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    Post-COP27: IPCC aligned indexes, time for changes?


    Post-COP27: IPCC aligned indexes, time for changes?

    Highlights

    To achieve a 1.5°C objective by 2050, the world has a finite carbon budget of only 300 Gt CO₂, according to the Intergovernmental Panel on Climate Change.

    The world can meet this carbon budget by reducing CO2 levels 12% each year from 2022 to 2050.

    One simple, transparent approach to address this challenge is for asset owners and investors to consider Net Zero Carbon Budget Indexes that track this requirement and thus capture the cost of time.

    Unfortunately, as the carbon budget shrinks with time, the objective becomes increasingly challenging. Decreasing 12% per year will become 20% in 2025 and 47% in 2028 to achieve a 1.5°C objective with an 83% probability by 2050.

    With a Net Zero Carbon Budget Index, lower carbon emitters within each sector are selected and reweighted to reduce emissions 12% each year. A simple but transparent solution.

    Modeling suggests the Tracking Error against a broad market-cap weighted index using this process is estimated to increase from 0.1% in 2020 to 1.4% in 2050.

    Figure 1: Remaining carbon budget (in 2021)



    Source: Bolton et al., 2022

    At COP26 in Glasgow, Scotland, banks, insurers and investors representing US$130 trillion made a historic commitment via Mark Carney’s Glasgow Financial Alliance for Net Zero (GFANZ) to reach net zero emissions by 2050 at the latest1, mirroring government pledges. As we now work through COP27, the scale of the challenge continues to crystalize.

    The question remains how to integrate these commitments into a solution that is simple and transparent with low-market impacts.

    S&P Dow Jones Indices seeks to address the challenge with the recent launch of a new series of innovative net zero carbon budget indices.

    The concept is simple: What is true for the planet is true for all forms of diversified financings.

    In other words, all types of financing should align to the remaining global carbon budget established by the IPCC in their most recent report to achieve a 1.5°C objective with an 83% probability: a 300 GtCO2 budget with a starting point of 31.5 GtCO2. in 2020.

    Year on year, the index series will allocate a carbon budget across corporate index constituents based on their total emissions. The sum of the yearly carbon budgets will mirror the trajectory necessary to be carbon-neutral (decreasing 10% per year in volume).

    We show it is possible to construct a net zero benchmark that is simple, transparent and robust, based on this carbon budget approach, and built on comprehensive Scope 1, 2 and 3 carbon emissions data provided by S&P Global Sustainable 1 (Trucost).

    Furthermore, the approach has limited index construction impacts as illustrated by a low Tracking Error across a broad market index (BMI) universe and with constant emissions over time.

     

    Figure 2: Tracking Error estimates


    Source: S&P Dow Jones Indices, July 2022

     

    And finally, with a sector-neutrality objective, capital is reallocated within each sector to the lowest carbon emitters so a competition is created within each sector toward reducing emissions. By simulating future portfolios, we can actively engage with corporates to let them know if, and when, they will exit the index.

    But time is of the essence. If being carbon-neutral in 2022 means to reduce the volume of CO2 by 10% per year, it becomes a reduction of 18% in 2025 and impossible by the end of the decade, based on current emission levels.

     

    Figure 3: Time impact on decarbonization rate


    Source: Bolton et al., 2022


    1 Amount of finance committed to achieving 1.5°C now at scale needed to deliver the transition | Glasgow Financial Alliance for Net Zero (gfanzero.com)