- Derivatives have a role to play in climate risk management, exposure to green opportunities and alignment with the transition to net-zero.
- Futures linked to the MSCI Climate Action Indexes could support institutional investors who seek to finance companies’ emissions reductions to drive climate change in the real economy.
- Misalignment between a climate benchmark and derivatives exposures could lead to notable differences in impact metrics, financial risk metrics and tracking risk.
The transition to a low-carbon economy is in motion, with a growing coalition of countries, institutions and corporations pledging to achieve net-zero emissions. Investors can play a critical role in the transition to net-zero by allocating capital to companies with credible net-zero targets.
To meet the demands of institutional investors seeking to implement and manage climate strategies, an expanding array of index-linked financial products has come to market, including ETFs, futures and OTC swaps.
In this blog post, we address two questions: Can derivatives linked to climate indexes impact the real economy? And what are the climate impact, financial risk and opportunity metrics of the indexes’ underlying climate futures contracts?
Climate derivatives and change in the real economy
Derivatives have long contributed to the investor toolkit by facilitating portfolio management that may not be readily accomplished through direct share ownership, such as efficient market access, index replication, cash equitization, hedging strategies, completion portfolios and transition management.1 Although these use cases remain relevant for climate investing, derivatives can also contribute to the overall climate profile of the portfolio.
Derivatives transfer risk exposure from one market participant to another. This risk transfer capability is relevant to climate investing and the real economy. Whereas holders of derivatives contracts do not have engagement rights and influence over their investee companies to the same level of traditional stock ownership, the theoretical replication of derivatives allows for effectively trading the underlying physical asset. Long directional exposure via derivatives could offer an indirect financing channel to the underlying companies. Because derivatives are tied to the valuation of the underlying reference asset, they assume the associated financial risk exposures. In the case of derivatives linked to a climate index, an investor needs to analyze the effects of climate impact, financial risk and opportunity metrics of the underlying index on the total portfolio.
MSCI categorizes our climate indexes into three broad categories based on objectives and path to net-zero: reduce emissions, drive the transition, and align. The MSCI Climate Action Indexes include companies that are actively driving the transition to a low-carbon economy.
The MSCI Climate Indexes: comparing metrics
We compare the impact, financial risk and opportunity metrics for the indexes that have listed futures. Some regional indexes may not have a listed future, but we have included them for completeness.
Impact metrics
The methodology of the MSCI Climate Action Indexes selects constituents based on their current direct and indirect emissions as well as on their strategy to achieve low-carbon emissions. The assessment balances a company’s current climate-transition risk, measured by emissions intensity, with its commitment to reduce emissions or emissions intensity. A company can indicate its commitment to reduce emissions by adopting a science-based target, based on guidance from the Science Based Targets initiative (SBTi).
The MSCI Climate Action Indexes, across regions, had a higher proportion of companies with approved SBTi targets compared to the other climate indexes and the parent index shown below, as of May 31, 2023.
MSCI Climate Action Index constitutents had a strong commitment to lowering carbon emissions
As of May 31, 2023. Source: MSCI ESG Research.
Risk and opportunity metrics
The MSCI Climate Action Indexes, across regions, had the highest exposure to companies with top-quartile low carbon transition scores2 relative to other companies in the relevant Global Industry Classification Standard (GICS®)3 sub-industry.
World climate action indexes had, however, higher exposure to product and operational-transition risk (9.6%) than other climate indexes, for example, World climate change indexes (4.7%).
MSCI Climate Action Index constitutents scored well on LCT Management Score
As of May 31, 2023. Source: MSCI ESG Research.
Assessing alignment before implementing
As the number of financial products linked to climate indexes grows, investors may need to consider these new products’ alignment with their portfolio’s climate benchmark. Misalignment between the benchmark and the financial instrument could lead to notable differences in impact and financial risk metrics and lead to higher tracking risk. For example, an investor with a portfolio benchmarked to the MSCI World Climate Action Index would have a tracking error of 1.9% against the MSCI World Index and a tracking error of 1.4% against the MSCI World Climate Paris Aligned Index, based on the three-year period from May 29, 2020, to May 31, 2023.
Tracking errors of the MSCI World Climate Indexes and the MSCI World Index
Annualized tracking error for the period May 29, 2020, to May 31, 2023.
Stepping into the futures of climate investing
Derivatives linked to climate investing are in the early stages of product innovation and investor adoption. As more investors seek net-zero solutions, these derivatives could be an option for managing climate risk. One size does not fit all, however. Investors who wish to add climate-index-linked derivatives to their portfolio may wish to align their choices with their overall approach to climate investing.
1Transition management refers to the process by which assets or funds are moved from one portfolio strategy to another. A future overlay creates a synthetic exposure to the target asset class and can be used to achieve an immediate allocation shift, eliminating the risk of holding cash.
2MSCI’s Low Carbon Transition (LCT) Score assesses the current and potential exposure to transition risks and opportunities through a company’s operations and business model. Scores range from 0 to 10. A higher LCT score indicates greater alignment with a low-carbon transition goal than a lower score.
3GICS is the global industry classification standard jointly developed by MSCI and S&P Global Market Intelligence.
Further Reading
Understanding the MSCI Climate Action Indexes
ESG and Climate Derivatives in Equity Exposure Management