The EU regulation adopted in July 2020 provides “Climate Transition” or “Paris-aligned” benchmarks for index strategies in line with the recommendations of the EU TEG (TEG, 2019). For an index strategy to use these labels now, the index must meet certain minimum requirements such as reducing carbon intensity by 30% at index launch and an additional 7% a year. The index is also required to have sufficient exposure to sectors with high potential impact on climate change (e.g., energy, transportation, and manufacturing). These minimum requirements allow comparability of climate benchmarks and limit the risk of greenwashing. The EU regulation brings some welcome clarity to climate investing, but does not eliminate all confusion because no universally accepted method for calculating CI has been adopted.
Ducoulombier and Liu (2020) recommend using revenue for measuring CI based on their analysis of the major issues associated with using EVIC. They point out that EVIC can only be used for publicly traded companies (for private companies, the EU allows the use of book value to measure EVIC, which can lead to data-comparability issues) and it is a much more volatile measure than revenue, which weakens the link between emissions and carbon intensity and can lead to greenwashing. Ducoulombier and Liu’s position contrasts with the TEG’s argument in favor of EVIC, based on their view that the revenue measure is not comparable across sectors and that companies with high exposures to stranded assets—coal companies, for example— disproportionally benefit from the use of revenue to measure CI (TEG, 2019).
To form our own opinion, we examined the effects of using each measure in the portfolio construction process, focusing on the following three measures:
- Degree of carbon emissions discrepancy when the two alternatives are used for portfolio construction and measurements.
- Value and growth style differences in the resulting portfolio.
- Transaction costs and other associated implementation characteristics.
For our analysis over the period April 2016–June 2021, we constructed several portfolios in the US market and the developed markets: a capitalization-weighted portfolio which selects the largest 86% of companies by market capitalization in each country;5 the preceding strategy that maintains a 50% reduction in CI relative to the cap-weighted index portfolio at each rebalance using carbon footprint scaled by revenue to measure CI;6 a strategy with the same parameters as the preceding strategy but with scaling by EVIC; and to determine the effect on smart beta strategies, we apply the same approach to a fundamentally weighted portfolio using the RAFI™ Fundamental Index™ methodology.7 For the fundamentally weighted portfolio analysis, we select the top 86% of companies within each country by fundamental weight and then maintain a 50% reduction in carbon intensity relative to the fundamentally weighted index portfolio at each rebalance, using revenue to measure CI in one portfolio and EVIC to measure CI in another.