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ESG Investment Insights
Understanding the Bloomberg MSCI Euro
Corporate Climate Paris Aligned ESG Select Index
February 2023

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ESG Investment Insights

A Fixed Income PAB Case Study
Paris Aligned Benchmarks (PABs) have received significant recent attention
in the financial industry. This is deservedly so, as their regulatory origin has
brought much-needed standardization to ESG and sustainable investing,and therefore they are of global interest.
Notably, while key de-carbonization and ESG requirements are made clear,
PABs are not fully prescribed. The flexibility is deliberate, as not only doinvestors have varying objectives and mandates concerning active risk, but
regulations also allow for innovation.
In this paper our aim is to•Provide a brief motivation for financial industry alignment with climate
objectives.

•

Review guidelines for PABs, highlighting both areas of flexibility anddifferences in asset classes.

•

Analyze the design and historical performance of the Bloomberg
MSCI Euro Corporate Climate Paris Aligned ESG Select Index, whoseparent index is the Bloomberg Euro Aggregate Corporate Index, awidely referenced market-value weighted benchmark.

This featured PAB index offers a good demonstration in bringing risk
management techniques into index construction, with the result being a PAB
implementation that goes well beyond minimum requirements. Of particularinterest to fixed income investors are rigorous controls for managing low
tracking error while satisfying the dynamic path towards net zero portfolio
emissions.

Kerry Angel+44 20 3525 1630
kangel4@bloomberg.net
Antonios Lazanas+1 212 617 0607
akazabas5@bloomberg.net
Zarvan Khambatta+1 212 617 5418
zkhambatta4@bloomberg.net
Lingjuan Ma+44 20 3525 0741
lma208@bloomberg.net
Aramian Wasielak+1 212 617 3628
awasielak@bloomberg.net
AJ Lindeman+1 212 617 7491
alindeman@bloomberg.net

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Introduction“It is unequivocal that human influence has warmed the atmosphere, ocean and land.” Indeed, the IPCC’s
most recent Summary for Policymakers declares that real-world climate risks are clear and manifest 1:
Human-induced climate change, including more frequent and intense extreme events, has caused widespread adverse impacts andrelated losses and damages to nature and people. (SPM.B.1)
Global warming, reaching 1.5°C in the near-term, would cause unavoidable increases in multiple climate hazards and present
multiple risks to ecosystems and humans […] Near-term actions that limit global warming to close to 1.5°C would substantiallyreduce projected losses and damages related to climate change in human systems and ecosystems, compared to higher warming
levels, but cannot eliminate them all. (SPM.B.3)

The Paris Agreement is an unprecedented framework for global action on climate change. It was adopted by
196 countries in Paris on 12 December 2015, and entered into force on 4 November 2016. Its goal is to limit
global warming to well below 2°C, preferably 1.5°C or less, compared to pre-industrial levels 2.
While various factors contribute to global warming, human-induced GHG emissions comprise the largest
contribution to radiative forcing – the physical term for drivers of the Earth’s surface and atmospherictemperatures. Because GHGs remain in the atmosphere for decades, emissions are what really matter. The
IPCC estimates that 300-500 Gt of CO2-equivalents remain in the “carbon budget” for meeting Paris
Agreement objectives. At a time when emissions are approximately 59 Gt/year, economy-wide reductions
are paramount.
The Paris agreement recognizes that “aligning financial flows” is necessary for real-world emissions reduction.
Thus in 2018 the European Commission formed a Technical Expert Group (TEG) to develop standards thatinvestment products must meet to be designated as “Paris-aligned” or “Climate-transition” benchmarks(PAB/CTB). The capstone of these standards is a requirement for portfolios to de-carbonize along a simple
prescribed pathway that is within the carbon budget and results near-zero emissions in 2050. 3
Naturally, investors should manage their portfolios’ carbon
trajectory for reasons beyond regulation. Asset owners andmanagers – many of whom have responsibilities as universal
owners – recognize that without sufficient climate-related
analysis, portfolios are likely to be exposed to increased risk
and may be missing opportunities arising from a world intransition. For many, PAB standards are only a reasonable
starting point in the broader discussion of the interaction
between financial and climate risks.

