FTSE Russell Insights

Squaring the circle on Carbon, ESG and Tracking Error

Aled Jones

Head of Sustainable Investment Solutions
  • Regulatory Support: Climate disclosures are expected to improve with the support of regulations from entities like the SEC, ISSB, and EFRAG, though these changes may take time to be fully effective.
  • Historical Emissions Performance: The V.2.0 CA100+ framework includes an indicator to track companies' historical greenhouse gas emissions performances, providing valuable insights for investors.
  • Transition Plans: Companies must provide clear and coherent 2050 pathway Transition Plans to gain credibility in their emissions reduction's commitments. Standardized guidance from initiatives like the Transition Plan Taskforce and Glasgow Financial Alliance for Net Zero is crucial in facilitating meaningful transition plan disclosures.

There’s a wave of investor demand for sustainable equity indices. But what do you do if the starting universe for your sustainable index is relatively carbon-intensive?

The UK’s most popular equity benchmark, the FTSE 100, poses just such a dilemma.

As at June 2023, four of the largest ten stocks in the index—Shell, BP, Glencore and Rio Tinto—were in the energy and basic materials sectors.

And according to a recent FTSE Russell study[1], energy, basic materials and utilities are the three sectors with the highest carbon emissions intensity in the whole UK equity market.

Scope 1 and 2 Carbon emissions intensity of FTSE UK and Industry components—minimum, maximum and weighted average

Chart shows that according to a recent FTSE Russell study, energy, basic materials and utilities are the three sectors with the highest carbon emissions intensity in the whole UK equity market.

Source: FTSE Russell and Trucost. Data based on the FTSE UK Index Universe for September 2022.

Past performance is no guarantee of future results.

[Carbon emissions intensity measures the rate of carbon emissions per unit of economic activity, often calculated relative to a company’s net revenues[2].]

Removing or reducing exposure to carbon-intensive stocks

One way of dealing with this realisation might be to downweight carbon-intensive stocks and sectors as far as possible, or even to exclude them completely. There are several indices within the FTSE Russell range that do just this.

For example, the FTSE ex Fossil Fuels index series represents the performance of companies in FTSE Russell indices after the exclusion of companies that have more than a threshold exposure to fossil fuels.

Another popular sustainable equity index approach is to incentivise steady, year-on-year decarbonisation by the index constituents.

The FTSE TPI Climate Transition index series achieves this goal by underweighting companies with fossil fuel reserves, over- or underweighting companies according to their greenhouse gas emissions and overweighting companies that generate revenues from the global green economy.

This index also over- or underweights companies according to the extent to which they are committed to carbon emissions pathways that are aligned with the goals of the 2015 Paris Climate agreement.

A measured approach

But not all equity investors are prepared to shift their core portfolios from a starting point of capitalisation weighting—which, in many cases, is an approach that’s endured for decades—to following a radically new index.

That’s because many popular risk management tools assess equity portfolios’ performance relative to popular, capitalisation-weighted regional or country benchmarks (such as the FTSE All-Share index or the FTSE 100).

The higher the divergence from the starting index’s weights, the greater the tracking error (and the higher the resulting use of the investor’s risk budget).

So many equity investors are taking a more measured approach: they seek to improve sustainability while also keeping a lid on the divergence in performance from their reference benchmark.

The UK equity market poses an additional dilemma for those building sustainable portfolios.

Its stocks, as a whole (and including the more carbon-intensive sectors), are already amongst the best performers in the world from an environmental, social and governance (ESG) perspective: the FTSE UK index series has an average ESG score that’s a lot higher than that of the global developed equity universe.

But is it possible to deliver both carbon reduction and an ESG uplift, while also constraining the divergence in performance from the starting benchmark?

With these goals in mind, in May 2023 we launched new ESG-adjusted variants of our flagship FTSE 100, FTSE 250, FTSE 350 and FTSE All-Share indices.

The FTSE UK ESG Risk-Adjusted indices remove exposure to specific products, services and certain conduct categories – including controversial weapons, tobacco, thermal coal, oil sands, shale energy, arctic exploration and conduct that is contrary to the United Nations’ Global Compact.

The indices then target a 50 percent reduction in fossil fuel reserves exposure versus the starting benchmark, as well as a 50 percent reduction in carbon emissions intensity.

The ESG-adjusted UK equity indices also aim for a 5 percent improvement in ESG scores versus the cap-weighted UK reference universe.

And by means of FTSE Russell’s ‘Target Exposure’ methodology, we control tracking error by ensuring that each ESG-adjusted index remains relatively factor-, beta- and industry-neutral.

FTSE UK ESG Risk-Adjusted index series—design steps

Charts shows that by means of FTSE Russell’s ‘Target Exposure’ methodology, we control tracking error by ensuring that each ESG-adjusted index remains relatively factor-, beta- and industry-neutral.

If you use one of these new indices in a tracker product or as a reference benchmark, you may be surprised to find that certain familiar company names from the energy and resources sectors of the FTSE 100 and All-Share haven’t disappeared completely.

But that’s because they now figure as part of a broader strategy that delivers real improvements in carbon and ESG performance whilst balancing these outcomes with investment risk (defined as tracking error, industry and factor deviations etc.). In doing so we expect the new indices to deliver risk/return characteristics that are similar to those of the underlying benchmarks.

[1] “Sustainability in the UK – a year on”, FTSE Russell, 9 March 2023.

[2] See “Mind the Gaps: Clarifying Corporate Carbon”, FTSE Russell, 9 May 2022.

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