
Andreas Hoepner, a key member of the regulatory advisory group which developed the initial concept behind the EU’s Climate Benchmarks format, has responded to critics at a workshop hosted by the European Commission on Thursday.
A number of speakers at the event raised concerns about the risk of growing tracking error between Climate Benchmarks and their parent benchmarks over time, particularly in scenarios where the economy fails to decarbonise at the same rate as required under a Paris-aligned trajectory.
Tracking error measures the difference between the returns generated by a portfolio against a chosen benchmark. This can be a priority for investors aiming to mimic the performance of broad market benchmarks as closely as possible, while achieving secondary climate or other sustainability objectives.
Climate Benchmarks have emerged as one of the success stories from the EU’s Action Plan on Sustainable Finance, and have gone on to be adopted by a broad range of institutional investors and asset managers.
The benchmark methodology requires aligned products to decarbonise significantly compared with parent indices, and then by 7 percent year-on-year. Investors can choose between the more ambitious Paris-aligned Benchmarks (PABs), which cuts the emissions intensity of an underlying benchmark by half, or Climate Transition Benchmarks (CTBs), which targets a 30 percent reduction.
During the commission’s event, Solactive head of product development Peter Diehl said that the tracking error of climate benchmark would “explode” if the economy is slow to transition because administrators would be forced to allocate assets to an increasingly smaller number of companies, straying away from a parent benchmark.
He said: “When you have a very small number of available stocks or bonds, then the tracking error goes up.
“Nobody will accept a tracking error of 2 or 3 percent versus their original universe. Indexes tracks reality, so our main goal is that it is investable.”
Echoing this, MSCI executive director Alexander Dorbrinevski said: “When we discuss these strategies with clients, we often hear the desire to understand how tracking error is controlled or limited, and to have maybe some objectives to minimise the tracking error as much as possible.
“That’s understandable because institutional investors need to control exactly how much risk they take on.”
Separately, the London Stock Exchange Group head of sustainable investment for indexes Anoushka Babbar raised concerns about the fixed 7 percent decarbonisation requirement, noting that emissions of the global economy had risen by over 2 percent a year between 2016 and 2022.
“We would encourage a review of the 7 percent requirement and review of the regulation on how to incorporate Scope 3 data given the volatility of disclosures,” she said.
Concerns over data availability were also flagged by AP2 head of quantitative dynamic allocation Kristian Hartelius, who stressed the importance of being able to apply Climate Benchmarks in emerging markets, regardless of data challenges.
“It doesn’t really make sense to reallocate our assets to a small country like Sweden, with very small fossil fuel industries,” said Hartelius.
Finally, IIGCC head of climate strategy implementation Valentina Ramirez argued for separate decarbonisation requirements for emerging markets and developed markets.
Ramirez said that the flat decarbonisation rule for climate benchmarks failed to account for the fair share principles in the Paris agreement which provides more time for developing economies to reach net zero.
Panellists also suggested the inclusion of other climate-related metrics including forward-looking data, taxonomy alignment and green revenues.
Platform member response
In his response, academic and current member of the commission’s Platform on Sustainable Finance, Andreas Hoepner, pushed back against what he described as “a couple of misunderstandings”.
“The benchmarks are a minimum standard. You can add additional criteria such as green revenue criteria, SRI screens – it’s absolutely up to you but the legislation does not require this at all. The only thing you have to do is ensure that the portfolio decarbonises by 7 percent as a weighted average and this is compatible with differentiated pathways as well.
“Let emerging markets decarbonise at 3 percent and maybe Germany can do 11 percent.”
With regards to Scope 3 data, Hoepner noted that benchmark administrators had the freedom to estimate volume of emissions and only use disclosed data when there is high conviction on its quality and usability. This is because Scope 3 data requirement “is not firm specific, it’s activity specific which is completely value-neutral about commercial approaches”.
He added: “The beautiful thing is that the benchmark regulation is short. The legislation is less than 20 pages, so please read it.”
Hoepner also played down concerns over tracking error, saying it is not a financial risk measure but “a measure of deviation with the parent universe, which itself isn’t risk optimal – far from it”.
In addition, he claimed that “the value at risk of Paris-aligned benchmarks is 8.9 percent while the universe is 10.8 percent across different providers”.
He said: “We know the world has to decarbonise, and there’s a lot of regulatory initiatives around the world. So either you are making a bet which is in line with the Paris benchmark or not, the question is who is making a riskier bet?
“Tracking error is a little bit like a kid assuming that their parent knows best. There’s a whole set of situations where the parent may not be right.
“To an extent, tracking error helps the person asking for it to keep the job. It’s a social risk measure, not a financial one.”
Hoepner said that the PSF was yet to see any credible accusations of greenwashing against Climate Benchmarks, describing the product methodology as a “fantastic success”. He added that the benchmarks had accumulated around $200 billion assets under management over the five years since the first product launch.