Excerpt from How Much Tracking Error Does Climate Ambition Really Cost? To download the full article free of charge, please submit the form below 

Institutional investors pursue climate-aware equity strategies for a variety of objectives. Some are mandated to decarbonise in line with the Paris Agreement; some seek to reduce climate transition risks or physical risks within the portfolio; some wish to contribute proactively to change by investing in companies that engage in climate solutions. Whatever the goal, one aspect is always present: investors must deviate from the benchmark, introducing tracking error for market participants whose risk budget is often explicitly defined in tracking error terms and intrinsically linked to fiduciary commitments. 

Yet balancing the twin goals of tracking error and climate outcomes in a live climate index (as opposed to convenient back-tests) is no easy task. A climate index adjusted to deliver a certain climate-related objective might have produced a particular average tracking error over a historic period, but the deviation could be very different going forwards. Conversely, portfolios that simply prioritise tracking error can leave climate goals under-achieved and ungovernable. 

How can investors navigate this challenge? In this note, we compare two approaches: portfolio tilting, a methodology that is widely used across the climate indexation sector, versus using a risk model to target an ex-ante level of tracking error. (In the interests of making our bias transparent, the latter is the approach used by SciX indices.)  

Our SciX climate resilient indices help equity investors meaningfully and efficiently reduce their exposure to physical risks: a 15% reduction in model-estimated future losses relating to physical climate risk can be achieved in exchange for a tracking error of approximately 1% versus cap-weighted benchmarks.

Author

Shahyar Safaee
Deputy CEO and Business Development Director,
Scientific Climate Indices

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