Two years on from the formation of the EU Paris-aligned benchmark, and its performance has been encouraging. And while the very short-term outlook for Paris-aligned strategies may seem overshadowed by a focus on other priorities such as Covid and the war in Ukraine, the longer-term case for sustainable investing has become even stronger.
In the spring of 2020, the EU Paris-aligned benchmark was finalised by the Technical Expert Group (TEG) and entered into application after years of deliberation. With the ultimate goal of supporting the Paris Agreement of 2015 by channelling financial flows into more sustainable companies and sectors of the economy, the benchmark regulation is a key component of our path to limiting global warming to 1.5-2°C by 2100. The introduction has been a highly significant step in the right direction both for investors as well as our planet – but a vast amount of work remains to be done.
To appreciate the success of the EU benchmark, but also the challenges that still lie ahead of us, consider the following numbers: towards the end of 2021 there were well over 150 funds aligned with global warming of below 2°C – with assets worth around $135bn. Given the market upheaval induced by the pandemic, this is a very substantial number, especially after such a short amount of time.
On the other hand, it still only represents a fraction of a percentage point of the overall asset management industry: about 60% of funds’ assets remained aligned with a warming of more than 2.75°C – in other words, most of the invested money is still financing an economy that, according to most scientists, leads straight into the climate abyss.
Meanwhile, however, the performance of the benchmark has been encouraging; with annualised returns of 16.9% and 24.5%, the Paris-aligned versions of the Stoxx Europe 600 and the S&P 500 index were in line with their respective investment universes, at similar risk levels. With a constant drag due to the necessary exclusion of strongly performing energy companies during both 2021 and 2022 and a general underweight in sectors currently benefitting from the commodities boom, this is no small feat.
Recent events
We have all witnessed two terrible recent events that have fundamentally altered the societies we live in: the Covid-19 pandemic and the Russo-Ukrainian war. The first one certainly accelerated an already existing trend toward digitisation, but also benefitted a more local appreciation, reduced for good the number of business trips, and improved the overall visibility and value of a healthy and liveable environment.
The second event has so far led to permanently elevated oil and gas prices, higher defence budgets, but also turbocharged the drive towards energy independence and the development of renewable energy sources. From a Western point of view, the drive towards net zero is no longer a medium-term social and environmental issue alone – as if this was not enough reason to take action – it now has an immediate geopolitical component, too.
In this context, there are three drivers towards implementing Paris-aligned strategies in financial portfolios: regulatory, economic, and demand-driven. An example of another regulatory push will take effect in August this year, when advisers will have to ask their clients about sustainability preferences (an extension of Mifid II). This also translates into the need for product providers to offer transparency – going hand in hand with benchmark requirements. The economic case has never been clearer than in the aftermath of the Russian invasion of Ukraine.
Last, a demand-driven factor is only in the early stages of development but may ultimately become the most powerful: millennials may, partly due to inheritance, become the richest generation in history. Incidentally, these are also the people that happen to care most about climate change.
This will, over time, put sustainable investing front and centre even for advisers or asset owners that may not yet be fully convinced today. Add to this a broader array of instruments in the Paris-aligned space, like emerging markets or even single-country exposure, there will be very little in the way of implementing a portfolio strategy that is net-zero aligned, broadly diversified, and satisfies regulators and customers alike.