PABs [aim to mitigate] climate change through ashift of their investment allocation from GHG
intensive activities – notably fossil fuels – torenewable energy and energy efficiency.
[They] can be perceived as tools for investors withthe willingness to be at the forefront of thetransition, favoring today the players of
tomorrow’s economy.
TEG Final Report, 2019

Overview of PAB Framework
Before turning to the Bloomberg MSCI Euro Corporate Climate Paris Aligned ESG Select Index (hereafter“PAB ESG Select”), we provide an overview of PAB requirements, emphasizing that these are minimum
requirements. This review includes an understanding the PAB trajectory relative to more sophisticatedclimate scenarios, some practicalities of incorporating GHG data, and choices of index construction methods.
An understanding of the overall context should serve to better understand the choices made in what follows.

1 IPCC Climate Change 2022 - Summary for Policymakers
2 The Paris Agreement on Climate Change. UN, 2015
3 Handbook of climate transition benchmarks, Paris-aligned benchmark and ESG disclosures. EU TEG, 20193

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Minimum Standards for PAB designation
A synopsis of minimum standards 4 for the PAB label is as follows:•

Determine a universe of securities via a parent index (that is, a set of securities with a weight assigned
to each). Typically this is a market cap or market-value weighted index representing a broad investible
opportunity set.

•

For each company, determine a per annum GHG emissions level. Types of emissions covered can varyby sector and time, though within four years of implementation Scope 1, 2 and 3 must all be included.
If a reported value is unavailable, estimated values are permissible. When relevant, benchmark
administrators are encouraged to follow the precautionary principle by incentivizing dissemination of
actual emissions levels.

•

Generally, a GHG intensity is calculated. This is the emissions level divided by a financial metriccontrolling for firm size. Bloomberg uses an inflation-adjusted enterprise value for its equity PAB
indices. Since a significant number of corporate bond issuers are private companies, for which no
market value of equity is available, fixed income indices may optionally skip the intensity step andimplement the trajectory in terms of absolute levels.

•

Once the parent index and GHG data are determined, key requirements are:•oHave an initial reduction of the GHG metric be 50% or more below that of the parent index,
and remain at or below 50% of the parent index over time.

oSelf-decarbonize at a further 7% per annum.

oHonor baseline exclusions by eliminating holdings in companies deriving significant revenue
from controversial weapons and activities inconsistent with the UN Global Compact. (Suchexclusions do not concern climate risk per se.)o

Honor activity exclusions by eliminating companies having revenue above certain thresholds
in coal, oil, natural gas; or electricity generation where lifecycle GHG emissions are above 100
gCO2e/kWh.

oFor equity indices, the PAB label requires maintaining aggregate parent weight amongprescribed climate high-impact sectors 5. Fixed income indices do not need to meet such arequirement.

Optional features areooConsider increasing weight of companies that set evidence-based emissions targets.
Green to brown revenue share should be significantly larger than that of the parent index (amultiple of 4 or greater).

Should the ex-post GHG constraints be breached for 2 consecutive years, the index forfeits its PAB label.
Although we will not delve into details here, the PAB label also requires disclosure of various ESG metrics insupport of index construction.
Before discussing the key steps in more detail, we note there is ample potential for innovation and financial
product differentiation. There are many possible ways to meet the standards, and this flexibility is essential
for fulfilling fiduciary responsibilities surrounding active exposures, turnover and transparency.

4 TEG final report on EU climate benchmarks, 2019.
5

NACE Section codes A-L, spanning Agriculture, Mining, Manufacturing, Power Supply, Water Supply, Construction, Trade, Transport and Real Estate.

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Emissions pathways
The IPCC, which curates scientific and economic information on behalf Paris Agreement signatories,
recommends global net anthropogenic GHG emissions decline by 45% from 2010 levels by 2030, reaching
net zero around 2050 6. However, there are many pathways that satisfy this aggregate target, as sector andregional trajectories can add up in different ways while being within the carbon budget. Figure 1 shows one
illustrative scenario from BloombergNEF that is consistent with 1.75°C warming by the year 2100. This is a lessaggressive target than 1.5°C, but it helps visualizes sector-based projections and gives us a peek into whatclimate pathway modeling involves. A “business-as-usual” scenario, labeled ETS, with an implied 3.3°C
warming, is shown for reference.

