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Transition Firmly on the Cards for Passive Market

GFANZ guidance expected to expand transition-informed indexes, while EU’s Platform on Sustainable Finance deepens scope of transition focus. 

Proposed climate transition-oriented index investment guidance for the EU and beyond is expected to better incentivise passive capital flows supporting companies’ journeys to net zero. 

This is according to experts reflecting on the EU Platform on Sustainable Finance’s (PSF) proposal for two voluntary transition-focused benchmarks and the now delayed guidance from the Glasgow Financial Alliance for Net Zero (GFANZ) on developing “transition-informed” indexes.   

GFANZ’s guidance in particular will allow for increased harmonisation in climate transition investing globally, according to Robert Edwards, Director of Product Management EMEA and ESG Indexes at Morningstar. 

“European investors have been at the forefront of climate transition investing, but there is a lack of harmonisation in approaches outside the region,” he told ESG Investor 

“This [GFANZ] guidance is a positive step forward [and] could help set a global standard – particularly for institutional investors – accelerating progress.” 

The guidance, which underwent consultation between October and January, outlines recommendations for index providers and users to voluntarily and independently develop and adopt transition-informed indexes that support decarbonisation efforts at the individual company level.  

GFANZ said existing approaches incorporating climate transition considerations in index funds limit investment to companies that are currently or clearly able to demonstrate future alignment with net zero, as opposed to those who have transition potential.  

As such, GFANZ proposed three categories of transition-informed indexes. Transition-potential indexes would comprise companies demonstrating potential to align with net zero in a time-bound manner. Transition-engaged indexes would include companies in development, as well as those aligning to net zero. Net zero indexes would only include companies that are fully aligned or provide a climate solution. 

“Indices will play an increasingly important role in supporting investors to manage climate risks and opportunities in the low carbon transition,” said Stephanie Maier, Global Head of Sustainability at FTSE Russell, a London Stock Exchange Group business. 

Limitations and delays 

There are nonetheless still some limitations with the guidance, according to Vincent Vandeloise, Senior Research and Advocacy Officer at European NGO Finance Watch. 

“The focus remains on the investee perspective, but it does not say much about the investor perspective,” he said.  

“An asset manager can launch an exchange-traded fund (ETF) that replicates a green or transition benchmark – yet this doesn’t tell us anything about how the investor is engaging with those companies to support the transition.” 

Previous research has highlighted shortcomings in passive managers’ stewardship efforts, with asset managers BlackRock, Vanguard and State Street reportedly opposing “more often than not” shareholder resolutions aimed at improving the environmental governance of large carbon-intensive companies. 

GFANZ also identified contradictions in how transition-related progress is currently benchmarked, noting it will remain a matter of judgement what metrics are used for each index, citing the current lack of robust, consistent and high-quality data.  

Until data is available and standardised, this will make comparing indexes more challenging, the body said. 

Although its consultation closed earlier this month, GFANZ has since announced plans to restructure following mounting pressure from the anti-ESG movement in the US.  

GFANZ last week also revealed its decision to “pause” its work on nature-focused transition plans and index investing. 

“With or without the formal GFANZ index concept, asset managers and asset owners are prioritising climate-focused strategies, recognising that climate change is both financially material and a growing concern for investors,” said Edwards in response to the pause.  

“Index providers, including Morningstar, will continue to develop new climate indexes and expand capabilities to help investors navigate the transition to a low-carbon economy.” 

FTSE Russell’s 2024 sustainable investment survey found that asset owners were utilising passive sustainable investment strategies more often than active strategies for the first time. 

In 2022, the UN-convened Net Zero Asset Owner Alliance urged index providers to accelerate the development of net zero-aligned benchmarks to support investors’ growing appetite to adopt passive strategies. 

New labels 

The PSF aims to augment the EU’s existing requirements for climate benchmarks with two voluntary transition labels. 

The proposed Investing for Transition Benchmarks with and without exclusions (ITB and ITBex) have been inspired by the success of the EU’s Paris-aligned Benchmarks (PABs), as well as the growth in taxonomy-aligned capital expenditure (capex), which the PSF said currently stands at €440 billion. 

ITBs would allow for diversification and engagement with all industries, including fossil fuels, while ITBex benchmarks would restrict activities related to coal, oil, and gas based on revenue and capital expenditure thresholds. 

The two benchmarks are designed to select, weight or exclude assets to ensure the resulting portfolio has a high or increasing degree of EU taxonomy-aligned capex. Investments made by an ITB or ITBex would also need to adhere to the EU PAB minimum standards. 

These voluntary benchmarks follow the Climate Transition Benchmark (CTB) and PAB, which were signed into law in 2019.  

CTBs are designed to be used by asset owners that have yet to set net zero targets for their funds but are looking to protect their portfolio against transition-related investment risks. PABs are for investors committed to aligning their portfolios with the Paris Agreement and therefore willing to invest in a narrower universe of companies with credible emissions reduction strategies.   

“We welcome that the EU PSF approach does not require significant upfront decarbonisation but instead focuses on companies actively allocating capital toward EU taxonomy-aligned activities,” said Morningstar’s Edwards. 

“For investors seeking a voluntary label, this offers a solution that maintains lower active share relative to the broad market.” 

Work in progress 

The PSF acknowledged that limited data availability – especially data on green capex outside of Europe – could limit progress in the near-term, calling for a review of all minimum standards after a three-year period to “ensure the highest level of ambition for climate benchmarks and Taxonomy-alignment”. 

Finance Watch’s Vandeloise emphasised the importance of the ITB and ITBex aligning with Europe’s existing and incoming sustainable fund labelling and reporting rules, including the European Securities and Markets Authority (ESMA) fund names rules and the Sustainable Finance Disclosure Regulation (SFDR). 

“For example, if an ETF replicates the composition of an index but also its naming, the ETF will face ESMA’s requirements, but the benchmark administrator will not,” Vandeloise said. 

Pending a review of the SFDR, a transition fund label could also be introduced. 

A question mark hovers over the depth of the EU’s sustainable finance regulation framework, as lawmakers across member states discuss a looming omnibus package designed to streamline and curtail regulatory requirements. 

The post Transition Firmly on the Cards for Passive Market appeared first on ESG Investor.

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