In recent years many asset owners in Europe¹, the Americas², Asia³ and Oceania⁴ have set themselves goals to reduce the carbon emissions of their investment portfolio to net zero. The timelines to reach this ambitious goal are generally far in the future, however, the increasing focus on carbon reporting has led to significant investment changes. Measuring and managing total portfolio carbon emissions under the updated UNPRI 2023 Reporting Framework released in January will only increase the importance. This new framework puts certain reporting obligations on any UNPRI Signatory institution, and includes climate metrics as a ‘CORE’ (i.e. non-optional) part of its Strategy module. It includes metrics such as the ‘Total carbon emissions’ of the portfolio, ‘Weighted average carbon intensity’ and the ‘Implied Temperature Rise’.

A common approach, and the easiest to implement, is tilting the portfolio to low emitters. It only requires carbon-footprint data and an optimisation that selects the low-emitters from any given index. An obvious drawback of this approach can be that the resulting portfolio may be too concentrated or have vastly different sector exposure. For example, a lower exposure to energy would have led the portfolio to underperform the benchmark substantially in 2022.

A more nuanced version of this approach is to minimise a carbon metric and simultaneously control for country and sector exposures as well as the tracking error to the parent index. This is what the MSCI World Low Carbon Target Index implements. The MSCI World Low Carbon Target Index solves for an ex-ante (model-based) tracking error of 0.3% at each of the semi-annual re-balance dates. Ex-post this can vary slightly. The benefit of this methodology is that it achieves a 61% reduction in carbon emissions of the parent index (see Table 1) with minimal tracking error. Any small alpha source on top of this index would be sufficient to have a high likelihood of meeting the YFYS performance benchmark while significantly reducing the portfolio carbon emissions. The only drawback of this approach is that it may never get the portfolio to net zero carbon emissions, since not all low-carbon companies intend to reduce their emissions.

To achieve net zero, investors may need a more forward-looking approach to identify companies that aim to reduce emissions (or have a net-zero target) and monitor their progress. Currently, there are only a limited number of companies that have pledged to become net zero emitters, and many of those target the year 2050. That leaves a limited investment universe for funds that are more ambitious with their own emission targets. Therefore, these investors may need to accept a higher tracking error to the Your Future, Your Super benchmarks to fulfill the net zero ambitions.

An index family that was designed with an automated annual emission improvement in mind is the MSCI Climate Paris Aligned Benchmark series. The construction ensures that the Enterprise Carbon Intensity decreases by 10% per annum reduction of carbon emissions per $1m invested. This approach currently achieves a 76% reduction in carbon emissions compared to the parent index, and will continue improving by construction. The Paris Aligned index only includes 646 constituents of the MSCI World universe and has a slightly higher tracking error of 1.44%.

Both the MSCI World Low Carbon Target Index and the MSCI Climate Paris Aligned Index can be invested in synthetically via total return swaps or futures. The TRS pricing is very similar to the MSCI World Index:

Table 1: Indicative total return swap pricing

Index	TRS pricing for 1yr tenor
MSCI World	SOFR - 25/-15
MSCI World Low Carbon Target	SOFR - 24/-14
MSCI World Climate Paris Aligned	SOFR - 24/-14

Table 3: MSCI World - index metrics