Figure 1. Sample de-carbonization trajectories for global GHG emissions – i.e. the entire global economy (not a portfolio). ETS is the Economic
Transition Scenario, a projection of what could happen if no policy action is taken and only economic forces are in play. A 7% per annum trajectory
starting from 2022 levels is also shown. Source: BloombergNEF.

The dotted yellow line is the 7% per annum trajectory. Since this graph represents global emissions and not
a portfolio’s footprint 7, we have not included the 50% initial haircut required by PAB.
Two things are evident: first, to achieve a 50% haircut, the Power sector will likely be strongly affectedaccording to this pathway. Secondly, the modeled de-carbonization rates vary by sector – for example Steelsector emissions are roughly flat through 2030, whereas Power and Road sectors decline earlier – reflecting
BloombergNEF’s views on sector capabilities. In any case, the overall shape of the trajectories can be different– this particular pathway declines more slowly than 7% initially, and faster later 8.
To be sure, there are many other sources of pathways, including the IPCC itself. These pathways are by nomeans unique, and they may not be equally realistic. The key advantage of the prescribed 7% rate is thatinvestors and benchmark providers can be assured of 1.5°C alignment without having to analyze the myriadof available climate scenarios themselves.

Quantifying emissions
GHG emissions are the main ingredient for quantifying alignment to climate scenarios. At present, companies
voluntarily disclose GHG emissions through various de-centralized channels — for example, sustainability
reports or the CDP 9.
6 Special report on global warming of 1.5C, IPCC 2016
7 Although PAB/CTB regulations do not use the term, detailed standards are being developed for a portfolio’s financed emissions.
8 The total warming impact – temperature rise – depends on cumulative emissions, i.e. the area under the curves.
9

A not-for-profit charity that runs the global disclosure system for investors, companies, cities, states and regions to manage their environmental impacts.

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GHG emissions are divided into 3 categories, or scopes 10:•

Scope 1 Emissions: All direct GHG emissions•

Scope 2 Emissions: Indirect GHG emissions from the consumption of purchased electricity, heat or
steam

•

Scope 3 Emissions: Value chain emissions: other indirect emissions from purchased materials,
transport, outsourced activities, use of sold products and more

Figure 2: Overview of GHG Protocol scopes and emissions across the value chain. Source: ghgprotocol.org.

EU regulations encourage the use of Scope 1+2+3 data in measuring GHG, but it is understood that at present
Scope 3 data and estimates are insufficiently standardized to be fully required for PAB labeling. Therefore,
the inclusion of Scope 3 can be phased in by sector, starting with Oil, Gas and Mining at inception, followedby Transportation, Construction, Buildings, Materials and Industrials after two years, and every sector being
included after four years. Because this is a minimum requirement, benchmark providers may include Scope
3 at inception.
While Scope 1+2 are well disclosed in Europe 11, reporting levels vary by region – either way necessitating theincorporation of estimates into aggregate GHG measures. Estimates can be derived by associating company
characteristics to a set of peers for which emissions are reported. This association could be implemented
using group averages (pivot tables), regression or even other more sophisticated techniques. It is worth
noting that estimated emissions do not necessarily lead to 100% coverage, because accurate estimatescannot be derived if sufficient company characteristics are unavailable for determining peers – a situation
more likely to arise for private companies.
As mentioned above, at present, relatively few companies report Scope 3. Even when companies do report,
10 Greenhouse Gas Protocol
11 As of August 2022, 91% of Scope 1+2 emissions were based on reported data for the PAB ESG Select index

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Scope 3 likely reflects a mix of actual (metered) readings and company-prepared estimate 12. This observationsuggests that even reported Scope 3 data reflects a material level of modeling, even if this is done undercompany oversight. For this reason, it is reasonable to consider using estimates for all Scope 3 data at thispoint in time, as it is easier to demonstrate a consistent set of assumptions is being applied.
Regardless of scope, the incorporation of estimates presents some challenges in meeting PAB requirements.
As more companies report, the values may differ from the previously used estimates. This can result in an
index’s GHG metrics changing simply due to estimation error. Index providers may wish to protect against
breaching constraints by incorporating a buffer (say using a de-carbonization rate greater than 7%) or using
a quantile estimate (say using the 75th percentile in an estimated range instead of the distributional mean).

