Can you satisfy climate objectives with low tracking error?

Recent flow data suggest investors who are interested in the climate appear to be focusing more strategically on those ETFs that offer closer tracking of standard benchmarks as well as greater visibility on how they aim to achieve any stated climate objectives. These two considerations can often conflict when combined in a single strategy, however, so investors need to have a good understanding of what they want to achieve in financial and non-financial terms. Fortunately, the ETF market offers a wide variety of ESG-related strategies, so just about any investor should be able to find one that aligns with their goals. 

When you build an investment strategy, every additional ESG consideration you make is likely to result in higher tracking error because you are forced to deviate increasingly from the core benchmark, in terms of the constituents and/or their weightings in the index. Therefore, it is important to understand what you want to achieve in order to determine what metrics you include, especially as it pertains to climate-related objectives. 

Climate risk versus climate impact

One of the most fundamental questions for an investor interested in the climate is whether they want to focus on the impact environmental issues may have on their investment or the impact their investment may have on the environment. A climate strategy may look to explicitly consider the impact on financial returns from transition, policy or physical risk associated with climate change, or it may increase exposure to clean technology solutions or decrease fossil fuel exposure with the aim of achieving a better climate outcome.

Carbon emissions intensity is a commonly used metric; however, there is a difference between an emissions intensity that uses revenue as its numerator, and one that uses enterprise value. The former quantifies the carbon a company is emitting to generate revenue (a risk measure) whilst the latter gives an indication of the percentage of company emissions an investor is responsible for (an impact measure). Of course, risk and impact metrics can, and often are, incorporated into climate strategies alongside each other, but identifying which is more relevant to you as an investor could allow you to reduce the number of metrics considered and hopefully, as a consequence, find a lower tracking error strategy.

Fossil fuel exclusions (or not)

For investors wanting to align their portfolio with net-zero climate objectives, the energy sector poses a challenge. If you were to invest in funds that exclude all oil and gas companies, you would increase the tracking error versus standard benchmarks. In the US, energy has been either the best-performing or worst-performing sector in the S&P 500 index in eight of the past 10 years. In 2022, for instance, the energy sector returned 65.7%, whereas the second-best performer was up 1.6% and all other sectors produced negative returns[1].    

Most climate funds incorporate exclusions around the fossil fuel space; however, it’s easily argued that this is a key area in terms of climate transition and could benefit most from the differentiation in investment that would be brought by a climate transition approach. You could also argue that a blanket exclusion doesn’t reflect the reality of the transition to a low carbon economy, where fossil fuels will be part of the energy mix for years to come, albeit a declining percentage as renewable capacity is added to the grid.

This is a key area where the EU defined climate benchmarks differ from each other. Whilst Paris-Aligned Benchmark (PAB) indices, and in turn the ETFs that follow them, will exclude most of, if not all, the energy sector, Climate-Transition Benchmark (CTB) tracking ETFs have no mandatory restrictions on fossil fuels. Investors wanting a portfolio that can more accurately reflect the transition may want to consider CTB, though the more aggressive approach taken by PAB strategies aims to facilitate a faster overall transition.

It may make sense in a climate strategy to remove issuers involved in the more controversial parts of the fossil fuel industry (such as oil sands and shale energy) but excluding the whole energy sector, particularly all oil and gas producers, will have a sizable impact on performance relative to the standard benchmark in certain conditions, as the sector may account for 4-6% of the index.

Forward-looking considerations

The minimum requirements for PAB and CTB indices consider only current, backward-looking figures to select and weight companies. A very straightforward way to incorporate future climate impact is to look at the fossil fuel reserves of a company; however, such a dataset is obviously limited to a handful of energy-related companies, and hence significant reductions can be achieved by changing the weightings of just one or two constituents of a portfolio.

Climate strategies could take an alternate approach by overweighting companies setting credible science-based targets or going a step further and utilising datasets on forward temperature alignment. Temperature pathway metrics incorporate these climate targets, alongside emissions figures and a consideration of future climate scenarios. They look to measure climate impact as an indicative temperature rise that a company is aligned with, such that if this company was the whole economy, this is the temperature increase the world would bear.

While evidently focused on limiting the impact on the environment, such a dataset may also be useful in limiting turnover for either a PAB or CTB approach. Emissions data is backward-looking, but a temperature alignment consideration may help push a portfolio towards companies that are actively decarbonising, and hence limit the level of rotation required in a PAB or CTB fund to achieve the required decarbonisation trajectory.

What about ESG?

Investors shouldn’t overlook the not-insignificant fact that PAB and CTB indices were established by the European Commission to focus on climate investing very specifically. If you’re wanting an investment that also factors in broader ESG factors, you should make sure the ETF includes additional considerations in its methodology for social, environmental and corporate governance related issues beyond just climate concerns.

Remember, however, that additional considerations – including broad ESG concerns – are likely to result in an increase in tracking error versus the standard, parent benchmark. If relative performance is important for your objectives, you should look carefully at how an ETF addresses performance in light of the non-financial considerations being made. Ideally, you would want an ETF that can meet its climate and any other ESG objectives while maintaining a similar profile to the standard benchmark.