Product InsightUnderstanding
MSCI Climate
Indexes
Methodologies, Facts and Figures
Guido Giese, Saurabh Katiyar, Guillermo Cano
November 2021

November 2021

Product InsightContents

Executive Summary

3

Introduction

4

Step 1: Defining Objectives and Preferences

8

Step 2: ESG and Climate Data for Climate Indexes

9

MSCI ESG Data

10

MSCI Climate Metrics

10

MSCI Sustainable Impact Metrics

11

Step 3: Climate Index Construction Methodologies

11

MSCI Climate Indexes

12

Climate Characteristics

15

Index Profile

17

Financial Risk and Performance Profile

19

Security Allocations of the Climate Paris Aligned Index

21

Conclusion

22

References

23

Appendix24

November 2021

UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

Executive Summary
Integrating climate considerations into an investor’s set of benchmarks is one way tobuild a consistent framework for integrating climate risk across an entire portfolio.
Climate change has been widely recognized as both a financial risk to investment
portfolios and a risk to the future living standards of humankind. 1
Investors often aim to capture more than one objective through their capital
allocations: They may seek to align their objectives to an investment policy thatsimultaneously addresses financial risks and opportunities in their portfolios,
incentivizes companies to change their business models and steers capital towardgreen technology companies that can provide positive environmental impact.
In addition, investors may have different preferences when it comes to selecting a
climate index: Some may prefer a broad market index that invests in mostcompanies in the broader universe and has low tracking error. On the other hand,some investors may prefer holding only leaders in climate technology solutions, tomaximize the climate impact of their portfolio. To address these different
preferences, MSCI has developed four categories of climate indexes. The first three
are broad-based, with limited tracking error, while the fourth takes a moreconcentrated approach.
1. Improving the carbon footprint of the index. The MSCI ex Fossil Fuels Index
excludes companies holding fossil-fuel reserves. The MSCI Low Carbon
Leaders and MSCI Low Carbon Target Indexes reduce exposure to bothfossil-fuel reserves and heavy greenhouse-gas (“GHG”) emitters while
controlling for tracking error.
2. Reducing exposure to heavy emitters and overweighting companies ingreen technology. The MSCI Climate Change Index takes this more
symmetrical approach: In addition, it decarbonizes the index by 7% per year inline with the EU Climate Transition Benchmark requirement.
3. Aligning the index with a 1.5-degree-Celsius (1.5˚C) temperature rise. The
MSCI Climate Paris Aligned Index overweights green technology more thanwhat is required by the EU Paris-aligned benchmark standard.
4. Taking a more concentrated approach. The MSCI Global Environmental
Index focuses on companies that have high revenue exposure from green
technology. With its relatively high tracking error, it is suited for investors thatwant to make a positive environmental impact.

1“Human cost of disasters: An overview of the last 20 years, 2000-2019.” Centre for Research on the Epidemiology ofDisasters and UN Office for Disaster Risk Reduction, Nov. 3, 2020.

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

Introduction
Climate change is the single greatest challenge humankind has faced, and its
consequences are already all too apparent. To safeguard the welfare of the planet
and the living standard of future generations, global political leaders adopted a goalof limiting the increase in the world’s average temperatures to well below 2°C above
pre-industrial levels under the 2015 Paris agreement. 2
At the same time, institutional investors started to recognize that shifting capital
toward issuers that align their business with climate change may drive the transition
to a low-carbon economy and help them manage climate transition risks andopportunities. This has led to a proliferation of climate investment strategies, bothactive and passive, reflecting both a more diverse set of investor objectives andimproved technical capability to implement more tailored solutions. In addition, they
have drawn off the increased breadth and quality of climate data. This paper aims to
explain different methodologies one can use to integrate climate considerations intoa benchmark and to illuminate the resulting differences in financial and climatecharacteristics.
Climate risks are typically categorized along two dimensions: 3, 4••

Transition risks: the risks associated with transitioning to a low-carbon economy— for instance, shifts in policy, technology or supply and demand in certain
sectors; andPhysical risks: the risks associated with the physical impacts of climate change
on companies’ operations, e.g., those resulting from extreme temperatures,
floods, storms or wildfires.

