Commentary: Noting a decade of evolution in climate data and investing

The start of a new decade is a natural opportunity to reflect on progress the industry has made improving the tools and solutions for sustainable investing — particularly for climate impact.

It's easy to forget that just 10 years ago, "climate investing" meant investing in clean tech sectors to most. We know now that incorporating climate change into portfolios is a much more foundational exercise. For asset owners that have multigenerational investment horizons, this can involve the re-engineering of asset allocation, engagement efforts and benchmarks. In just the last few years, we have seen a growing number of asset owners reallocate AUM from traditional passive equity mandates into climate-adjusted benchmarks.

In 2010, climate investment data models were in their infancy, and asset owners weren't ready to embrace sustainable investing in a comprehensive way. FTSE Russell launched one of the first carbon strategy indexes at the time. These were essentially low-carbon indexes that used one data input — carbon intensity — to reallocate weights in the benchmark. While a few large clients used them, the indexes were not widely adopted. Building an index for a future low-carbon economy required new construction techniques as well as new data sets that hadn't been tracked before on a significant scale, if at all. So we went back to the drawing board.

Some important improvements in data have taken place since then. The quality and quantity of carbon emissions data that is reported by companies continues to improve. At the same time, additional measures have entered into investors' consideration of climate risk. Fossil fuel reserves, and the embedded emissions they represent, are now used alongside operational carbon emissions to get a more complete picture of a company's exposure to carbon risk. There was also a growing expectation that the low-carbon transition would produce winners as well as losers. This led to a recognition that more data is needed to understand which companies stand to benefit from providing the clean and green solutions that a lower-carbon economy will require.

After years of development and research we produced a "Green Revenues" data model that provides a taxonomy for low-carbon products and measures the revenue that companies were deriving from these activities. With this data we could start to deflate a number of false impressions about the global green economy. One myth was that it was small. The FTSE Environmental Opportunities index series, which requires companies to have at least 20% of their business derived from environmental markets and technologies, represents 6.4% of the market capitalization of the FTSE Global All Cap index. This is nearly 30% larger than the market capitalization of the oil and gas industry in the same index. Another myth was that the green economy was comprised of mostly clean energy companies. In fact, the renewable energy sector makes up only the third-largest component of the FTSE Environmental Opportunities All-Share index, whereas energy efficiency and waste and pollution control together make up nearly 75% of the market cap of the index, demonstrating the diversity of the green investment opportunities.

A third common myth is that investors sacrifice performance in exchange for environmental benefits. However, the FTSE Environmental Opportunities All-Share index has actually outperformed the FTSE Global All Cap index over the last 10 years.

As the global investment community continues to shift in the direction of passive investment, asset owners focused on integrating climate considerations increasingly realize that core passive portfolios must be part of that effort. As a result, index providers are developing new data sets, tools and construction techniques to support their ability to manage climate exposures across passive portfolios in a more holistic way. One example is the move away from standard cap-weighted exposures in favor of an alternatively weighted construction that incorporates climate considerations, namely: fossil fuel reserves, operational carbon emissions and green revenues. These data sets are combined in a smart beta index methodology that re-weights each security across all three climate "factors" — so it's like a triathlon in that companies can be relatively weaker or stronger in one area to offset others. However, if a company is really poor in one area its portfolio weight may be significantly reduced or it may lead to outright exclusion. The end result is a climate-aligned index that delivers meaningful climate outcomes (lower emissions, lower reserves, higher exposure to green revenues) but also minimal tracking error against the benchmark, meaning it is suitable for use in core equity portfolios.

We've also begun to see the same type of models, ideas and data applied to fixed income. While many of the tools for analyzing corporate equity can apply to corporate credit, it's incredibly challenging in the non-corporate realm. That is especially true for assessing climate risk for sovereigns. The longer investment horizon of the sovereign bond asset class aligns well with the forecast economic costs and risks associated with climate change, suggesting that these risks are likely to affect the long-term investment prospects of sovereign bond investors to an even greater degree. And some firms have begun to develop methodologies for measuring the relative climate risk of sovereign bonds across markets, taking into account the physical and transition risks of climate change.

As we reflect on the last decade, we've seen significant developments in the tools, data and methodology that global investors are using to create portfolios that consider the impact of climate change.

Once a narrow sliver or niche part of the investment portfolio, climate change is now being viewed as foundational to it. Today, the concept of a low-carbon transition is better defined, investors are better educated and the menu of investment options is expanding to include a wide range of data models, across equities and fixed income.

Over the last decade we have seen investors, particularly long-term owners of capital, recognize that a major challenge for the next 10 years and beyond will be investing during a period of industrial transition to a global green economy. At least we will enter this coming decade armed with better data and investment tools to support those investors that are leading the charge to a low carbon future.

Tony Campos is head of sustainable investment, Americas at FTSE Russell, New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.