The de-carbonization inequality
The de-carbonization trajectory is the cornerstone of PAB and merits careful explanation. Conceptually, thecentral requirement is that at each rebalance date, the PAB emissions metric be the minimum of 50% of theparent index level and the previous target reduced by an “inflation”-adjusted factor. The “inflation” factor issubject to further definition depending on exactly how GHG is measured, but its role is to correct bias arisingfrom nominal increases in revenue, market cap or EVIC (and not a price index such as CPI).
While there is much focus on the geometric 7% trajectory, it is worth noting that the parent index will bedecarbonizing along with the regular economy; the regulation ensures that PAB indices do no worse thanthe parent at any point in time. This general process is represented by the following formula:
PAB GHG𝑡𝑡 ≤ min �50% × Parent GHG𝑡𝑡 ,50% × Parent GHG0 × (1 − 𝑅𝑅)𝑡𝑡/𝑓𝑓
� , where
𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡•t is the number of rebalance periods since PAB inception•

f is the rebalance frequency per year•

PAB/Parent GHG are the weighted average index values 13. The value must be an intensity for equity
PABs but may be absolute GHG for fixed income indices.

•

R is the annual reduction rate, which needs to be 7% or greater•

IAF is an inflation adjustment factor, which can differ depending on how GHG is measured.

Index construction
As with any investment product, PAB index construction needs to ensure all objectives are being met – in thiscase, both regulatory and traditional considerations surrounding tradability and risk management.
Figure 3 summarizes two basic approaches. Optimized approaches offer the most flexibility and specificity,
as PAB requirements can all be implemented as constraints. Additional constraints to manage risk andturnover may be added. To obtain unique solutions, it is necessary to specify an objective function that
determines which of the constraint-meeting portfolios is best. While the results do rely on numerical software,
many investors appreciate the precision optimization techniques offer.
Alternatively, one can specify an order for removing securities from the portfolio. This Rules-based Exclusions
approach checks if the emissions target is met at each step, and stops when the target is met. While thisresults in straightforward-to-verify security selection, the challenge is that risk exposures are not explicitly
controlled – at least not without a significant increase of complexity that involves making the ordering scheme
itself risk-aware.
12 Technical Guidance for Calculating Scope 3 Emissions. Greenhouse Gas Protocol 2013. Scope 3 FAQs. Ibid, June 2022.
13 Treatment of missing emissions data in the parent is not fully specified by regulation and can vary.

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Rules-based
Exclusions

approach.
• A rule specifies the exclusion order - could be in termsof absolute emissions, or intensities, or round-robin
across sectors.
• At each step, check if the emissions target is met andterminate iterations if so.

• Manage decarbonization requirements and various

Optimized

active risk exposures via constraints, with trade-offs
made by the optimizer.

• Choice of objective function, such as maximizing a scoreor minimizing tracking error/active weights.

Figure 3. Summary of differences between Rules-based Exclusions and Optimized methods of index construction.

Comparing equity and fixed income PABs
Guidance from the EU TEG recognizes that in the steady-state (non-material changes in AUM), fixed-income
funds mostly purchase bonds at issuance, meaning they largely affect the primary market and are directly
funding corporations – potentially even financing projects detrimental to climate change mitigation andadaptation. On the other hand, equity investors transact on the secondary market and exert influence via
engagement and voting 14. Based on this reasoning, it is permissible for fixed income PABs to meet decarbonization requirements via exclusions and weight reductions, even if this eliminates holdings in carbonintensive sectors such as Energy. On the other hand, equity holders, are expected to maintain aggregate
holdings in carbon intensive sectors, as owner influence remains paramount.
A second permissible difference is in the measurement of GHG. Ideally, all PABs would de-carbonize in termsof intensity, as this is neutral (invariant) under mergers, acquisitions, and divestitures. To see this, consider acompany emitting 500 units of GHG comprising 5% of an index. Suppose they split into two companies
emitting 250 units each. The original GHG contribution is 5% × 500 = 25 units, and post-split contribution is
2 × 2.5% × 250 = 12.5 units. However, in an intensity measure, the contribution to index intensity is unchanged
provided the index weights are proportional to EVIC15.
However, bond funds often have significant holdings in private companies, for which no market capitalization
is available. While one could mix book and market values for EVIC, this is of concern to some investors. To
alleviate such concerns, targeting absolute emissions is permitted in fixed income.
Finally, there is a more “mechanical” difference: both GHG and risk are affected by ticker (company) weightdecisions in an equity index. In fixed income, ticker weights affect GHG and risk as well, but individual bondweights affect risk further. Such “tiering” of metrics between ticker and bond level makes fixed income index
construction more complicated. A summary of these differences is given in Figure 4.