These risks may also present opportunities, which companies may capitalize on by
providing climate solutions such as producing or using renewable energy or leasing
green buildings. These can have an impact on financial performance in the short tolong term.
We find that investors typically pursue both financial and social objectives, which
represent the four objectives of MSCI climate indexes.
Climate change has been recognized widely as a financial risk for businesses
involved in the fossil-fuel value chain. Therefore, reducing emissions and mitigating

2 “The Paris Agreement.” United Nations Climate Change.
3Although we usually refer to climate “risks,” there also can be upside opportunities resulting from climate change, as we

will discuss in subsequent sections of this paper.
4
For a further description, see Task Force on Climate-related Financial Disclosures 2017, “Final Report: Recommendationsof the Task Force on Climate-related Financial Disclosures,” Section B1 (Pgs. 5-6).

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

stranded-asset risks is the first of the four objectives that investors may pursue toprotect their portfolios.
At the same time, there may be financial opportunities from investing in climate
solutions businesses, which may form a ‘’natural hedge’’ against stranded-asset
risks. Substantial investments in green technologies may be needed over the next
decade and beyond to finance the energy transition. 5
The third objective involves aligning investments with the Paris Agreement’s goal of
limiting global warming to well below 2°C by the year 2100. Setting an appropriate
benchmark can help investors track their progress in meeting this long-term goal. 6
For example, one can decarbonize the index at a rate that is in line with reaching netzero.
The fourth investment objective is focused on creating a more sustainable economy
and therefore making a positive environmental impact.
These investment objectives are illustrated in Exhibit 1.
Exhibit 1: Objectives of Climate Change Investing

We now return to “net-zero alignment,” which is widely used in the public debate
about climate change investing but its definitions sometimes vary. To constructclimate-index methodologies, we need a precise definition of what this term means.

5“Net Zero by 2050.” International Energy Agency, 2021.

6 Ibid.

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

Giese et al. (2021) defined net-zero alignment as indexes or portfolios that follow
emission reduction trajectories that reach net-zero emissions no later than 2050 andwhose cumulative emissions by 2050 stay within remaining emission budgets. The
emission budget defines the temperature a net-zero pathway is aligned with: thelower the temperature, the tighter the budget and the faster the portfolio must
decarbonize. MSCI Research has calculated that an annual decarbonization rate of
7% (as proposed by the European Union) is sufficient for MSCI ACWI IMI to align witha temperature well below 2°C, while a strict 1.5°C temperate alignment requires adecarbonization rate of 10% per year. These two rates are used in MSCI climate
indexes.
Integrating climate considerations into an investor’s set of benchmarks is one
way to build a consistent framework for the integration of climate risk acrossthe entire portfolio. In the financial industry, benchmarks are used at a
strategic level (i.e., as policy benchmarks for defining the eligible investment
universe of an investor or to help determine asset allocation), as well as at an
implementation level (i.e., as a performance benchmark for actively or
passively managed allocations or as a benchmark for financial products).

MSCI Climate Index Construction Methodologies
MSCI has developed different categories of climate indexes to address different
priorities investors may have in terms of mitigating climate-related risks, availingthemselves of climate solutions investment opportunities and providing positivesocial impact.
All these climate indexes follow the three-step index construction approachsummarized in Exhibit 2.

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

Exhibit 2: MSCI’s Three-Step Modular Approach to Creating Climate Indexes

In choosing or creating a climate benchmark, an investor first defines climate-related
investment objectives, and then maps these objectives to climate-related metrics.
Finally, the investor chooses an index construction approach, based on these
metrics.
The choice of objectives, datasets and index methodologies may be assessed using
the following questions:•••Objective: What is my climate-related investment objective? Do I want to improvemy carbon footprint to mitigate stranded-asset risks, or do I want to addresstransition risks and/or physical risks as well? Do I want to increase my exposure
to companies pursuing climate solutions?
Index methodology: Do I want to use sophisticated but potentially opaque
portfolio optimization techniques to manage the trade-off between climate risk
integration and other variables (such as tracking error, country and sector
deviations) efficiently? Or do I prefer simple and more transparent index
methodologies based on component selection or component reweighting?
Breadth: Do I prefer a broad climate benchmark that keeps most of theopportunity set of the parent index, or do I wish to focus my investments on asmaller number of companies with the highest possible exposure to leaders inclimate transition? Do I seek to divest from companies with the worst emission
footprint, or should I account for those who are setting credible emission
reduction targets?

