Non-financial considerations in climate indices could affect financial returns: MAS

Incorporating non-financial considerations when constructing climate indices could result in lower financial returns, compared with conventional benchmark returns.

The Monetary Authority of Singapore (MAS) in its sustainability report released on Thursday (Jul 4) said this is one of its learnings after embarking on an S$8 billion climate transition programme last year.

So far, part of this S$8 billion allocation, which is about 2 per cent of the equities portfolio of the central bank’s official foreign reserves, has been invested into an off-the-shelf climate index and a bespoke product tailored to suit MAS’ requirements.

MAS said in its report that the introduction of non-financial parameters in a climate index to help decarbonise a portfolio, for example, could result in “significant deviation in financial returns from conventional benchmark returns”.

First, the investment universe would be smaller, as less would be allocated to carbon-intensive sectors such as energy.

A portfolio underweight in energy stocks would underperform a conventional, market-weighted portfolio in an environment of high oil prices, such as in 2022.

However, MAS noted that such trade-offs can be mitigated if an asset owner imposes constraints that reflect how much it can accept in deviations in returns. This could include imposing limits on sector tilts, which could result in a sector-neutral index that leans towards low-carbon leaders within each sector.

Silverdale Capital senior associate for growth and strategy Urvi Guglani said that the experience at the fund management firm is similar. However, since it focuses only on fixed-income investments, there is lower dispersion in returns.

She added that the challenge of balancing financial returns and climate considerations is critical for asset allocators. Silverdale actively engages with clients to explore subtle adjustments to their mandates that could enhance portfolio alignment with climate change goals and promote long-term sustainability.

One way the firm tries to mitigate trade-offs between returns and climate goals is by proactively identifying corporates through both credit quality and climate-related parameters. 

“This approach allows us to significantly reduce potential deviations in financial returns compared to conventional benchmark returns, while still achieving a positive climate impact within the portfolio,” Guglani said.

Phillip Capital’s head of environmental, social and governance strategy Stephen Beng said that the investment firm assesses inward and outward climate-related risks and accounts for the speed and scale of sectoral support when structuring a portfolio.

“A portfolio need not be constructed with a best-in-class strategy to effect real world decarbonisation, and returns may not be compromised if non-financial parameters work as an additive to investment foundations,” he added.

Lack of availability of climate data

Another challenge in implementing climate indices is the lack of availability of climate data, as well as its quality. Climate data, including carbon emissions, green revenue and climate value-at-risk, is needed to quantify climate objectives in indices.

For example, in the evaluation of climate transition risk, a comprehensive view necessitates the use of all three scopes of carbon emissions. But data on Scope 3 emissions – which refer to indirect emissions from its supply chain – is still lacking.

In addition, emissions data is backward-looking and offers limited insight into future exposure.

Forward-looking metrics, such as climate value-at-risk, are an alternative, and can offer an indication of companies’ potential exposure to climate risks and opportunities in the future. The climate value-at-risk metric models the potential impacts on companies’ valuation based on climate scenarios, and takes into account drivers of physical and transition risks, such as extreme weather events, government policies and technology developments.

However, these modelled metrics are sensitive to assumptions, and subject to underlying methodologies which are still evolving, noted MAS.

Index rebalancing

A third problem is how index rebalancing methodology and frequency can affect the returns and overall feasibility of the indices. Changes in the climate data can also create substantial swings in the composition of index constituents, and a higher turnover of index constituents can incur higher transaction costs for rebalancing to target, compared to conventional, market-weighted indices.

However, less frequent rebalancing may lower transaction costs but could result in suboptimal index tilts. Hence, there is a need to balance between timeliness of climate data updates in index design and transaction costs relating to index rebalancing.

These are some of the challenges in implementing climate indices, often necessitating careful consideration of trade-offs associated with their design, said MAS.

This S$8 billion climate transition programme, which has a particular focus on transition risk, is the latest avenue employed by MAS to make its overall portfolio more climate-resilient. Transition risk refers to uncertainties companies could face as a result of changes in regulations, as well as consumer and investor preferences in the shift towards a low-carbon economy.

Carbon intensity

MAS previously announced its target of reducing the weighted average carbon intensity of its equities portfolio by up to 50 per cent by FY2030 from FY2018.

While the overall carbon intensity of MAS’ equities portfolio for developed markets declined to 74 tonnes of carbon dioxide equivalent (tco2e) per US$1 million in FY2023, from 120 tonnes in the previous year, the carbon density of the emerging markets’ equities portfolio actually went up to 224 tonnes, from 216 tonnes over the same period.

The increase was mainly attributed to active investment decisions by MAS’ external fund managers, to increase weights to selected companies with higher carbon intensity in the utilities sector. 

Nonetheless, MAS noted that the carbon intensity of its portfolio remained significantly lower than the benchmark for emerging markets’ equities. This is because its portfolio continued to remain underweight to the energy, materials and utilities sectors overall compared to the benchmark.

Targeted portfolio actions, such as the climate transition programme and the exclusion of thermal coal mining and oil sands companies, helped to tilt the portfolio towards less carbon-intensive companies relative to the benchmark, it added. This exclusion criteria, however, does not apply to coal-fired power plants.

These two portfolio actions are among some strategies that MAS intends to implement, to hit its carbon intensity target. It also includes setting expectations and monitoring stewardship and engagement efforts of its fund managers, and investing in transition opportunities and climate solutions.

As for MAS’ corporate bonds portfolio, its carbon intensity decreased at a faster pace than the corporate bond benchmark from FY2022 to FY2023.

This is due to active investment allocation by its external managers, resulting in a reduction in exposure to corporate bonds by utilities issuers. The lower carbon intensity is also because MAS’ portfolio construction framework screens out debt securities with smaller issuance sizes, which tend to be in more carbon-intensive sectors.

Carbon emissions

Beyond MAS’ portfolio emissions, the organisation as a whole reported higher carbon emissions in FY2023 at 14,330 tco2e, compared with 12,531 tco2e the year before.

The higher Scope 2 emissions – which refer to indirect emissions associated with the purchase of electricity – recorded in FY2023 were due to higher electricity consumption in its data centre to meet business needs, as well as increasing artificial intelligence and work transformation applications.

Nonetheless, MAS said it is still on track to achieve its target of a 17.5 per cent reduction across all three scopes of emissions by FY2025 from the FY2018 baseline.

Its total emissions for FY2023 were 10.7 per cent lower than the FY2018 baseline.

Source: Business Times © SPH Media Limited. Permission required for reproduction.

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