14 Handbook of CTBs, PABs and ESG Disclosures, TEG 2019, sections 1.9 and 3.2.
15 If the split in GHG is g and 1-g, and the split in EVIC is s and 1-s, note that (g×G+(1-g) ×G)/(s×E+(1-s)×E) and s×g×G/(s×E) + (1-s) ×(1-g) ×G/((1-s) ×E) both equal G/E.

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Equity PAB

Fixed Income PAB• Must maintain aggregate holdings in "highclimate impact sectors"• Can meet de-carbonization goals by both
exclusions (including sector exclusions) and underweighting.

• This ensures retaining influenceengagement and voting rights.

via• GHG must be measured in terms of intensity• GHG and risk are managed by the same
security-level weights.

• This avoids funding activities which may be
detrimental to climate mitigation.
• GHG may be measured in terms of absolute levels
to avoid inconsistent treatment of enterprise value.
• GHG is associated to companies, whereas risk
includes bond-level characteristics, increasingindex construction complexity.

Figure 4. Summary of key differences between equity and fixed income PAB guidelines.

Case study
The Bloomberg MSCI Euro Corporate Climate Paris Aligned ESG Select Index
The PAB ESG Select Index demonstrates the opportunity to go above and beyond minimum requirements
while also utilizing powerful tools to manage financial risk and ensure investability. Notably, the index targets
a 10% per annum de-carbonization trajectory 16 in both absolute levels and intensities, and optimization isused to manage a wide variety of goals. Key elements of the specification are listed in Figure 5 below 17.
Beyond the ESG and climate-related objectives, we want to draw attention to the investability objectives.
Firstly, there are explicit constraints in terms of yield-to-worst (YTW), option-adjusted duration (OAD),
duration-times-spread (DTS) and sector/country/issuer weight differences versus the screened parent
index 18 . These constraints alone control headline sources of active exposures in sector, rates and credit
spread factors.
Beyond these first-order controls, the index also utilizes the Bloomberg Fixed Income Multi-Factor Risk model
to minimizing ex-ante tracking error to the parent index. This risk model generates a robust portfolio
covariance matrix based on a rich set of factors including curve, volatility and spread factors. Finally, we notethat relative bond-to-ticker weights are maintained between this PAB index and its parent index. This ensuresthat each issuer’s curve characteristics are maintained in the PAB index, as well as preventing GHG and ESG
objectives being met at the cost of introducing curve, coupon and idiosyncratic active risk.
We emphasize that optimization is necessary to manage this comprehensive array of goals. As we shall see
below, not all constraints are necessarily binding. As might be intuitive, ESG constraints can work in
conjunction – for example, higher ESG scores, and “green” revenue ratios are correlated to each other andto lower emissions. Having multiple metrics in the specification may be statistically redundant at any point in
time, but they provide assurance that the portfolio is not over-fit to any specific metric. Additionally, binding
constraints can be a source of turnover; correlation among constraint variables reduces the likelihood all
constraints are binding.

16 In addition to being nominally higher than the required 7%, a 10% de-carbonization rate provides a strong buffer in the event reported emissions exceed estimates.
17 Details are further provided in the index’s methodology guide18 The screened parent index is that result of applying baseline, activity and ESG exclusions, but prior to optimization.