We now consider index construction steps in more depth.

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

Step 1: Defining Objectives and Preferences
Broadly speaking, there are four categories of standard MSCI climate indexes, all ofwhich follow strict rules-based approaches and use the MSCI ACWI Index as theirstarting point. These four categories implement different combinations of the four
investment objectives shown in Exhibit 1.
1. MSCI Low Carbon Indexes are focused on one objective: reducing the carbon
emission intensity of the index and lowering exposure to fossil-fuel reserves(which constitute potential future emissions). This approach helps reduce index
exposure to potentially stranded assets.
2. MSCI Climate Change Indexes combine three objectives: They reduce risk
exposure to carbon-intense companies — including companies that are exposed
through their supply chain (Scope 3 emissions). They also overweight climate
solutions opportunities and implement an annual decarbonization rate of 7% thatis aligned with achieving a temperature of below 2°C, as explained earlier.
3. MSCI Climate Paris Aligned Indexes implement an even stronger shift fromfossil-based companies toward “green” solutions companies and decarbonize atan annual rate of 10% to ensure a temperature aligned with 1.5°C.
4. The MSCI Global Environmental Index focuses on positive environmental
impact, targeting companies that provide solutions in key areas such as
renewable energy, green buildings or pollution prevention.
The MSCI Climate Change Index aims to meet the requirements of the EU Climate
Transition Benchmark regulation, as spelled out in the related delegated act. The
MSCI Climate Paris Aligned Index aims to exceed those requirements, i.e., it
decarbonizes at an annual rate of 10% to ensure strict alignment with a 1.5°C
temperature.
These four categories of climate indexes reflect different investor preferences thatlead investors to the climate index approach that may be best-aligned to theirobjectives. We illustrate these preferences in a decision tree (Exhibit 3)© 2021 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

Exhibit 3: Decision Tree for Investors’ Preferences

As we detail later, low-carbon indexes comprise both ex Fossil Fuel and Low Carbon
Leader/Target indexes.

Step 2: Detailing Data Used in MSCI Climate Indexes
We provide an overview of the datasets used in the different climate index
methodologies in the exhibit below.
Exhibit 4: Data Used for Four Categories of MSCI Climate Indexes© 2021 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

MSCI ESG Data••

MSCI ESG Controversy Score: Provides an assessment of controversial
events linked to companies and their severity for stakeholders and financial
relevance. Scores range between zero (very severe) to 10 (no recent
incidents). The controversies also can be assessed on individual ESG pillars.
MSCI Business-Involvement Screens: Provide an analysis of the percentageof revenue companies derive from certain business activities, such as
alcohol or tobacco production.

MSCI Climate Metrics•

Weighted Average Carbon Intensity: The amount of Scopes 1 and 2 GHG(direct emissions and electricity use) in tons of CO2-equivalent (tCO2e) per
USD 1 million of sales.

•

Scope 3 Carbon Intensity: The amount of Scope 3 GHG emissions in tCO2e
per USD 1 million sales, based on MSCI’s Scope 3 Estimation Model,
generated by a company’s supply chain. This covers all 15 categories of
upstream and downstream Scope 3 emissions, as defined by the Greenhouse
Gas Protocol. Details on the methodology can be found in Hadjikyriakou et al.
(2020).

•

Fossil-Fuel Reserves: Potential GHG emissions in million tCO2e embedded incompanies’ coal, oil and gas reserves per USD 1 million market capitalization.

•

Low Carbon Transition Score (LCT Score): A measure of a company’s
climate transition risk arrived at by aggregating Scope 1, 2 and 3 emissions,avoided emissions and the quality of companies’ climate management into ascore between 0 (highest risk) and 10 (lowest risk/highest opportunity).

•

Low Carbon Transition Category (LCT Category): A category assigned to acompany that highlights the predominant transition risks and opportunities
the company is most likely to face. The LCT Category is based on the LCT
Score. There are five LCT Categories: stranded assets, product transition,
operation transition, neutral and solutions. Details can be found in Badani etal. (2019).

