Climate ETFs do little to decarbonise the economy, report finds

Are ETF issuers in an impossible situation when choosing whether to exclude or engage with companies in controversial sectors?

Jamie Gordon

a large plume of smoke

Climate change-related ETFs overstate their virtues while doing little to incentivise emissions reduction in the global economy, according to research conducted by EDHEC-Risk Institute. 

While examining ETFs tracking “low carbon”, “Paris-aligned” and “climate change” indices from commercial providers such as MSCI, S&P Dow Jones Indices and FTSE Russell, the report, titled Doing Good or Feeling Good? Detecting Greenwashing in Climate Investing, found green-labelled products were allocating more heavily to companies with deteriorating climate performance than those with a key role in decarbonising the economy.

Looking at methodologies of different climate ETFs, the research said climate scores represent “at most” 12% of the determinants of constituent weightings within these products’ baskets. Meanwhile, market capitalisation “overwhelms” all other considerations, making up an estimated 88% of the factors that dictate stock weights with these ETFs.

When combining climate issues with social and governance considerations in ESG ETFs, climate scores have an even smaller impact of just 6%. Overall, ‘E’, ‘S’ and ‘G’ scores have a combined 21% influence in mixed objective sustainable ETFs, though market cap remains the main driver with 73%.

The report argued: “We suggest that when climate considerations represent less than 50% of the determinants of the weight of the stocks in a portfolio that is presented as promoting the transition to a low carbon or net-zero economy, then this portfolio should be considered to be at a significant risk of greenwashing and should not be permitted to claim that it is climate-friendly or aligned with net-zero ambitions.”

Another feature of climate and ESG ETFs is they tend to maximise their “greenness” by under-weighting or completely excluding high-emitting sectors which play an essential role in society’s daily functioning such as the energy sector.

The problem with washing one’s hands of these industries is they still operate and exist irrespective of climate products’ investment decisions, however, their non-involvement means they cannot influence the likes of fossil fuel companies to invest in technology that enables them to decarbonise their operations.

One suggestion the report offered is investors should allocate capital intra-sector towards climate change leaders and encourage progress across and within each sector.

“Firm-level weighting decisions need to send clear signals to firms’ management to motivate them to improve their climate performance,” EDHEC-Risk Institute added. “Such clear signals are also important for engagement strategies to be effective. There needs to be a synergistic relationship between portfolio construction and engagement.”

Currently, climate change strategies underweight sectors such as electricity by as much as 91%, the report found. Instead, it said they should engage with higher risk sectors and offer quid quo pros, whereby higher weightings are awarded with “relevant strings” attached. 

Finally, the research highlighted a third shortcoming in climate strategies: they weight significantly to stocks with climate scores that deteriorate over time.

In the strategies analysed by the research, around 35% of deteriorators are rewarded with larger allocations. This rises to 41% when using popular emissions metrics that do not normalise by firm value, including carbon intensity.

“Weight changes do not have any statistically significant dependence on climate score changes,” EDHEC-Risk Institute continued. “This suggests that strategies are basically indifferent to the evolution of climate performance and thus fail to send clear signals to companies.

“When assessing methodologies from commercial index providers, we do not find any rule that would explicitly address the problem of increasing weights of deteriorators.”

Offering some sympathy for ETF issuers, Kenneth Lamont, senior analyst, passive strategies, at Morningstar, said ETF issuers are caught between a rock and a hard place when picking benchmarks for their ESG products.

“If you are an issuer, you do not want the hassle of having to explain why there is an oil company in your ESG ETF so most have adapted to this. That is what the market has demanded and that is what the providers have given them.

“Then you have EDHEC-Risk Institute which comes out criticising the asset managers because they have excluded all energy firms. ETF issuers are sort of damned if they do and damned if they do not.” 

However, he agreed passive vehicles have a vital role to play in the process of long-term engagement.

“Who is going to be there, month in, month out voting at your shareholder meetings or shareholder resolutions? It is going to be the funds which keep holding your stock, and in fact, non ESG funds have a large role to play – the traditional index funds traditional ETFs.”

Lamont admitted one edge currently enjoyed by active managers is their ability to sit in a room with companies and threaten to divest if performance on their desired issue is not satisfactory. At present, he said the passive strategies on offer are not nuanced enough to achieve such feats.

Rather than look exclusively at ETF issuers, though, he suggested industry participants look to data and index providers to improve the ESG roster.

“Most of these products rely on the big ESG data providers, the biggest being MSCI, and so they have a huge amount of power,” he concluded. “Most indices are built around the data these companies provide. We are going to see more in terms of product development in that space, especially as the quality of data gets better.”

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