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Smart sustainability: Giving pension providers controlled sustainable exposure

Recently, a major shift has been observed among asset owners who once took a “tokenistic” approach toward environmental, social and governance (ESG) and are now looking to integrate it into core investment strategies. The pensions industry is considering ESG themes, including the transition to a green economy, as an integrated part of their investment philosophy and processes. Asset owners, including defined benefit schemes, are citing ESG risks as central to their fiduciary responsibility. FTSE Russell recently surveyed 200 asset owners globally and asked what their strongest motive was for incorporating ESG considerations into their investment decisions. The top motive was not “societal good” but rather “avoid long term risk.”

In responding to these trends and meeting the changing requirements of our clients, FTSE Russell has developed an approach that combines a commitment to ESG with the sophistication of smart beta indexes. We call this combination of sustainable parameters and risk premia via factor exposure within a single index solution “smart sustainability”.

The launch of the innovative FTSE4Good Index 15 years ago was one of the first clear and decisive moves into the sustainable space by an index provider. At the time, the index appealed largely to the retail rather than the institutional market. However, in the intervening years we have seen a profound change in asset owner attitudes toward ESG, with a growing appreciation of the economic drivers associated with sustainability, as well as the reality and growing risks associated with the transition to a green economy.

This trend has been reinforced by layers of multinational, institutional- and country-level legislation and directives designed to mitigate global warming, improve corporate working practices, and strengthen corporate governance. In relation to climate change these include—and are often framed by—the over-arching Paris Agreement (made between 195 governments in 2015) that aims to limit increases in global average temperature to less than 2°C above pre-industrial levels.

There have also been a number of investor-focused initiatives, including the Montreal Carbon Pledge launched by the Principles for Responsible Investment, the G20 Green Finance Study Group co-chaired by the People’s Bank of China and the Bank of England, and the Financial Stability Board’s Task Force on Climate-related Financial Disclosure.

The accelerating global trend toward the reduction of greenhouse gases presents all investors with a range of risk factors to consider. Mark Carney, the Governor of the Bank of England, set out in a speech at Lloyd’s of London that there were three key risks to financial stability due to climate change: liability risks, transition risks, and physical risks.

These risks have also been picked up by the UK Institute of Actuaries (IFoA), the international professional body for actuaries. This past May, the IFoA sent a “Risk Alert” to all of its members drawing their attention to the “material risk” that climate change poses, stressing its members’ responsibility to “consider how climate-related risks affect the advice they are providing.”

The results of the FTSE Russell smart beta survey for 2017 clearly illustrate the extent of the shift in attitudes. Among asset owners who are using, evaluating or planning to evaluate smart beta index-based strategies, 41% anticipate applying ESG considerations to a smart beta strategy. While the move towards ESG appears to be global, it is most pronounced among large European institutional investors.

In response, FTSE Russell has developed two different types of data sets to help asset owners better understand and evaluate ESG risks. The first is based on FTSE Russell’s ESG Ratings data model. It measures how well companies manage operational risk exposures and evaluates over 4,100 companies on 14 different “themes” such as health and safety, anti-corruption, tax transparency, climate change, and water use. Based on a precise and clearly defined methodology, a tiered data set of ESG Ratings is calculated, reflecting each company’s overall exposure to, and management of, ESG risks.

The second data set – the FTSE Russell Green Revenues Low Carbon Economy (LCE) data model – focuses on the revenues companies generate from green products. The Green Revenues (LCE) data model, which includes detailed corporate financial history, covers 13,500 companies (99% of global market capitalization), of which more than 3,000 have green revenues from one or more of the 60 LCE green industrial subsectors. The model is based on line-entry level revenue data from constituent companies, collected and collated by FTSE Russell analysts according to a rules-based and transparent process, and mapped across a new industrial classification system specific to the green economy, the Low Carbon Economy Industrial Classification System™. FTSE Russell’s sustainable investment data platform enables users to drill down to companies’ data attributes, conduct portfolio analysis, measure exposures and perform attribution analysis.

The increased focus on ESG has coincided with the rapid rise in investors’ adoption of smart beta index-based strategies. Market demand is now moving from single factor index-based strategies (e.g., value, quality, yield, size, volatility and momentum) to strategies combining a number of factors (multi-factor). The FTSE Russell smart beta survey for 2017 shows that among asset owners with a smart beta index allocation, multi-factor combination strategies have grown from 20% in 2015, the first year asked, to 64% in 2017. Not surprisingly, we are now seeing a growing desire for an integrated approach that achieves different factor and sustainability objectives in a consistent manner.

The concept of a smart sustainability index provides investors with tools to assist them in implementing sustainable investment strategies with greater sophistication than in the past. By incorporating ESG considerations with a smart beta index methodology, a single smart sustainability index can now allow asset owners to address their investment beliefs on both traditional risk premia and ESG parameters.

In creating such indexes, FTSE Russell can combine a wide range of sustainable investment data into a single smart sustainability index solution. To see how this works, consider the design of the new FTSE All-World ex CW Climate Balanced Factor Indexes—it applies factor tilts based on four risk premia factors (volatility, quality, value and size), and integrates them with three climate parameters. FTSE Russell uses a unique and transparent methodology, a system of sequential tilts that can be applied consistently to “traditional” risk premia factors as well as to sustainability parameters. This contrasts with a composite index approach, which is akin to applying separate allocations to each different element of the smart beta and sustainability methodology and consequently does not consider the interactions between each component.

In the FTSE All-World ex CW Climate Balanced Factor Indexes, the three climate parameters achieve the following:

  1. Reduced exposure to companies with carbon intense fossil fuel reserves
  2. Reduced exposure to companies with higher carbon emissions through tilting the weights of companies within a sector based on their relative operational carbon emissions
  3. Increased exposure to companies leading the industrial transition to a low carbon economy through ”green revenues” from goods, products and services

This smart sustainability index launched in November 2016 and was developed in cooperation with HSBC Bank UK Pension Scheme and Legal & General Investment Management (LGIM). HSBC Bank UK Pension Scheme used it as the basis for its DC equity default option, worth £1.85 billion ($2.38 billion), through LGIM’s new pooled Future World Fund that tracks the index.

This is the start of the next phase in the evolution of both smart beta and sustainable investing. FTSE Russell is providing a flexible framework and tools to combine a variety of sustainability and risk premia factors together into new indexes. The dawn of a new era of ESG integration into passive investment has arrived.