the same provider can continually produce different versions of an index.”

Active versus passive

Also open to interpretation is the increasingly blurred line between active and passive investments.

According to Wold Nilsen, there are numerous dimensions. “For example, is a person assigning weights in the portfolio or an algorithm? To what extent do they manage risk? Are they trying to add outcomes in any way? How much forecasting is involved?” he said. “The definition should not be limited to whether the strategy is created by a benchmark provider or asset manager.”

Few investors have picked up on the nuances, with most relying on an established framework with active and passive buckets.

Wold Nilsen would like to see regulators conduct a review of the terminology. “An increasing number of strategies are being packaged and marketed – perhaps misunderstood – as passive. And to some degree, the index providers are exploiting this misunderstanding,” he said.

“What we see today is that the difference between a passive and active strategy is a line of separation in the value chain, not between high and low risk or how much due diligence is required.”

Bringing the debate into the open was the reasoning behind the ‘Passive pretenders’ whitepaper.

“Investors should look at the risk they are taking, not at which institution the person making these discretionary choices works. The multitude of choices requires a multi-dimensional way of looking at things,” he added.

Financial alignment

To underscore the complexities in climate-aware index investing, Wold Nilsen used a real-life example – the performance of EU PAB trackers following Donald Trump’s US presidential election victory earlier this month.

“If you are Paris aligned and a president is elected who says he will backpedal on Paris commitments, then you would expect your portfolio to take a hit – but that wasn’t necessarily the case. For example, two of the three EU PABs that I looked at overperformed,” he said.

Storebrand makes the distinction between Paris-alignment reporting and financial alignment. Its ESG Plus strategy, for example, has two layers of beta: one in relation to the market cap index and the other to what it terms the “Paris Agreement implementation”.

“We created a portfolio that is expected to perform better if there are unexpected positive outcomes on Paris-aligned progress, as well as the opposite,” he explained.

The portfolio’s results in the week of 5 November showed that it was financially aligned. “All boats rose, but we were slightly underperforming. We can demonstrate that a large part of the underperformance came from exposure to climate solution companies, which is what you would expect,” said Wold Nilsen.

However, some EU PABs were financially long Trump and benefited when he won. “Therefore, there is a misalignment between the ‘tick box’ reporting according to EU specifications and the actual financial outcome,” he explained.

While there are many ways to be Paris aligned in the investment world, which is why the EU stepped in to avoid diverging definitions, Wold Nilsen is not convinced that the PAB approach is the best way to reaching its explicit objective of 7% year-on-year portfolio-level decarbonisation, noting the simplicity with which it could be gamed.

“If we wanted to [cynically] follow the rules, we would first need to buy more of the higher emissions companies so that we had a better starting point for decarbonising. Then we could sell off some steel and cement stocks, for example. As such, we could easily deliver on decarbonisation for 10 years without actually doing much with the portfolio,” he explained.

Something so easy to get around, is not a good proof, said Wold Nilsen. “Yet everyone wants a proof statement so that investors, asset owners and producers of funds can all say that they are Paris aligned in their annual report and can’t be accused of greenwashing,” he added.

In his opinion, there is little downside to simply following the rules laid down in the PAB regulation. “However, that’s not to say that approach is the only way or the best way,” he said.

Having identified the “most sensible approach”, Storebrand favours using the financial exposure in the Paris Agreement as a guideline, not the reporting metric exposure according to a third party’s definition. It also uses the Science Based Targets Initiative guidance for a large share of its portfolio.

Best practice

In 2023, financial products referencing an EU climate benchmark reached more than €116 billion.

Wold Nilsen has seen some pushback against the PABs over the past few years, however these benchmarks are still seen as the gold standard for corporate disclosure of climate goals. “If we didn’t have them, everyone would be free to make their own calls, which would be a far worse situation,” he added.

Storebrand would like to have some leeway to differ from this path, however Wold Nilsen said there is little wiggle room. “Within the regulatory framework, you are at a disadvantage if you don’t play along with the EU rules because it’s optimised for those who do. They will have an easier time in terms of reporting and being allowed to make bolder marketing statements,” he said.

But if the portfolios are outperforming when Trump is elected, then there is something worth talking about, he added.

Over the past few years, many asset managers have claimed that climate change and sustainability is important and embedded in everything they do, but then outsourced their investment positions related to ESG to a third-party provider.

Wold Nilsen believes that is a delegation of their responsibility and advocates for asset managers to build up their in-house competence and create their own models. “This would then make it possible to have a more dynamic debate across the industry around the best way to deliver on sustainability objectives,” he said.

The post A Far from Passive Approach to Paris-alignment appeared first on ESG Investor.