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It always surprises me how effective it is to give a child a gold star for good behaviour. They can’t do anything or buy anything with a gold star — they just seem to like being rewarded. One theory behind sustainable investment is that investors will reward companies that are doing well on the environment — though this sort of gold star does involve money.
But figures this year suggest investors have done the opposite. So-called Paris-aligned benchmark (PAB) funds suffered outflows in the first six months of 2024 for the first time in their short history, according to data from Morningstar. These funds seek to limit the rise in global temperatures, and are stocked with companies that are arguably well behaved — they have low carbon emissions and are continuing to lower them.
Most PAB funds are passive and follow a sustainable version of an existing mainstream index, such as the MSCI World Climate Aligned Index, an offshoot of the MSCI World. PAB funds came into being in 2020 following European regulations and aim to invest in companies that are aligning with the 2015 Paris Agreement goal of keeping global warming to just 1.5C above pre-industrial levels by 2050.
I say “aligning” rather than “aligned” because hardly any public companies in the world — less than 10 per cent, according to MSCI — actually do align with this target now. A portfolio that only invested in these companies would be highly unbalanced. So the PAB definition includes certain criteria: along with not investing in companies that gain too much of their revenues from fossil fuels, the index usually has to reduce its carbon intensity by 7 per cent a year.
For a long time this proved a winning strategy. Among so-called climate transition funds, the most popular funds until this year were passive PABs. In 2023 they saw more than $18bn in net inflows, up from $14bn the previous year. But now something has changed. Between January and June passive PABs suffered net outflows of more than $8bn. What are we to make of this? Are investors no longer rewarding good behaviour?
Hortense Bioy, global director of sustainability research at Morningstar, reckons that strict criteria, set back in 2020, are proving hard to live up to as this isn’t how companies reduce emissions in reality. Setting a strict target of 7 per cent a year may not be achievable as companies’ ability to cut emissions might ebb and flow depending on other global events.
But the main reason is a shift in thinking among sustainable investors. Using forward-looking rather than backward-looking metrics has become a trendier way to make decisions. “It’s not the carbon footprint today that’s interesting, it’s what action the company is taking and the targets they set themselves. This is what investors today are looking at,” Bioy notes.
It’s perhaps no surprise, then, that Carbon Transition Benchmark (CTB) funds are still seeing inflows this year, albeit at a lower rate. These are a sort of PAB-lite option, with less stringent rules about fossil fuel companies and carbon emission reduction targets. Like a PAB index, a CTB one is based on the “normal” parent index.
On the face of it, the top 10 holdings in these three types of funds look basically the same. The MSCI World index and the CTB index hold the obvious tech candidates — Apple, Nvidia, Microsoft, Amazon and so on. The top 10 in the PAB version are more or less identical, with the addition of JPMorgan Chase.
For what it’s worth, the PAB version has outperformed its parent index, the MSCI World, every year since 2014 with the exception of 2022, the annus horribilis for sustainable funds hit by the energy crisis. This could just be accounted for by the fact its tech holdings are weighted even more strongly. The real divergence in the indices comes outside the top ten holdings — the PAB index tracks less than half the companies that the MSCI World does, while the CTB index is less restricted, holding about three-quarters of its parent index.
A greater focus on CTB funds doesn’t mean that investors have entirely given up on rewarding good behaviour. If one sibling tidies their room every day without being asked, while the other sibling doesn’t bother, the gold star is likely to be more effective in the latter case.
Still, a passive index will never be perfect. A recent paper by Neuberger Berman argues that blanket exclusions of companies on carbon intensity grounds in both PAB and CTB indices means that some companies with, in their view, a high potential for transition, such as TotalEnergies, General Motors and Trane Technologies miss out on their gold star.
PAB funds are certainly not disappearing. Under new guidelines from the EU regulator Esma aimed at greenwashing, European funds will need to comply broadly with PAB rules in order to give themselves an ESG label. Those that comply with the looser CTB rules will be those more focused on the energy transition. Analysts at JPMorgan recently argued that this could bring both PAB and CTB funds under greater scrutiny from investors worried about greenwashing, who might view them as a “safe haven” in an environment of increasing regulation.
But they clearly have their limitations for investors wanting to reward good behaviour. There have even been concerns that companies might be reluctant to disclose emissions arising from their supply chains, known as Scope 3 emissions, if they turn out to be higher than current estimates, meaning they would get kicked out of sustainable indices.
The cynical interpretation of the move from PAB to the less stringent CTB funds is that some investors want to tick a sustainable box while not diverging too much from the index.
The more generous take is that as sustainable investment matures, investors are reassessing what makes a well-behaved company. It might be a fossil fuel company that’s allocating more capital to renewable energy. It might be a retail company reporting high emissions in its supply chains and being serious about trying to reduce them. It might be an industrial company responding positively to shareholders wanting it to set firmer emissions reduction targets.
That means the gold star system could get counterintuitive. But I expect that companies, like my kids, will still want them. After all, for them there is money involved.
Alice Ross is the FT’s acting international economy news editor. X: @aliceemross
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