To start, it is important to highlight how climate-aware investing is different from ESG investing. ESG investing uses environmental, social and governance factors to evaluate companies on how sustainable they are along all three dimensions. Climate investing focuses on mitigating climate change and reaping opportunities.
For certain sectors, such as insurance writing, climate risks are tangible as any increase in the severity and frequency of natural disasters can adversely impact underwriting risks, especially in the property and casualty segments. Recognising the potentially huge costs associated with climate, the French central bank released the first results of its climate stress tests in 2021, which found that natural disaster-related insurance could rise up to five-fold in the country’s most affected regions.1
In this paper, we examine how investors can incorporate climate-aware indices into an investment portfolio from a strategic asset allocation standpoint. To this end, we examine how climate-aware indices, namely the MSCI Climate Paris Aligned index series, differ from their traditional market-value-weighted counterparts.
As a reminder, the MSCI Climate Paris Aligned indices seek to maintain diversified exposure to equities within a tight tracking error budget, while improving on their green credentials through reducing climate risks and pursuing opportunities as well as aligning with the Paris Climate Accord commitments.
The world is increasingly acknowledging the dangers of climate change and grappling with the challenges of its consequences. This awareness is present in the investment community, where investors continue to allocate huge sums of money into climate investment funds.
According to Morningstar, assets in European climate funds doubled in 2021 to $325 billion.2 However, under 1% of global total assets have a temperature pathway that is aligned with the Paris Agreement, with the majority of the other assets aligned to over 2.75oC of global warming.3 Recognising the increasing importance that investors attach to climate change issues, 457 investors (representing more than $41 trillion in assets under management) recently signed the 2021 Global Investor Statement to Governments on the Climate Crisis, which urges governments to work with institutional investors to “raise ambition and accelerate action to tackle the climate crisis by reducing global net carbon emissions by 45% from 2010 levels by 2030.”4
Other initiatives undertaken by investors include the commitments made by some asset owners (for example, signatories to the Net Zero Asset Owner Alliance) to set targets to reduce emissions and increase allocation to climate solutions.
The rising investor focus on climate change issues and sustainable finance had existed for some years but was further bolstered by the European Commission’s launch of the Sustainable Finance Action Plan in 2018, which created standards for benchmarks that seek to address climate risks and avoid “greenwashing.” Two types of benchmarks, the EU Climate Transition Benchmark and the EU Paris-aligned Benchmark, were defined. The former is seen as a tool to facilitate the transition to a low-carbon economy while the latter, which is much more ambitious, seeks to favour companies with sustainable business models and serves as a tool for investors at the forefront of the climate transition.
1 Source: Climate risk for insurers, S&P Global.
2 Climate Investing in 2022: Our Bumper Report, Morningstar.
3 Source: October 2021, CDP.
4 Halper et al. (2022), Asset Management Industry Confronts the Challenges Presented by Climate Change Transition, Harvard Law School Forum on Corporate Governance.
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The returns on a portfolio of securities whichexclude companies that do not meet theportfolio’s specified ESG criteria may trail thereturns on a portfolio of securities which includesuch companies. A portfolio’s ESG criteria mayresult in the portfolio investing in industrysectors or securities which underperform themarket as a whole.
Past Performance is not a guarantee offuture results.
The value style of investing that emphasizesundervalued companies with characteristics forimproved valuations, which may never improveand may actually have lower returns than otherstyles of investing or the overall stock market.“A “quality” style of investing emphasizescompanies with high returns, stable earnings,and low financial leverage. This style ofinvesting is subject to the risk that the pastperformance of these companies does notcontinue or that the returns on “quality” equitysecurities are less than returns on other stylesof investing or the overall stock market.”The Fund may emphasize a “growth” style ofinvesting. The market values of growth stocks maybe more volatile than other types of investments.The prices of growth stocks tend to reflect futureexpectations, and when those expectationschange or are not met, share prices generally fall.The returns on “growth” securities may or may notmove in tandem with the returns on other styles ofinvesting or the overall stock market.
The momentum style of investing emphasizesinvesting in securities that have had higherrecent price performance compared to othersecurities, which is subject to the risk that thesesecurities may be more volatile and can turnquickly and cause significant variation fromother types of investments.
Low volatility funds can exhibit relative lowvolatility and excess returns compared to theIndex over the long term; both portfolioinvestments and returns may differ from thoseof the Index. The fund may not experience lowervolatility or provide returns in excess of theIndex and may provide lower returns in periodsof a rapidly rising market. Active stock selectionmay lead to added risk in exchange for thepotential outperformance relative to the Index.
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