•

Climate Value-at-Risk: Forward-looking scenario-based analysis ofcompanies’ transition risk, physical risk and technology opportunities as apercentage of current market capitalization. MSCI calculates companies’© 2021 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

Climate VaR for 3°C, 2°C and 1.5°C warming scenarios. A company’s total
Climate VaR is the sum of three sub-components:
1. Policy Climate VaR: estimating the business impact ofdecarbonization
2. Technology Climate VaR: estimating financial opportunities fromclimate solutions technology
3. Physical Climate VaR: estimating companies’ future cost form
physical risk

MSCI Sustainable Impact Metrics•

Sustainable Impact Metrics: Designed to identify companies that derive
revenue from products or services with a positive impact on society and theenvironment. Sustainable Impact Metrics comprise of six Environmental
Impact categories and seven Social Impact categories, arranged by theme.

•

Green Revenue Share: Is part of MSCI Sustainable Impact Metrics anddenotes the recent-year percentage of revenue, or maximum estimatedpercent, a company has derived from products or services related toalternative energy, energy efficiency, green building, pollution prevention,
sustainable water or sustainable agriculture.

Step 3: Climate Index Construction Methodologies
All MSCI Climate Indexes follow transparent and rules-based index-construction
methodologies that allow for cost-efficient index replication and are based on astandard market-capitalization benchmark. Depending on investor objectives,different climate indexes can be designed using one or more index-methodologies
1. Exclusions of certain companies from the underlying benchmark universe. The
purpose can be to either align with general ESG considerations (divest fromcontroversial activities or when breaches of global norms such as the UN Global
Compact occur) or to specifically divest from certain fossil-fuel-intense
exposures.
2. Selection of companies with superior climate profiles.
3. Weight tilt of companies within the benchmark universe toward companies withsuperior climate profile.
4. Optimization of the climate profile of the index, while controlling for additional
climate-related or financial objectives, such as active sector and regional
exposures, index turnover or tracking error limits.

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

MSCI Climate Indexes
Exhibit 5 summarizes MSCI’s four standard climate index series.
Exhibit 5: Overview of MSCI Climate Indexes

Gradient fills denote indexes using optimization techniques.

Low Carbon Indexes
The MSCI ex Fossil Fuels Index is designed for investors that aim to reduce theirfossil-fuel reserves exposure in their investments, excluding companies that own oil,gas and/or coal reserves.
MSCI Low Carbon indexes (MSCI Low Carbon Leaders and MSCI Low Carbon Target
indexes) reduce climate-transition risks while representing the performance of thebroad equity market. These indexes were designed to address two dimensions ofcarbon exposure: carbon emissions and fossil-fuel reserves but excludes Scope 3
emissions.
MSCI Low Carbon Leaders Index Methodology:
Step

Description

1. Exclude
high emitters

Exclude highest 20% (by number) of carbon emitters in terms of Scopes 1 and 2
emission intensity (up to 30% benchmark weight per sector can be excluded)

2. Exclude
high reserves

Exclude highest fossil-fuel reserves ownership until 50% of fuel reserves havebeen excluded from the benchmark

3. Optimize

Use optimizer to reduce GHG emissions per USD of market cap by at least 50%
under active sector exposure, active country exposure and turnover constraints.

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MSCI Low Carbon Target Index Methodology:
Step

Description

Optimizeclimate profile

Minimize carbon exposure of the index (defined as carbon-emission intensityand potential emissions per dollar of market capitalization)
Optimization constraints:•••

30 bps ex-ante tracking error
Active sector weight and active country weight
Turnover (one-way) of max. 10% at each index review

MSCI Climate Change Index
The MSCI Climate Change Index addresses climate risks and opportunities. The
methodology uses the MSCI Low Carbon Transition (LCT) Score and Low Carbon
Transition Categories to increase exposure to companies associated with climatetransition opportunities and reduce exposure to those related to transition risks.
The MSCI Low Carbon Transition Score is a more comprehensive risk measure thanemission intensity: the LCT score incorporates Scope 3 emissions (which indicatecompanies’ upstream and downstream climate-transition risks) as well ascompanies’ climate-related management quality. The index is based on a reweighting approach designed to exceed the minimum standards of the EU Climate
Transition Benchmark (CTB). 7
MSCI Climate Change Index Methodology:
Step

Description

1. ESG
exclusions

Excludes companies from the benchmark that are involved in the manufacturingof controversial weapons, tobacco-related businesses or thermal coal extraction
and mining and companies with very severe ESG Controversies or severe
environmental controversies.

