Introduction

We are delighted to introduce the latest Scientific Climate Indices special issue of the EDHEC Research Insights supplement to Investment & Pensions Europe (IPE). Here, we hope to provide institutional investors with insight on key issues in the industry today, focusing on areas where academic research and real-world implementation collide.

We first look at the ambition-credibility gap in corporate decarbonisation, seeking a new way of understanding whether companies are ’walking the talk’ in relation to their own emissions targets. The findings strongly indicate that recent historical data and current/planned capital expenditure are not in line with companies’ stated goals. The implications are significant for investors who are pursuing portfolio decarbonisation or alignment: we should avoid over-reliance on companies’ professed targets when shaping strategy, tailor stakeholder engagement to prioritise real-world activity indicators, and press regulators to mandate relevant disclosures.

The subject of climate comes back into focus later in the supplement but, next, we turn to another timely challenge facing investors: equity return simulation. This is an old and problematic question for investment practitioners, but it has been receiving interesting new answers with the arrival of machine learning techniques. In our view, improvements in this field will be of particular importance to investors who are seeking to understand how portfolios perform in periods of macroeconomic stress, manage ’extreme risk’, and more besides. Here, we propose an innovative hybrid methodology combining econometrics with generative neural networks (’GARCH in the machine’) to produce more realistic simulated factor returns in a computationally feasible manner.

Third, we consider the subject of physical climate risk and explore a new way of quantifying climate physical loss (CPL). In two articles – addressing Europe and the US – we set out a methodology for calculating CPL that is parsimonious, aligned with the NGFS scenario set and directly applicable to portfolio construction thanks to its use of a discounted cash-flow model. We find that, while European countries on average exhibit lower macroeconomic sensitivity to physical climate risks than the US, we find that the European cap-weighted equity benchmark displays a larger CPL (-4.7%) than the US benchmark (-4.0%), due in part to its greater exposure to low-WACC (high cashflow-duration) sectors.

Finally, and perhaps importantly in a supplement that has a substantial focus on climate investing, we close with an examination of the ’hidden ethics’ in the creation of climate alignment metrics. Although the sector strives for scientific methodological rigour, certain key decisions are irreducibly ethical in nature: we seek to identify those decisions and assess their relevance to measurement outcomes for a diversified portfolio of 1,300 stocks. Three ’ethical investor’ archetypes are proposed, giving a framework through which an investor might establish clarity, consistency and transpar ency for their own ethical position.

We hope that the articles in the supplement will prove useful, informative and insightful. We wish you an enjoyable read and extend our warmest thanks to IPE for their collaboration on the supplement.

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