Bloomberg Systematic Strategies

A Bloomberg Professional Service offering

Climate Investment Insights
Roads to Paris alignment - Climate Transition Pathways andIndicesNovember 25, 2022

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Bloomberg Systematic Strategies

A Bloomberg Professional Service offering

Climate Investment Insights

Roads to Paris alignment - Climate
Transition Pathways and Indices
How does one align a portfolio with the economic and regulatory forces driving
decarbonisation and climate goal alignment whilst maintaining fiduciary
duties? We discuss investment implications of climate pathways in portfolioalignment. By looking across granular, science-based climate transition
pathways, investors can be more efficient at mitigating transition risks whilst
meeting climate objectives.

Lingjuan Ma+44-20-35250741
lma208@bloomberg.net
Edo Schets+44-20-35258549
eschets@bloomberg.net

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A Landmark Pledge with a Global Response
Through the 2015 Paris Agreement, 196 countries have committed to limiting global warming
to well below 2°C – and preferably to 1.5°C – compared to pre-industrial levels.1 In practice, thismeans that global greenhouse gas emissions (GHG) ideally reach net zero by 2050. By directing
capital flows sensibly, investors can play an important role in achieving international net-zerotargets. The task is not without challenges. Investors looking to provide transition finance tocompanies and governments to meet their net-zero commitments, will want to ensure thatthese investments earn sufficient compensation in the future.
This is where benchmarks come in. They provide investors with a broad investment opportunity
set that is consistent with a pre-specified set of objectives, such as aligning to net-zero and/ormitigating climate risks. The benchmark returns can furthermore be easily replicated throughexchange traded funds (ETF). Within the EU, the concept of climate target-aligned benchmarks
has been regulated in a delegated act to the EU Benchmark Regulation, which prescribes
minimum criteria for the EU Climate Transition Benchmark (EU CTB) or Paris-aligned Benchmark(EU PAB).2 The Net-Zero Asset Owner Alliance set out several key best practices for constructing
net-zero aligned benchmarks for asset owners globally.3
Meaningful Climate Benchmarks
There are several ways to align with a climate goal within an index. One approach is to set asingle, global emissions pathway for the entire index (for example, reducing index GHG
intensity by 7% annually). These target reductions can then be achieved within the index
methodology through techniques such as optimization, tilting, or exclusions. We call these OneSize-Fits-All (OSFA) indices.
However, more often than not, the speed and shape of decarbonisation differs by region andactivity. We argue that investors can make better use of tracking error, and transition risk canbe mitigated more efficiently, if consideration is given to the representative decarbonization
trajectories of the sectors and countries that the index represents.4 We call indices based on
this approach Granular Representative Energy Transition Aligned (GRETA) indices.
To establish representative pathways for GHG emissions of different countries and sectors, weturn to the emissions pathways collected in the Sixth Assessment Report (AR6) by theIntergovernmental Panel on Climate Change (IPCC).5 The term net-zero is often used to refer topathways that are consistent with 1.5°C climate targets. Since reducing emissions faster earlyon will result in greater chances of achieving climate targets, we consider the set of 97 moststringent emission pathways to demonstrate our approach.6 This approach can however beadapted to align with other emission pathways, depending on investment objectives.

1United Nations (2015). Paris Agreement.
Commission Delegated Regulation (EU) 2020/1818.
3
Development and Uptake of Net-Zero-Aligned Benchmarks (November 2022).
4
A similar approach is suggested by the Net Zero Asset Owners Alliance in its recent report, Development andUptake of Net-Zero-Aligned Benchmarks (November 2022).
5Sixth Assessment Report — IPCC.
6Consistent with 1.5°C of global warming with no or limited overshoot.
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To ensure that the regional and sectoral emissions pathways are mutually consistent and reflect
the same technological and socio-economic assumptions, we select just one of the 97 global
pathways in AR6 and then use the sectoral and regional breakdown of the emissions pathways
generated by the corresponding model. Figure 1 (left) shows emissions pathways across regions
under a projection that takes a middle-of-the-road view on the technology mix of the future.
Using these regional emissions pathways, together with a set of sectoral pathways from thesame model, we construct a GRETA-type index. We compare the investment implications of thisindex with an index that uses only the global emissions pathway (OSFA index). The eligible
investment universe is the Bloomberg World Index, representing ~85% of the global market.
Bloomberg emissions data, which fully covers the Bloomberg World Index, is used to determine
companies’ operational carbon emission footprints. Figure 1 (right) shows that between 2020
and 2030 the global decarbonisation rate for the OSFA and GRETA index is similar at c.7% p.a.,but the regional decarbonisation rates are quite different. Given that the regional compositionsin the GRETA and OSFA index are comparable with the underlying benchmark, this suggeststhat the OSFA index achieves emission reductions through underweighting higher emitting
assets in Emerging Markets.

Figure 1 (Left): Emissions pathways across regions in a
representative 1.5°C scenario with no or limited overshoot.

Figure 1 (Right): Annual decarbonisation rateby region (2020- 2030) in GRETA and OSFA.

35 GtCO2 / Yr30Worldc.60 0 Gt, net-zerocarb on b ud getconsistent with 1.5d egrees warming

2520Dev
Asia

15Rest of EM

10NorthAmerica
Dev EUInd ia
5020 15 20 20 20 25 20 30 20 35 20 40 20 45 20 50
EM China
EM India
Rest of EM
Dev EUNorth America
Dev Asia
Source: Byers et al. (2022), using REMIND-MAgPIE 2.1-4.2,
EN_NPi2020_600_COV
Source: Bloomberg

China
0%5%

10 %

15%

20 %Decarb onisation Rate p .a.
GRETA OSFA
Source: Bloomberg

Transition Risks
One of the key reasons for implementing net-zero aligned portfolios is to mitigate transition
risks. For illustration, we define a simple transition-risk indicator where firms whose emission
intensity is below the sector average are categorised as “Green,” and those above as “Brown.”
Figure 2 shows the average active weights for Green and Brown in GRETA and OSFA. It isevident that OSFA underweights carbon-intensive sectors, irrespective of whether the4constituents are Brown or Green. With GRETA, on the other hand, we observe positive active
weights for Green and negative active weights for Brown, across sectors. Given that companies
in carbon-intensive sectors could also be the ones that reap the benefits of low-carbon
technologies, it is more efficient to discriminate between leaders and laggards in a given sector.
Figure 2: Granular sector pathways more efficiently mitigate transition risks
GRETA

OSFA

Source: Bloomberg

Source: Bloomberg

Making Better Use of the Tracking Error
Table 1 shows the historical trade-off between tracking error and carbon reductions during thebacktest period in 2015 and 2022. Despite similar tracking errors and carbon reductions, GRETA
exhibits greater dispersion between Green and Brown. OSFA underweights Green in several
carbon-intensive sectors. We therefore believe that investors can make better use of tracking
error when the portfolio is aligned to emission pathways on a granular level.

Table 1: Tracking error is better used when aligning to granular regional and sectoral
pathways.
Tracking Error (p.a.)

Emission cut
relative to baseyear (=2015)

Dispersion:
Average active wt forGreen - Brown

Average active wt forGreen in O&G, Material,
Utilities

GRETA

0.40%

55%

10%

1.3%

OSFA

0.40%

55%

6%

-0.7%

Source: Bloomberg

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