2. Weight tilt

Company weights are tilted using MSCI Low Carbon Transition Category(companies in the solutions category are upweighted, while transition-risk
categories such as asset stranding and product transition get downweighted).
The MSCI Low Carbon Transition Score is used to re-weight companies withineach category according to their climate transition profile.

3. Align with
net-zero /below 2 °C

Afterward, an additional iterative component reweighting is applied to fulfill therequirements of the EU Climate Transition Benchmark, including an annual selfdecarbonization rate of at least 7% per year.

7 In the event of changes in the EU-delegated acts (Regulation (EU) 2016/1011 as amended by Regulation (EU)2019/2089) and an update to the index methodology is required, MSCI will issue an announcement before
implementing the changes in the methodology. MSCI will not conduct a formal consultation for such an update.

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MSCI Climate Paris Aligned Indexes
The MSCI Climate Paris Aligned Indexes aim to align with a net-zero world. They
seek to mitigate climate transition and physical risks, emphasize opportunities arisingfrom the transition to a lower-carbon economy and allocate capital in a way that
supports the decarbonization of the economy in line with the Paris agreement
requirements. The indexes incorporate the recommendations of the Task Force on
Climate-related Financial Disclosures (TCFD), and are designed to exceed theminimum requirements for the EU Paris Aligned Benchmark.8
MSCI Climate Paris Aligned Index Methodology: MSCI Climate Paris Aligned
Indexes optimizes constituents to achieve these different climate-related objectives.
Step

Description

1. ESG
exclusions

Exclude companies that are involved in controversial weapons, ESG Controversies,
tobacco-related activities, environmental harm, thermal coal mining, oil and gas andpower generation from fossil fuels.

2. Optimize
climateprofileOptimize index to improve climate profile:
1. Reduce transition risk:•
At least 50% reduction of emission intensity (Scopes 1, 2 and 3)•
At least 50% reduction in potential emissions•
Underweight companies facing transition risk through at least 10%
improvement in LCT score•
At least 20% overweight in companies with credible emission-reduction targets•
Neutral exposure to high climate-impact sector
2. Invest in green opportunities:•
Weighted average of green revenue over fossil-based revenue ratio at least
four times that of the parent index•
Weighted average green revenue at least twice the parent index•
Overweight companies providing climate solutions through at least 10%
improvement in LCT score
3. Net-zero / 1.5°C temperature alignment•
Annual emission-intensity reduction rate of at least 10% per year•
Neutral Aggregate Climate VaR under 1.5°C scenario
4. Reduce physical risk•
At least 50% reduction in Extreme Weather Climate Value-At-Risk
Additional optimization constraints:•
Active security weight, active sector weight and active country weight•
Limit one-way turnover to 5% at each semi-annual rebalance

8 The EU Paris Aligned Benchmark is contained in the EU Commission’s Technical Expert Group on

Sustainable Finance’s Final Report on Climate Benchmarks and Benchmark ESG Disclosures.

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MSCI Global Environment Index
The MSCI Global Environment Index identifies a select set of companies whose
products and services can have a positive impact on the environment.
The MSCI Global Environment Index Methodology
Step

Description

1. ESG
exclusions

Exclude companies with ties to controversial weapons and severe controversies

2. Selectleaders

Select companies that derive 50% or more of their revenue cumulatively from thefollowing six clean-tech themes:
1. Alternative (renewable) energy
2. Energy efficiency
3. Green buildings
4. Sustainable water
5. Pollution prevention
6. Sustainable agriculture

Climate Characteristics
To better understand how different MSCI Climate Indexes reflect various investor
climate objectives, we looked at each climate index along the following dimensions:
Carbon footprint, fossil-fuel reserves and green versus fossil-fuel-based revenue.
In the carbon-footprint comparison in Exhibit 6, we observe that the series of MSCILow Carbon Indexes has achieved a significant reduction in emissions intensity,
potential emissions and weight of fossil-fuel-reserve holding companies comparedwith the parent index. The Climate Paris Aligned Index was the only index achieving
an even better footprint than the series of Low Carbon Indexes, while the ACWI
Global Environment Index showed the smallest reduction in terms of emissions
intensity, which is not surprising because the index methodology does not explicitly
target emissions reduction.

