In the sustainable investment world, the launch of the S&P 500 ESG Index in April was a major event and a serious indication that investor demand for ESG products is too big to ignore. Early this summer, I interviewed Mona Naqvi, senior director, ESG Indices at S&P Dow Jones Indices, about the launch and the future plans for S&P Dow Jones ESG Indices. 

How The S&P Dow Jones ESG Indices Address Long-term Risk

Naqvi is clear that the broader consensus within the investment community is shifting, and more attention is being paid to issues like climate change, human rights and gender equality. European regulators, according to Naqvi, are moving ahead in redefining what it means to be a responsible fiduciary—though not all regulators across the globe agree that ESG should form part of the equation. Naqvi explains that index providers “can help shape the market to better account for these types of ESG issues. And S&P Dow Jones Indices offers a spectrum of ESG index solutions to suit the diverse needs of different types of investors.”

Naqvi explains that ESG issues are sometimes linked to unprecedented macro trends that can take time to materialize. But investment decision making is typically informed by back tests and historical information, where past performance may not be indicative of future results when you add ESG into the mix. The challenge, says Naqvi, is that the average discounted cash flow model looks out for three years at the most. Long-term issues like climate risk often don’t fit into this time horizon. “If the benchmark indices used to define the investable landscape take a lead in accounting for ESG issues with more forward-looking and long-term metrics baked in, like we’re doing here at S&P Dow Jones Indices,” says Naqvi, “the system as a whole may just be better equipped to properly price in the risks and secure a more stable allocation of capital for the long term.”

For example, Naqvi describes the two types of climate risk that do not necessarily share the same time horizon: Physical climate risk, like catastrophic weather events, can impact the real assets on the ground—and is more intuitive to understand. These physical risks are predicted to be more common because of climate change. The second type is transition risk, which comes from emerging regulation, policies and trends towards the global transition to a low carbon economy. Transition risk can create asset price risk, which is potentially material for investors. Naqvi describes a stranded assets narrative where a fossil fuel company is valued on the assumption that both its current proven and probable reserves listed as assets on the balance sheet will eventually be realized. The problem is, if we are going to meet the 2-degree reduction in CO2 emissions goal from the Paris Accord, more than 80% of those known and probable reserves will need to remain firmly in the ground. So, as Naqvi explains, “the valuation of fossil fuel companies continues to assume that the Paris Agreement will never be realized, even though it presents a clear signal and level commitment from policymakers around the world. If they are successful, those fossil fuel assets may become “stranded.” As such, there is probably a systemic mispricing that is currently taking place, creating a carbon bubble that may someday burst and impose tremendous cost to investors and society.”

The Government Pension Investment Fund Of Japan (GPIF) And S&P’s Carbon Efficient Index Series

S&P Dow Jones Indices created a low carbon index series, which Japan’s Government Investment Pension Fund (GPIF), with $1.2 trillion AUM, selected for a $15 billion allocation to begin systematically reducing its exposure to high carbon companies. 

The index series was created specifically for GPIF with the needs of other universal asset owners in mind. “Because GPIF owns 8-10% of the Japanese domestic equity market and 1% of the world at any point in time, it can’t possibly outperform or beat the market because it is the market,” says Naqvi.  “For a universal asset owner like GPIF that has high conviction in the rewards to low carbon investing, the best strategy for them is to try and reshape the market and influence the companies within it rather than divest.” 

Reweighting companies based on their carbon emissions and giving a higher weight if companies disclose encourages greater transparency around carbon reporting. But the groundbreaking methodology created by S&P doesn’t just simply reweight based on carbon exposure and transparency of reporting. It also takes into account how far ahead or behind a company is compared to its industry peers, accounting for industry-specific differences, to encourage the long-term diversification of companies towards the lower carbon technologies that are available to them in their industry. As Naqvi explains, “An energy company is always going to be more carbon intensive than a media company, for instance, so the methodology takes into account the range of possible emissions within a given industry and adjusts the weights by a lesser or greater extent depending on how much scope there is for a company to do anything to change its overall carbon efficiency. If a carbon intensive company has lots of room to improve, it gets a significant weight reduction. But if a carbon intensive company is only slightly behind its most carbon efficient peers it still gets a weight reduction, but not by as much. As companies understand this, they’re incentivized to try and do more in terms of both disclosure and diversifying their business models towards low carbon alternatives to get that extra weight.” The sophistication of this methodology can help to influence the behavior of companies and bring about systemic change to better equip the financial markets to deal with the low carbon transition. 

The S&P 500 ESG Index

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