Three surprising insights from our new ETF temperature tool

We’ve been delighted with all the positive feedback as we encourage the industry towards total transparency and honesty. We hope you continue using the tool to analyse the implied temperature rise of your investments. And remember: we show you Lyxor ETF temperatures, but they are based on underlying indices which are also being tracked by several other ETF issuers.

In any case, the COtool has been live for a little over a week – and today we are going to share some of the most interesting things we’ve learned so far.

Many European utilities are 1.5°C aligned

Utilities companies provide electricity, natural gas and water, among other amenity services. This sector is excluded from many ESG indices due its high carbon impact. Yet, in the COtool, the European utilities sector (as represented by the STOXX Europe 600 Utilities Index) is 1.5° aligned, with 65% of its AuM under the 1.5° threshold.

Even the MSCI World Utilities index, comprised of over 50% US companies, has an implied temperature of 1.8°C – under the Paris Agreement’s 2° central scenario. Why?

Utilities are aligned because the sector is “under budget”. Our methodology assigns a carbon budget to utilities using the sectoral decarbonisation approach (SDA). SDA factors in the decarbonisation opportunities of a given sector – and while high carbon budgets are allocated to utility companies because they tend to be carbon-intensive, those budgets are decreasing year on year.

In fact, most utility companies are aligned because the sector is more advanced than other industries in terms of its transition to a low-carbon economy.

Even though much more needs to be done to decarbonise the sector, a significant number of emission-reducing projects have been launched over the last decade. Many utilities have also made firm commitments to a well below 2° scenario with the Science Based Targets initiative.

Most indices are above 3°

Depending on your knowledge of the financial industry, this might not be a big surprise. But it’s worth highlighting that most indices are aligned with a ‘business as usual’ temperature outcome, above 3°.

One option to reduce the temperature impact of a core portfolio building block, such as the S&P 500, would be to consider the S&P Paris-Aligned benchmark variant, compatible with the Paris Agreement’s most ambitious 1.5° warming scenario.

ESG indices can be ‘hot’

We’ve received several questions on why an ESG ETF can have a high temperature, or be ‘hotter’ than its parent index or comparable non-ESG ETF.

Taking the DAX 30 as an example: this index reflects a part of the German economy with high carbon intensity, due to the large share of coal in the German power sector and the high representation of power companies in this index.

However, the COtool shows that the DAX 30 is compatible with a 1.5°C temperature scenario, whereas the DAX 50 ESG benchmark is >3°C.

The answer to this is that an index may have a very high carbon footprint today, and still be aligned with the Paris Agreement. The temperature reflects the fact that the index is on a pathway aligned with the Paris Agreement, not if it is carbon-intensive today.

In our example, the DAX 30 contains several big companies in the power sector. These companies are well known for having a lot of coal in their power mix. They are accountable for very high volumes of emissions, and therefore are excluded from ESG indices. But because they have taken strong commitments to reduce their emissions – even more ambitious than their expected SDA decarbonisation trajectory requires – they are 1.5°-aligned.

Ultimately, the best way to understand this is by recognising that an ESG measure is fundamentally different from a temperature measure.

An ESG score evaluates an issuer on Environmental, Social and Governance aspects, while a temperature measure has a narrower focus on alignment against the goals of the Paris Agreement. A carbon-intensive company can still have a high rating on social and governance topics, which might compensate a low score on environmental side to give a strong ESG score.

If an ESG index methodology overweights issuers with high ESG scores, and if these are also unaligned with the Paris Agreement goals, it can lead to a high temperature, or a higher temperature than its parent index.

Some caveats

This is very much a moment-in-time snapshot. Temperatures can and will change in the coming months. There are a few reasons why that might be:

• Changes in the fund composition and weightings in the fund
  
  
• Variations of enterprise value among issuers in the fund (fluctuations of their market capitalisations, increase or decrease of their debt, available cash, etc.)
  
  
• Effective reduction of emissions of issuers in the fund
  
  
• Change in theoretical carbon budgets from updated climate scenarios
  
  
• Expansion of Trucost database with new data for issuers that were not covered until now

Note that a decrease of a fund temperature is not necessarily due to a real reduction of emissions of issuers in a fund. An increase is not necessarily due to higher emissions.

The COtool does not yet consider what are known as ’scope 3 emissions’. Scope 3 refers to indirect GHG emissions that are a consequence of the company’s activities, but which come from sources not owned or controlled by the company.

For some sectors such as automotive and oil & gas, scope 3 emissions represent a major part of the sector’s emissions and taking them into account to evaluate alignment in these sectors is necessary to get a true picture of their carbon intensity.

Unfortunately, there is incomplete reporting of scope 3 emissions by companies, it’s hard to model these emissions, and climate scenarios used for target-setting do not yet integrate scope 3 emissions in transition pathway forecasts.

To fulfil the COtool’s potential, we are working to integrate scope 3 emissions in our methodology in 2021 for automotive and oil & gas.

That’s all for this update. Send us any questions or comments you have on the tool and we’ll try to answer them in a future blog.

Discover our new COtool or explore our range of Climate-focused ETFs. 

For professional clients only

This communication is issued by Lyxor Asset Management UK LLP (“Lyxor LLP”), part of Lyxor Group. This material reflects the views and opinions of the individual authors at this date and in no way the official position or advices of any kind of these authors or of Lyxor LLP and thus does not engage the responsibility of Lyxor LLP nor of any of its officers or employees. This communication is not an offer to sell or the solicitation of an offer to buy any security and/or to provide a financial service in any jurisdiction. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Clients should consider whether views, opinions, advice or recommendation in this communication is suitable for their particular circumstances and, if appropriate, seek professional advice, including tax advice. Our salespeople, portfolio managers, and other professionals may provide oral or written market commentary or recommendations to our clients, and may take investment decisions that reflect opinions that are different or contrary to the opinions expressed herein. Data, sources and materials are provided “as is” and may change over time. Lyxor LLP makes no commitment to their reliability, accuracy and actuality.

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