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

Exhibit 6: Carbon Footprint Comparison of MSCI ACWI Climate Indexes

As of June 30, 2021. Bubble sizes represent the weight of companies holding fossil-fuel reserves.
Carbon intensity includes Scopes 1 and 2 emissions.

However, when looking at exposure to green technology in Exhibit 7, we see the
ACWI Climate Change, ACWI Climate Paris Aligned Index and especially the Global
Environment Index showing significantly higher exposure to green technology, withthe latter 100%-invested in green technology companies.

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Exhibit 7: Fossil-Based vs. Green Profile of MSCI ACWI Climate Indexes

As of June 30, 2021. Bubble sizes represent the ratio of green versus fossil-based revenue.

More details on the climate profile of these indexes can be found in the Appendix.

Index Profile
In the following section, we look at the potential climate-versus-diversification tradeoff, as well as the climate-versus-tracking-error profile of the different MSCI Climate
indexes.
Exhibit 8 looks at the trade-off between achieving an improved carbon footprint
versus diversification (which we measure as the effective number of stocks in theindex) and coverage of the underlying market. 9 We observe that the Low Carbon
Index series, the Climate Change Index and the MSCI Climate Paris Aligned Index
experienced only a slight decline in diversification and market coverage.
By contrast, the MSCI Global Environmental Index showed a significant reduction inboth diversification and market coverage. This is in line with its underlying
investment objective to focus solely on companies that provide green solutions.

The effective number of stocks of a portfolio is defined as 1 / Herfindahl index, which is a standard measure for portfolio
diversification.

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

As of June 30, 2021. Bubble sizes represent the market coverage of the indexes. Carbon intensity
includes Scopes 1 and 2 emissions.

Exhibit 9 shows the trade-off between emission intensity versus tracking error andturnover.

As of June 30, 2021. Bubble sizes represent the turnover of the indexes. Carbon intensity includes
Scopes 1 and 2 emissions. Tracking error and turnover were calculated from Nov. 29, 2013, to June30, 2021.

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

The ACWI Low Carbon Leaders Index and the ACWI Low Carbon Target Index (which
are both tracking error-controlled using an optimization framework) showed very low
levels of tracking error and moderate turnover. The MSCI ACWI Climate Paris Aligned
Index also controls for tracking error. However, due to more stringent climate-related
optimization constraints, the resulting tracking error was higher. The Global
Environment Index had by far the highest tracking error due to its relatively
concentrated investment profile.

Financial Risk and Performance Profile
Exhibits 10 and 11 summarize the historical performance and risk characteristics of
MSCI ACWI Climate indexes.
Exhibit 10: Historical Performance of MSCI ACWI Climate Indexes

Data from Nov. 29, 2013, to June 30, 2021.

The MSCI Low Carbon Index series, Climate Change Index and Climate Paris Aligned
Index have tracked the performance of the broad market (defined as the MSCI ACWI
Index) quite closely with similar levels of risk, in accordance with their design.
None of these indexes underperformed between during the study period — in fact,
except for the MSCI ACWI Low Carbon Leaders Index, all of them showed a slightdegree of outperformance during the study period. The MSCI Global Environment
Index experienced much higher tracking error from the parent index due to its higher
concentration. It also showed the strongest cumulative outperformance during thestudy period.

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

Exhibit 11: Performance and Risk Characteristics

Data from Nov. 29, 2013, to June 30, 2021.

What explains these returns? Exhibit 12 looks at active return contributions fromcountries, industries, equity style factors and currency exposures. The ACWI Low
Carbon Leaders and Low Carbon Target indexes had very little active-factor exposuredue to their tight tracking-error controls. However, the other climate indexes showedsignificant positive performance contributions from industry exposures. This has two
implications: 1) industries that were heavily involved in fossil-based technology andthat were underweight in these climate indexes underperformed, and/or 2) green
industries that were overweight in these climate indexes outperformed. In addition,
the Global Environmental Index showed a significant positive specific performance
contribution, which means selecting companies that had high exposure to green
technology was a driver of returns.