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Parent & Base Date
• Bloomberg Euro Aggregate Corporate Index• Base date for GHG baseline is June 30, 2020
Objective• Minimize total active risk
• Minimze turnover
ESG and Climate Data
• GHG, revenue, ESG ratings/scores, controversy flags are all provided by MSCI.
• Scope 1+2 emissions are mixture of reported and estimated. Scope 3 emissions are included for all sectors using
estimates only.
Climate Constraints• 50% initial reduction in both weighted absolute emissions and intensity versus parent• Minimum 10% per annum reduction in both weighted absolute emissions and intensity• Minimum 100% increase in weighted average green revenue versus parent• Minimum 4x increase in green-to-fossil-fuel revenue ratio relative to parent• Minimum 20% increase in weight for issuers having and meeting reduction targets
ESG Constraints• Minimum 15% increase in weighted average MSCI ESG score• MSCI ESG rating of B or higher• Exclude any issuer with MSCI ESG Controversies score of "Red" or that are not covered by MSCI ESG Controversy
Research• If neither a reported nor estimated GHG level is available, the issuer is excluded. If only the intensity is unavailable, theissuer is included in the index, and only ignored in the intensity constraint.
Baseline Exclusions• EU delegated acts: controversial weapons, tobacco producers, UNGC violations.
Activity Exclusions• EU delgated acts: environment controversy, thermal coal revenue (1%), oil & gas revenues (10%), power generation(50%).

• Additional: nuclear weapons, civilian firearms (5%), unconventional oil & gas (5%), tobacco (5%), conventional weapons(5%), weapons systems (10%).
Investability Constraints• Ticker weight relative to screened parent 0.1x - 5x and ±1%, with max of 4.5%

• DTS ±5%
• YTW greater than or equal to parent• OAD ±0.25• BCLASS3 sector weight difference ±5%• Country weight ±5%• Turnover, parent index +4%
Optimization variables• The optimizer works in terms of ticker-level trades, meaning that the relative bond weight of each ticker is the same asthat of the parent index.
• Risk measures continue to include the effect of bond-level positions.
Infeasibility• If, on any month, the optimization task is not feasible, the ESG Score constraint will be reduced in increments of 2.5%
until a result is found.
Figure 5. Summary of the PAB ESG Select Index specification. Source: Bloomberg MSCI.

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Carbon Trajectory. We begin our quantitative performance analysis by looking at the de-carbonization
trajectory through the August 31, 2022 index re-balance. Figure 6 shows the parent trajectory, the two
operative constraints (50% of parent and 10% annual), and the standard 7% trajectory, for both level andintensity. At inception, the 10% trajectory was a binding constraint for level. Since late 2021, re-balances haveresulted in both being below constraints, consequences of exclusions, weight reductions, and meeting otherconstraints.

Figure 6. Summary of de-carbonization trajectories as of August 31, 2022. Source: Bloomberg MSCI.

ESG Metrics. Results for other ESG metrics are presented in Figure 7. We observe that as of the August 31,
2022 index rebalance, the Green Revenue and ESG Score improvement constraints are binding at +100%
and +15%, respectively. On the other hand, there is a considerable buffer of Green to fossil fuel ratio at 13x –again a consequence of exclusions and meeting other constraints.
MetricRequirement

Parent

PAB

Green Revenue

PAB index is required to have an increase in weighted averagegreen revenue relative to parent of +100% at rebalance date.

5.023

10.027+100%

Green to Fossil
Fuel Ratio

PAB index is required to have green to fossil-fuel ratio of at least 4x
vs. the parent at rebalance date

1.418

18.46313x

Issuers with GHG
Reduction Targets

PAB index is required to have reduction target coverage 20%
greater than the parent in relative terms.

7.4%

13.1%
+77.5%ESG Score

PAB index is required to have an increase in ESG score revenue
relative to parent of +15% at rebalance date

7.179

8.230
+15%

Figure 7. Summary of non-GHG ESG constraints as of August 31, 2022. Source: Bloomberg MSCI.

