Scientific Beta: We welcome the NZAOA’s Principles for Net-Zero-Aligned Benchmarks

April 11, 2023

By Erik Christiansen, ESG Investment Specialist at Scientific Beta

The UN-convened Net-Zero Asset Owner Alliance (NZAOA) recently launched a call to action for asset owners and index providers for the development and uptake of Net-Zero-Aligned Benchmarks.

NZAOA spells out 10 principles such indices should follow to underpin the alliance’s goal of transitioning investment portfolios to net-zero greenhouse gas (GHG) emissions by 2050, consistent with a maximum temperature rise of 1.5°C above pre-industrial levels:

1. Ensure transparency in methodology and design.
2. The starting point of decarbonisation should be set to ‘today’.
3. No mechanical exclusion of high-emitting sectors (except thermal coal) or countries.
4. Net-Zero-Aligned indices should correspond to real-economy decarbonisation.
5. Account for differences in speed of decarbonisation across sectors and geographies.
6. Ensure that forward-looking Indicators are a key input in the decarbonisation process.
7. Every index universe needs to report on climate Key Performance Indicators.
8. Lack of data must be correctly addressed.
9. Key metrics should be comparable to the parent index and tracking should be practical.
10. The benchmark universes should incorporate metrics for a just transition, acknowledging that appropriate metrics are still to be refined.

In recent research¹, we show how Scientific Beta’s Climate Impact Consistent (CIC) indices integrate these 10 principles. In effect, the CIC indices are designed to maximise the climate impact potential of an investment strategy and, in line with the commitment that NZAOA members make, they ‘emphasise GHG emissions reduction outcomes in the real economy’.

Paris Aligned Benchmark falls short

The NZAOA also points to some of the shortcomings of the European Union’s climate benchmarks. Scientific Beta has previously voiced concerns about this regulation and concurs with the NZAOA’s arguments. In our research, we show how many indices that comply with the regulated Paris Aligned Benchmark (PAB) constraints fail to reflect some of the NZAOA’s core benchmark principles.

The PAB fossil fuel screens are in contradiction with NZAOA Principle 3, that there should be ‘No mechanical exclusion of high emitting sectors (except thermal coal)’. The regulation may at first glance seem to make a relevant distinction between the three main types of fossil fuels – coal, oil, and gas – as the exclusion thresholds of 1%, 10% and 50% of revenues respectively indicate a consistent hierarchy. However, in practice, all companies in the fossil fuels sector in the Scientific Beta Global Universe of mid and large cap companies end up being excluded from PAB-compliant indices.

The PAB requirements include another fossil-related exclusion, namely of companies ‘that derive 50% or more of their revenues from electricity generation with a GHG intensity of more than 100 g CO₂ e/kWh’. As a result, electric utilities relying on fossil fuels for most of their activity are to be shunned.

Paris Aligned Benchmark proves counterproductive

All in all, the PAB fossil screens lead to the withdrawal of funding for companies representing about 35.8% of the renewable electricity generated in the global listed equity universe. This tightening of funding increases the cost of capital for these companies and hampers their ability to pursue further investments in renewable energies.

While such counterproductive effects are a direct consequence of the fossil-screening requirements of the PAB regulation, these requirements also allow for further greenwashing. In particular, many PAB-compliant indices fail to reflect the NZAOA’s Principle 4 that ‘Net-zero-aligned indices should correspond to real-economy decarbonisation’.

The shift to an economy compatible with no more than 1.5°C warming will require massive investments, in particular in low-carbon electricity generation and storage and transmission infrastructure, as shown in the International Energy Agency’s net zero projections (see IEA (2021), Net Zero by 2050: A Roadmap for the Global Energy Sector, May).

However, the real-economy outcome of many PAB-compliant indices is the exact opposite: less financing of electric utilities, not more.

In a paper on detecting greenwashing in climate investing strategies, we show that typical methodologies used to construct climate indices lead to a drastic reduction in the capital allocation to the electric utilities sector. Whether the portfolios are built by tilting (over- and underweighting stocks, relative to a standard cap-weighted benchmark, based on their carbon intensity measures) or by optimisation (using a portfolio optimiser to achieve an average carbon intensity reduction while minimising tracking error with respect to a standard cap-weighted benchmark), the outcome is a severe reduction in the weighting of electric utilities.

Moreover, imposing the greenwashing constraint of the PAB, which prohibits the underweighting of high climate impact sectors in aggregate – as opposed to sector by sector – has almost no effect on this problem.