Addressing Concerns: Andreas Hoepner Defends EU Climate Benchmarks
In a recent workshop hosted by the European Commission, Andreas Hoepner, a prominent figure in the development of the EU’s Climate Benchmarks, addressed growing concerns regarding the potential tracking error associated with these benchmarks. As a key member of the regulatory advisory group that conceptualized the benchmarks, Hoepner provided insights into the methodology and objectives of these climate-focused financial instruments, aiming to clarify misconceptions and reinforce their significance in sustainable finance.
Understanding Tracking Error
At the heart of the discussion was the concept of tracking error, which measures the deviation of a portfolio’s returns from its benchmark. For institutional investors, minimizing tracking error is crucial as it allows them to closely mimic the performance of broad market benchmarks while pursuing secondary objectives related to climate and sustainability. However, critics at the workshop expressed fears that as the economy transitions to a low-carbon future, the tracking error between Climate Benchmarks and their parent benchmarks could widen significantly, particularly if decarbonization efforts lag behind the targets set by the Paris Agreement.
Peter Diehl, head of product development at Solactive, warned that if the economy transitions slowly, the number of investable companies aligned with climate benchmarks would shrink, leading to increased tracking error. He emphasized that investors typically expect a minimal tracking error of around 2 to 3 percent, as deviations from the original universe could undermine the investability of these indexes.
The Role of Climate Benchmarks
Despite these concerns, Climate Benchmarks have emerged as a notable success story within the EU’s Action Plan on Sustainable Finance. They require aligned products to achieve significant decarbonization compared to their parent indices, with a mandated reduction of 7 percent year-on-year. Investors can choose between two types of benchmarks: the Paris-aligned Benchmarks (PABs), which aim for a 50 percent reduction in emissions intensity, and Climate Transition Benchmarks (CTBs), targeting a 30 percent reduction.
However, the fixed 7 percent decarbonization requirement has drawn scrutiny. Anoushka Babbar, head of sustainable investment for indexes at the London Stock Exchange Group, highlighted that global emissions had risen by over 2 percent annually between 2016 and 2022, suggesting a need for a review of this requirement. Additionally, concerns about data availability, particularly in emerging markets, were raised by Kristian Hartelius, head of quantitative dynamic allocation at AP2, who emphasized the importance of applying Climate Benchmarks in diverse economic contexts.
A Call for Flexibility
In response to these criticisms, Andreas Hoepner sought to clarify what he termed “a couple of misunderstandings.” He emphasized that the benchmarks serve as a minimum standard, allowing investors the flexibility to incorporate additional criteria, such as green revenue metrics or socially responsible investment (SRI) screens. He argued that the legislation does not mandate these additional criteria, but rather ensures that portfolios decarbonize by 7 percent on a weighted average basis, accommodating differentiated pathways for emerging and developed markets.
Hoepner also addressed concerns regarding Scope 3 emissions data, explaining that benchmark administrators have the discretion to estimate emissions volumes and utilize disclosed data only when its quality is assured. He noted that the requirement for Scope 3 data is activity-specific rather than firm-specific, allowing for a more flexible approach to emissions accounting.
Reassessing Tracking Error
Hoepner downplayed the significance of tracking error as a financial risk measure, describing it instead as a social risk measure. He argued that tracking error reflects a deviation from a parent universe that may not be optimal from a risk perspective. He pointed out that the value at risk for Paris-aligned benchmarks is 8.9 percent, compared to 10.8 percent for the broader universe, suggesting that aligning with climate benchmarks may actually represent a less risky investment strategy.
Furthermore, he highlighted the success of Climate Benchmarks, noting that they have accumulated approximately $200 billion in assets under management since their inception. Hoepner asserted that the benchmarks have not faced credible accusations of greenwashing, reinforcing their legitimacy and effectiveness in promoting sustainable investment practices.
Conclusion
As the dialogue surrounding Climate Benchmarks continues, it is clear that the balance between achieving sustainability goals and maintaining investment viability is a complex challenge. Andreas Hoepner’s defense of the benchmarks underscores the importance of flexibility, transparency, and a nuanced understanding of tracking error. As institutional investors navigate the evolving landscape of sustainable finance, the insights shared at the European Commission workshop will undoubtedly play a crucial role in shaping future strategies and policies aimed at fostering a low-carbon economy.