Let’s look in more detail at how exclusions and optimization work in tandem to lower emissions. Figure 8
shows the weighted-average emissions levels at different stages of the rebalance for August 31, 2022. We
see immediately that the standard exclusions have the largest effect, removing 33.6 MMTCO2e, with the
majority stemming from down-weighting Energy and Consumer Cyclicals. Because weights must sum to one,
exposure to some sectors must be increased, which can increase emissions contribution. This is depicted by
the portion of the second bar that is above the black line. We can also see that the additional exclusions havenegligible impact on emissions. However, the optimization step, where ESG and revenue constraints are
enforced, removes an additional 5 MMTCO2e. We can also observe that in the PAB index, the largest
contribution of emissions level comes from the remaining Industrials, Banking and Consumer Cyclicals
sectors.
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Figure 8. Waterfall depicting weighted-average emissions levels at different stages for the August 31, 2022 rebalance. Source: Bloomberg MSCI.

Non-ESG Investability Constraints. Keeping our attention on sector differences, which must be within 5%(except for Energy), we see from Figure 9 below that REITs, Technology and Finance gain weight (but lessthan 5% upper bound), and Energy, Consumer Cyclical and Natural Gas have decreased weights (but remain
greater than the lower bound). In fact, the PAB weight of Energy is zero, due to the baseline exclusions ofrevenues greater than 10% to oil and gas.

Figure 9. Sector weight differences as of August 31, 2022. Weight differences are in dark blue and correspond to the bottom axis. The top axis is for
total PAB weight, depicted as shaded bars. Source: Bloomberg MSCI.

The headline financial objectives are to achieve similar-or-better expected return, as measured by YTW, withsimilar levels of rate and credit risk (OAD and DTS), and, as seen, sector exposures. Figure 10 shows that asof the August 31, 2022 rebalance, the PAB index has a slightly longer duration (by 0.03), and a slightly lower
DTS (by 0.2); neither is binding. The objective function is minimized with 2.81bp of remaining active risk.

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Risk Metric(August 2022)
Yield to Worst (YTW)

Requirement

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Parent

PAB

Greater than or equal to parent

2.99

2.99

Option Adjusted Duration (OAD)

Within 0.25 of parent

4.78

4.81

Duration Times Spread (DTS)

Within 5% of parent

6.02

5.82

Total Active Risk

Minimize (subject to all constraints, as discussed)-

2.81bpFigure 10. Summary of risk metrics for the August 31, 2022 portfolio rebalance. Source: Bloomberg MSCI.

As the direction of duration and DTS differences may change during rebalances, we are reminded that sometracking error is inevitable. For this reason, the PAB ESG Select Index includes the objective of minimizing
total active risk using Bloomberg’s Fixed Income Multi-Factor Risk Model.

Historical Performance Metric(June 2020 – August 2022)
Annualized Return

Parent

PAB-3.59%-3.67%

Annualized Volatility

6.84%

6.79%

Maximum Drawdown-13.38%-13.58%Annualized Relative Return--8.9bp

Tracking Error Volatility (TEV)-

22.4bpMaximum Relative Drawdown--48.3bp

Figure 11. Relative performance between PAB and Parent index. Data from August 2019 through index launch (March 2022) is pro forma. Bars depict
monthly excess returns (left axis, in basis points), and the line shows cumulative excess return (right axis, 100 base). Source: Bloomberg MSCI.

Examining Figure 11, we see that over the available historical period the realized tracking error is 22.4bp
annualized – roughly 6.4bp per month. In this period, the annualized excess return was slightly negativeat -8.9bp, which is -0.7bp per month. Given the strength of risk controls in the index construction process,one can expect that sources of tracking error will remain limited to specified risk exposures and nondiversifiable risk.

Conclusion
In this paper we have reviewed the motivation and key criteria for Paris aligned indices and have used theBloomberg MSCI Euro Corporate Climate Paris Aligned ESG Select Index as a case study to demonstrateindex design considerations and consequences. This PAB index exhibits ambitious de-carbonization
objectives by tracking both levels and intensities at 10%, exceeding what is necessary by 3%. Moreover, theindex implements a variety of risk controls in order to limit active risk and, ultimately, remain positioned for
low realized tracking error.
Acknowledgements. The authors wish to thank Matthias Wang at Blackrock and Jarrad Linzie at MSCI for helpful comments andsuggestions.

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Important Disclosures and Disclaimer:
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