GFANZ Maps Passive Path to Transition
Alliance flags challenges around metrics and data quality in consultation aimed at spurring development of ‘transition-informed’ indexes.
A lack of timely, robust, consistent and high-quality data may hamper efforts to create credible net zero-aligned indexes, according to a consultation document from the Glasgow Financial Alliance for Net Zero (GFANZ).
The body responsible for overseeing the largest coalition of financial institutions with a net zero pledge is consulting on the development of indexes that support passive investors seeking decarbonisation strategies.
The consultation paper – ‘Index Guidance to Support Real-Economy Decarbonisation’ – outlines potential guidance for index providers and users “to voluntarily and independently develop and adopt” so-called transition-informed indexes which GFANZ says are necessary for a successful migration to a low-carbon economy.
The alliance said existing indexes “do not directly support real-economy decarbonisation, because they do not recognise companies’ climate strategies; their design excludes heavy emitting industries; or they require year-on-year emissions reduction which is hard for companies to deliver and may be challenging for active and index managers to implement”.
Stephen Beer, Head of Responsible Investment Strategic Relationships and Integration Strategy at Legal and General Investment Management, a member of the GFANZ Index Investment Workstream, said the size of the index investing universe meant passive investors had to play a role in supporting decarbonisation.
“There is already a variety of approaches to incorporating climate transition considerations in index funds. These can focus on reducing carbon emissions intensity at the portfolio level or can leave out high-emitting companies from the index composition,” he said.
“These meet many investor objectives, [but] such indexes might limit exposure to companies with the potential to align to net zero, with accompanying engagement, too early for some investors.”
The European Commission sought to encourage the development of passive investment tools that support the net zero transition through the creation of the EU Paris-Aligned Benchmark and the EU Climate Transition Benchmark, with the latter aimed at reducing portfolio carbon intensity by 30% versus its parent index.
A 2022 assessment of climate benchmarks by the UN-convened Net Zero Asset Owner Alliance found that the portfolio construction was sometimes complex and lacking transparency.
Three paths to transition
According to PwC, passive assets under management will reach US$36.6 trillion by 2025, around a quarter of the global total. Because indexes are used by investors for a range of purposes – including designing both index and active strategies, making investment decisions, and tracking performance – index design can significantly impact the financial sector’s ability to deliver the transition finance, said GFANZ.
As such, the proposed guidance encourages the creation of benchmarks that support real-economy decarbonisation at the individual company level.
“These indexes might initially include not only companies aligning and aligned to net zero, but companies that have made a commitment, or which have the potential to transition. Engagement would focus on encouraging companies to adapt fast enough to ensure their securities remained in the index as index rules shifted weightings more towards aligned companies,” Beer said.
GFANZ recommended the development of three categories of transition-informed indexes.
‘Transition-potential’ indexes would comprise companies that demonstrate the potential to align with the net zero transition in a time-bound manner as well as those companies that are included in ‘transition-engaged’ indexes.
‘Transition-engaged’ indexes would encompass companies ‘in development’, as well as those aligning or aligned to net zero, or which provide a climate solution. Meanwhile, ‘net zero’ indexes only include companies that are fully aligned or provide a climate solution.
Data lag
GFANZ said that while reported climate data “is the key input for an index participant when assessing whether a company meets criteria for continued inclusion in a ‘transition-engaged’ index… there is a lag in the availability of robust, consistent, and high-quality climate data that is needed to ensure credible indexes”.
GFANZ suggested that companies “may consider providing more transparency by disclosing the underlying calculation data of their greenhouse gas emissions and reduction targets, which would allow an index participant to understand the quality of the data”.
Robert Edwards, Director of Product Management for ESG Indexes at Morningstar Sustainalytics, said the net zero imperative required index providers and passive investors to accept imperfect data. “What the industry can do is continue to push companies to improve their climate data disclosures. The better and richer the underlying data, the more targeted action we believe we can take,” he said.
The GFANZ guidance also highlighted challenges arising from disparities in sources of information available to index providers and in their interpretation, potentially leading to “a risk of unnecessary inconsistencies and incomparability of results”.
These included discrepancies in how data are tracked or weighted for scoring.
Further, GFANZ identified contradictions in how ambition and progress on transition to net zero is benchmarked, “potentially making data providers a key stakeholder in company assessments”.
Beer said: “It is a matter of judgement what metrics are used for assessing net zero alignment, and the GFANZ paper consults on what metrics might be highlighted in voluntary guidance. But the data needs to be in standardised, comparable form.”
GFANZ recommended that index providers simplify datasets and “focus on addressing comparability issues first”. It also called for a public data utility that could provide a common platform for index participants to access comparable, verified climate data to inform the index assessment process.
The alliance said a public data utility could go beyond offering a centralised dataset, also providing quality control capabilities to index participants. It added that regulators could oversee the quality of the data and ensure that it was validated over time.
Beer welcomed this approach noting that such a facility would “help level the playing field for validated climate data”.
GFANZ pointed to the Net Zero Data Public Utility as a possible provider, noting that that the repository is freely accessible to the public.
The alliance added: “While further work would be needed to mature such a utility for index construction and usage, the prototype signals promising advancements in securing comparable datasets.”
The GFANZ consultation is open for three months until 9 January 2025.
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