The flaws of climate ETFs

Lack of focus on Scope 3 emissions

George Geddes

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As ESG becomes one of the most popular strategies investors this year, there has been further development within the environmental part of the strategy that focuses on tackling climate change.

However, like many products in their infancy, these climate-focused ETFs have their flaws meaning there is plenty to be done as we head towards the Paris-agreement climate transition date of 2050.

With an objective of complying with the Paris Agreement which aims for a 2°C limit to rising temperatures by 2050, climate ETFs track certain benchmarks which comply with the European Commission’s strategies to achieve this goal.

The Climate Transition Benchmarks (CTB) and the Paris-Aligned Benchmarks (PAB) encourage companies to reduce their carbon emissions by 7% year-over-year.

However, one area where the benchmarks fall down, as Scientific Beta highlighted, is they exclude carbon emissions from Scope 3.

Scope 3 emissions include all other indirect emissions from activities of the organisation, occurring from sources that they do not own or control.

Scientific Beta said in a letter to the European Commission: “[Scope 3] emissions are larger than the sum of direct (Scope 1) and energy-related indirect ("Scope 2") emissions by an order of magnitude in most sectors.”

Therefore, a company can still be included in the products even if its Scope 3 carbon emissions does not decrease by the 7% YoY as expected for Scope 1 and 2 emissions.

Furthermore, Scientific Beta warned the introduction of these ESG benchmarks means there will be an unfair advantage for the index providers that have an affiliation with an ESG data provider.

The regulation requires the index providers to state how ESG factors are reflected in its benchmarks which would require significant administrative costs and material data licensing costs for those which do not have a relationship with an ESG data provider.

Additionally, the lack of consistency among ESG data providers leaves investors vulnerable to misleading indicators.

Roughly half the regulation’s indicators mandated by the act are ESG ratings, and inconsistent ESG definitions mean they are unfit as indicators of ESG performance.

“For sustainability’s sake, it is critical that the regulator steers clear of condoning these dangerously misleading metrics,” Scientific Beta added.

To ensure investors are not misled by greenwashing and to allow an equal playing field for index providers of all sizes to launch climate products, these are just a couple of faults that need to be taken into consideration if the ETF ecosystem wants to have a material impact on the agreement made in Paris five years ago.

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