Scientific Beta

This overview paper introduces the standards used for greenhouse gas accounting and definitions of carbon metrics, describes Scientific Beta's ESG integration approach and the negative and positive carbon filters embedded in the Low Carbon option and presents Transition Risk exposures and financial risks and performances of representative Low Carbon indices.

Scientific Beta is offering a Low Carbon fiduciary option that is applicable across its entire flagship offering of multi-factor indices. In  addition, we  also offer a Climate Transition Benchmark (CTB) compliant version of the Low Carbon fiduciary option,  which  is  limited  to  the  standard multi-factor offering without any risk-control options such as sector neutrality or market beta adjustment.

The Low Carbon fiduciary option addresses investors’ three most common decarbonisation objectives:

1. Contributing to the transition to a low carbon economy;
2. Reducing the "carbon footprint" of investments, i.e. their indirect contribution to Climate Change;
3. Reducing exposure to Climate Change risks.

These objectives are achieved with three approaches to decarbonisation:

• Negative screening ensures divestment from companies with strong involvement in coal and tar sands activities – phasing out coal is a priority in transition scenarios as coal produces the highest CO2 emissions per heating unit produced and needs to be phased out in line with Net-Zero ambitions. Companies deriving significant turnover from tar sands are also screened since its extraction and upgrade into synthetic crude oil  come at high environmental costs. Furthermore, the coal and tar sands exclusions reduce exposure to these assets, which face considerable stranding risks.
  
  
• Positive screening targets companies with the highest emissions per unit of revenues (carbon  intensity) in key sectors exposed to Transition Risks and beyond. The carbon intensity measure uses Scope 1 and 2 carbon emissions as Scope 3 emissions data currently lacks the granularity required for inter-company comparisons. Carbon emissions are normalised by revenues, as recommended by the Taskforce on Climate-related Financial Disclosures (TCFD). Screening is region neutral but given flexibility to strike a balance between exclusion efficiency and sector protection, while preserving sector representation and upholding best-in-class selection within each affected sector. The positive screening thus reduces exposure to transition risks proxied by carbon intensity across all sectors.
  
  
• A WACI/CTB Mechanism ensures a minimum reduction of carbon intensity. For the standard Low Carbon option, if the positive and negative screens are not sufficient to achieve a 35% reduction in the Weighted Average Carbon Intensity ( WACI) of the index using Scope 1, 2 and 3 emissions relative to the Cap-Weighted benchmark, a mechanism based on peer groups derived from NACE sectors is used to guarantee the targeted level of reduction. The mechanism is set up to ensure that weights do not deviate far from the initial weights. The 35% target WACI reduction serves as a desirable long term reference level for the index carbon intensity, and the inclusion of Scope 3 emissions in the target supports decarbonisation of unlisted corporates and non-corporate actors, including households. Meanwhile, for the CTB-compliant low carbon option, a similar mechanism is applied to ensure that the index fulfils the criteria of the CTB regulations. It includes a 7% self-decarbonisation trajectory and a 30% carbon intensity reduction relative to the benchmark, both using Scope 1, 2, and 3 emissions normalised by enterprise values. A third CTB criteria also prevents the index from underweighting high climate impact sectors relative to the Cap-Weighted benchmark to maintain representation of key transition sectors. For both the standard and CTB-compliant Low Carbon options, the conditional adjustment procedure thus promotes reductions in transition risks pertaining to value-chain emissions.

As the Low Carbon fiduciary option also includes filters that screen out those companies that fall short of global standards of responsible business conduct and corporate governance or that are involved in activities that conflict with global Environmental, Social and Governance (ESG) norms or their objectives globally, the pursuit of decarbonisation and financial performance does not harm the respect of ESG norms.

The application of the Low Carbon option produces a drastic reduction in the allocation to coal and tar sands activities, which represent the fossil fuels most incompatible with the Paris Agreement. Allocations to the most carbon-intensive companies are also decreased. The option thus incentivises the transition of shunned and other companies towards more sustainable activities and technologies. It also contributes to material reductions in both carbon footprints and exposures to the companies most liable to be affected by Transition Risks, including assets facing high risks of stranding. Over the last 10 years, the average index WACI has been about half that of the benchmark on Developed Markets. These Climate Change and ESG benefits are delivered while retaining the financial outperformance of the standard flagship indices.

As such, the Low Carbon fiduciary option is relevant to ethical and socially responsible investors who wish to dissociate from companies that contravene global norms, to promote the transition to a low carbon economy and to reduce their indirect contribution to Climate Change. It is also relevant to business-as-usual investors who recognise that Transition Risks may materially impact portfolio values and wish to mitigate these risks as a precaution.