Untangling the confusing landscape of forward-looking climate measures

As the world moves forward with carbon reduction targets, investors now widely demand that companies make ambitious climate commitments that can be incorporated into portfolio construction. This has led to the emergence of a bewildering abundance of forward-looking indicators that track companies’ decarbonization trajectories. In a recent white paper[1], Qontigo’s sustainable investment team offers valuable insight into Forward-Looking Climate Indicators (FLCM).

Why forward-looking metrics are needed

Lagging metrics, such as financial reports, are retrospective and static. While useful for decision making, these past performance indicators usually provide limited information for the future. In contrast, leading (or forward-looking) indicators provide information about the direction a company’s performance is taking before it shows up in static data. Examples are business metrics such as customer engagement or climate indicators such as temperature targets.

Figure 1 – Example of trade and climate measures lagging behind prospective ones

Source: Qontigo.

One metric is never enough

Just as many traditional metrics are used in traditional financial decision-making, no climate-related metric can fully describe the position of a product, company, fund or investment strategy in relation to to the climate. For example, if it is possible to build a portfolio estimated to be “aligned at 1.5 degrees”, its performance could still be affected by systemic risks associated with climate change (for example, the failure of a government to effectively manage transition to climate goals). Therefore, a broader dashboard of performance indicators and forward-looking metrics is needed to achieve these goals.

Qontigo’s sustainability team has categorized FLCMs according to the four use cases below.

Figure 2 – Use case of FLCMs

Source: Qontigo

Since utility often lies in comparative rather than absolute metrics, it cannot be overstated how important it is for users to consider multiple FLCMs, as opposed to single isolated metrics. Additionally, given the large differences in the scope, measurement and weighting of individual indicators, ratings from different vendors vary widely even when expressed in similar units, as in the case of temperature alignment. .[2]

Data coverage, standardization and reliability pose challenges

Investor demand for climate data integration has spurred the development of more robust climate science and modeling in recent years. However, challenges remain with the coverage, standardization and reliability of the data underlying these models.

Many FLCMs rely on past greenhouse gas (GHG) emissions data to estimate future trends, and the lack of historical data can exacerbate the uncertainty of future assumptions. To illustrate this: CDP – one of the most widely used climate disclosure frameworks in the world – has indicated that it currently needs to estimate data for about a third of Scope 1 emissions and just over half. Scope 2 emissions from the more than 5,000 companies it covers.[3] In particular, few companies report Scope 3 GHG emissions, although these may represent more than 50% of their total emissions. In addition, there are glaring inconsistencies between the estimates of different Scope 3 emission data providers, due to differences in their estimation models, among others.[4]

We further illustrated this discrepancy problem by comparing methodologically similar FLCMs for 135 companies from three different data providers. After transformation and normalization of scores from different sources, correlations between data points ranged from 0.4 to 0.65, indicating only a modest positive relationship between providers.

Investors seek transparency

The lack of standards for assurance and verifiability of climate data means that investors are reluctant to use potentially inaccurate data to avoid liability associated with miscalculation of FLCMs.

In response to a recent TCFD[5] In consultation, many investors pointed out that current disclosure methodologies and frameworks developed by different data providers are “black boxes” that offer little scope and little information to compare their holdings across sectors. Even where there are publicly available descriptions of methodologies, differences between data providers can still make the resulting disclosures difficult to compare. Some respondents suggested that the adoption of FLCMs should be phased in, thus ensuring that the measures are more useful in financial decision making.

Implications for index design

In any case, the future is promising for benchmarks that combine financial and climate objectives. Although climate-adjusted versions of traditional benchmarks have been around for over a decade, they were historically designed to focus on historical data. The new EU climate benchmarks – EU Climate Transition Benchmarks (CTB) and EU Paris-aligned Benchmarks (PAB) – go beyond climate risk to also include a forward-looking objective of directing investments towards energy transition opportunities. . In doing so, they pave the way for integrating the use of FLCMs into the design of indexes.

Qontigo introduced the benchmarks STOXX® Paris-Aligned Benchmark (PAB) and STOXX® Climate Transition Benchmark Indices (CTB) in June 2020. These meet and exceed the minimum requirements of the methodologies recommended by the EU and ensure diversification and comparability with the Underlyings. universe.

STOXX Climate Benchmarks use various FLCMs to assess trends, targets, quality of climate risk management and exposure to climate related financial risks of portfolio components.

Figure 3 – How the STOXX PAB and CTB indices use the FLCMs

Source: Qontigo.

With a better understanding of the limits of the effectiveness of such methodologies in generating real climate impact, supported by increasing data availability, new regulations and ever-wider adoption by investors[6], the climate reference methodologies are also subject to change.

For example, given the limitations associated with the use of GHG intensity data, in the future, the focus may be on the use of actual economic outcomes, absolute emission reduction pathways and sector specificity in a minimum number of climate relevant sectors.

To learn more about this topic, access the Qontigo white paper here.

[1] Rodolphe Bocquet, Anna Georgieva and Saumya Mehrotra, ‘Forward-Looking Climate Metrics: An Introduction to the Current Global Landscape’, Qontigo, June 2021.

[2] Florian Berg, Julian Kölbel and Roberto Rigobon, “Aggregate Confusion: The Divergence of ESG Ratings”, May 2020.

[3] “CDP’s Complete GHG Emissions Data Set”, Summary 2019, CDP.

[4] University of Hamburg / WWF Deutschland 2018. Consistency of corporate carbon emission data.

[5] Climate-Related Financial Disclosures Working Group.

[6] The bold adoption by investors of climate benchmarks is accelerating rapidly. For example, in 2020, Andra AP-fonden (AP2) – one of the largest pension funds in Northern Europe – announced that it had gradually adjusted around 55% of its assets under management (bonds d global companies and foreign equities) to investments aligned with the PAB, without compromising the risk and return characteristics of the index. Other notable examples are more and more frequent. https://ap2.se/en/applying-eu-rules-andra-ap-fonden-cesse-investment-in-fossil-fuel-companies/