The Paris climate agreement and investments in sectors with high CO2 emissions

Why do indexes that follow the Paris climate agreement also invest in sectors with high CO2 emissions?

This may seem paradoxical at first glance: portfolios based on a benchmark aimed at the 1.5 degree Celsius climate protection target set in Paris in 2050 may include airline stocks, a sector that does not exactly shine with low CO2 emissions. . Resolution: Unlike other criteria labeled “sustainable” or “ESG-related,” the “Paris-aligned” criteria focus on the journey as much as the destination. “They are looking at the broader market, including some industries with higher carbon emissions, to help transform the economy over the long term,” says Olivier Souliac, ETF expert at DWS. This means that, for example, the transport or construction sectors are also part of the Paris-aligned criteria, which are responsible for relatively high CO2 emissions. So why invest in industries with high CO2 emissions? Simply because the savings potential there is naturally already greater than in the “green” sectors. The aim is to avoid ‘cherry picking’, i.e. a ‘green’ portfolio consisting only of low-carbon companies.

A dynamic index to support long-term decarbonisation

On the other hand, the Paris strategy criteria apply precise specifications to work towards reducing emissions, in addition to investing mainly. First, the companies included in the index must emit less greenhouse gas on average than the traditional market portfolio. Second, emissions for the index portfolio must continue to decline each year, as required by the European directive. This means that companies that do not reduce their CO2 emissions find it difficult to get into the index – their access to the capital market is even more difficult. Instead, more and more capital is flowing into climate pioneers. In this way, investors can pressure companies to do more to protect the climate while remaining broadly diversified in their investments. This is especially true for institutional clients.

To illustrate how the Paris-aligned criteria work, it helps to first look at the classic indices labeled “sustainable” or “SRI, socially responsible”. They usually start with strong exceptions for many1 activities considered potentially controversial. These include alcohol, traditional energy companies, or electricity producers with too much fossil fuel in their energy mix. Index members are then selected based on ESG criteria, often selecting companies with significantly lower levels of greenhouse gas emissions. Simply put, this is the approach taken by the MSCI Low Carbon SRI Leaders indices, on which the ESG Xtrackers indices are based. While indices of this design achieve one of the sustainability goals of significantly reducing emissions relative to the market portfolio, they currently do not deviate from this goal.

Investors can therefore choose a portfolio combining strict ESG criteria and low CO2 emissions, or more inclusive products based on Paris-aligned criteria. The goal is a journey in a sense, that is, the transformation of the economy towards a significant reduction of climate-damaging emissions. Climate goals need to be achieved through a dynamic index to guide investments across the economy, not just in a few low-emitting sectors. In detail, the rules for Paris-aligned benchmarks are defined as follows: Initially, the carbon intensity of the Paris-aligned Benchmarks portfolio should be approximately 50% of the value of the market portfolio. In the future, its carbon intensity should decrease by at least 7% per year. Carbon intensity corresponds to the amount of CO2 equivalent generated by the respective company and its suppliers compared to the market value of the company.

As the Paris-aligned criteria are designed to reflect the wider market, this means that climate protection requirements for companies in almost all sectors covered by the index will increase in the long term. Emissions can only be reduced sustainably if, for example, the carbon intensity of the transport, construction, chemical and engineering sectors also decreases. An important detail: there are also exceptions to the criteria aligned with the Paris strategy for companies that exceed certain turnover limits in the field of fossil fuel extraction or processing. In this regard, the EU relied on the results of the scenario analysis of the Intergovernmental Panel on Climate Change (IPCC) on the reduction of greenhouse gases from fossil sources.

Encourage pioneers, not just weightless climate culprits

Another important difference of benchmark indices aligned with the Paris model compared to other indices: They are the only ones that come directly from the regulation of the European Commission. Anyone investing in an ETF based on the Paris-aligned Benchmark can be assured that the same strict rules apply. This includes the fact that the Paris-aligned criteria are designed for long-term investment to help finance the transition to a lower-carbon future. “It’s also about taking advantage of the opportunities that are emerging for companies that have successfully adapted to the decarbonization trend,” says ETF expert Souliac. Therefore, the indices used by DWS in the Xtrackers Paris Aligned ETF are also in line with the recommendations of the Institutional Investors Group on Climate Change (IIGCC). Based on these, companies that set transparent and understandable targets for reducing waste should be given priority in the weighting of the index. The decisive factor is the extent to which the Science-based Targets defined by the initiative of the same name are adopted.

In summary, the criteria aligned with the Paris strategy are calibrated against a broadly diversified investment universe and are suitable for investors who wish to support the decarbonisation of their portfolio and economy through their long-term investments. .

1 Neither cement companies, nor traditional car manufacturers, nor airlines are excluded from the SRI indices.

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