Exhibit 12: Active Annualized Return Contributions
Active return ACWI ex Fossil
ACWI Low
ACWI Low
contribution
Fuels
Carbon Leaders Carbon Target
Total Active
Country
Industry
StylesCurrency
Specific

0.78%
0.02%
0.41%
0.09%
0.05%
0.21%

0.05%
-0.02%-0.01%
0.03%-0.02%
0.07%

0.10%-0.01%-0.12%-0.04%-0.01%
0.30%

ACWI Climate
ChangeACWI Climate
Paris Aligned

1.11%
0.06%
0.70%
0.17%
0.01%
0.17%

1.21%
-0.02%
0.50%
0.08%-0.10%
0.74%© 2021 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

GlobalEnvironment
4.53%
0.19%
0.49%
1.76%
-0.45%2.53%

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

Security Allocations of the Climate Paris Aligned Index
Using an optimization approach allows for the targeting of multiple climate-related
investment objectives while controlling for financial variables such as turnover,active sector weights or tracking error. However, an optimization process makes it
more difficult to assess the impact of each constraint used on the resulting index
composition. Therefore, we took a closer look at how the Climate VaR and Extreme
Weather Climate VaR constraints used in optimizing the MSCI Climate Paris Aligned
Index affected the index’s asset allocation (Exhibit 13).
Exhibit 13: Impact on Index Allocation Due to Climate VaR Constraints

As of MSCI’s May 2021 index review.

Exhibit 13 shows the aggregate weight multiplier for companies within each range of
Climate VaR values (e.g., between 5% and 20%) in the MSCI Climate Paris Aligned
Index relative to the parent index weight. Companies with positive Climate VaR were
overweighted as a group in the MSCI Climate Paris Aligned Index. Similarly,
companies with poor Climate VaR values were significantly downweighted as agroup. We saw similar behavior for physical-risk climate metrics as well.

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

Conclusion
MSCI has developed a range of climate indexes to address the preferences ofvarious investors. At the top level, these indexes can be classified by four investment
objectives:
1.
2.
3.
4.

Decarbonize the index
Address climate transition risk in the index’s construction
Align the index with the objectives of the Paris Agreement
Focus the index on companies providing clean technologies and solutions

The MSCI ACWI ex Fossil Fuels Index, the MSCI ACWI Low Carbon Leaders Index and
Low Carbon Target indexes are the first series of indexes that focus on
decarbonizing the index compared with their parent index. While the first one simply
excludes companies that own fossil-fuel reserves, the latter two reduce both theemissions intensity and fossil-fuel reserves while keeping their tracking error at avery low level.
The MSCI ACWI Climate Change Index reduces transition risks in a symmetrical way:
The weight of carbon-intense companies is scaled down, while green-solutions
companies’ weight is scaled up. Therefore, the index addresses both financial risks
and financial opportunities in its construction. In addition, the index decarbonizes at
a rate of 7%per year to align with a temperature of below 2°C.
The MSCI ACWI Climate Paris Aligned Index goes beyond the Paris Agreement,
implementing an annual decarbonization pathway of 10% per year. to align with astrict 1.5°C target temperature. In addition, it reduces physical-risk exposures in theindex construction.
While these climate index series offer broad coverage of the underlying market withmodest to low levels of tracking error, the MSCI Global Environment Index is aconcentrated index that focuses solely on green technology companies, which led tohigher tracking error and lower levels of diversification than the parent index.
Different investors may have varying climate-related objectives and preferences fortheir equity portfolios. The four categories of climate indexes discussed in this paper
offer them options in deciding how to choose an appropriate benchmark.

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

References
Badani, Jaineel, Doole, Stuart, Kumar, Neeraj, and Shakdwipee, Manish. 2019. “Climate
Change and Climate Risk: An Index Perspective.” MSCI Research Insight.
Giese, Guido, Nagy, Zoltan, and Cote, Chris. 2021. “Net-Zero Alignment Objectives andStrategic Approaches for Investors.” MSCI Research Insight.
“Scope 3 Carbon Emissions Estimation Methodology.” MSCI ESG Research LLC,
September 2021.

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UNDERSTANDING MSCI CLIMATE INDEXES | NOVEMBER 2021

Appendix
Exhibit A1: Climate Profile of MSCI ACWI Climate Indexes© 2021 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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