Indexology^® Blog

This piece originally appeared on Risk.net.

The dust has now settled on the 2021 UN Climate Change Conference (COP26). Did the gathering of almost 200 nations succeed in putting us on a path towards limiting warming to 1.5°C?

COP26 concluded with the signing of the Glasgow Pact, which agreed to “keep 1.5°C alive.” Some of the agreements made include strengthening 2030 emissions reduction targets, annually revising these targets and a “phase-down” of coal.

However, post-COP26, many felt an air of deflation. Alok Sharma, president of COP26, said: “We’re all well aware that, collectively, our climate ambition and action to date have fallen short on the promises made in [the Paris Agreement on climate change].”

Some areas of concern

There was a lack of visible commitment and priority from some of the world’s largest polluters. Notably absent were national leaders from China and Russia, the largest and fifth-largest contributors, respectively, of national carbon dioxide emissions. However, China did issue a surprise declaration on Enhancing Climate Change Action in the 2020s in partnership with the US.

There is a legacy of failed pledges – most famously the unfulfilled pledge for $100 billion in climate finance for developing nations by 2020. It is therefore unsurprising that headline-grabbing pledges made in the first week of COP26 have been overshadowed by inevitable questions around whether they will be realized. Then there is the failure of some countries to commit to net zero by 2050. India’s commitment to reach net zero by 2070 was a notable announcement at COP26. A significant step, certainly, but 2070 net-zero commitments will not restrict warming to 1.5°C.

Reasons for optimism

There were many pledges and commitments made at COP26. In addition, COP26 provides a platform for smaller nations. Though the limelight focuses on high-profile politicians and the crucial pledges of large nations, the conference is an important forum to also hear the pleas of smaller nations that may produce little in terms of greenhouse gas emissions, but may face the negative consequences of climate change.

COP26 represents a great opportunity, not just for official delegates from nations to gather but also for the wider community to lobby for change. For example, the Fairtrade Foundation supported the participation of a delegation of farmers whose livelihoods are threatened by climate change. Local campaigners demanded climate action from politicians.

Climate change is climbing agendas, and this rise is facilitated by high-profile events such as COP26. Climate issues are now covered more comprehensively in the media and are better understood by the wider population, and there is broad support for the idea that action needs to be taken.

Many companies have, for some time, recognized their ESG responsibilities. It is positive to see segments of the private sector demonstrating an understanding of the risks and opportunities specifically regarding climate change and committing to net zero by 2050. During COP26 there was a notable announcement through the Glasgow Financial Alliance for Net Zero (GFANZ) to commit more than $130 trillion of private capital to transform the economy to align with net zero.

What does this mean for indices?

As a provider of climate benchmarks, we closely follow developments at all UN Climate Change Conferences and evolving investor requirements. Increased demand from asset owners and commitments made by asset managers to account for climate change in their portfolios result in more interest surrounding net-zero-aligned indices.

The S&P PACT indices (S&P Paris-Aligned & Climate Transition Indices) are 1.5°C-aligned and available in several regional exposures, with the S&P UK Net Zero 2050 Paris-Aligned ESG Index being the most recent addition.

S&P DJI is committed to providing transparency on the methodology of its indices and regularly discloses how the sustainability objectives of its S&P PACT Indices are met.

Time will tell if COP26 will be remembered as a success. In the meantime, S&P DJI will continue to produce rules-based indices that align with a 1.5°C scenario to help investors on the path to net zero.

Over the past week, global financial markets have been roiled by the discovery of the “Omicron” COVID-19 mutation. It’s far too soon to know how much this new variant will impact the world’s economy—but its discovery suggests an interesting thought experiment in, of all things, corporate governance.

The experiment is this: suppose Omicron turns out to be very dangerous and leads to a series of draconian economic shutdowns. Suppose further that a pharmaceutical manufacturer “X” comes up with a miracle cure—a vaccine that’s easy to administer and 100% effective. How should X’s shareholders want X to price its vaccine? How, in other words, should X’s real-world invention produce financial “alpha” for its owners?

The answer depends on the nature of X’s shareholder base. Suppose that X is included in most major stock market indices, so that a large fraction of its shares are held by index funds. Then many of X’s stockholders are “universal owners”—they own not just X but many of X’s competitors, customers, and suppliers. The growth of indexing has attracted considerable commentary, not all of it favorable, but in the case of X’s Omicron vaccine, the impact of universal owners should be entirely benign.

Why? From a narrow perspective, X should charge quite a lot for its vaccine, since it’s obviously worth a great deal. But from a universal owner’s perspective, X should give the stuff away (or at least sell it for marginal variable cost, which would be close to the same thing). X might well lose money, but an effective and plentiful vaccine would arguably cause the whole market to move upward sharply. Index funds would profit far more from the beta effect on their portfolios than from the alpha on a single stock.

Notice three things:

• This argument is not altruistic. It may well be “socially responsible” for X to give the vaccine away, but that’s not why universal owners are putatively for it. The argument that they should disregard X’s profitability to boost the world’s stock markets is entirely self-interested.
• Sufficiently diversified active managers have the same incentives as index funds. A given active manager might have an overweight in X, but it probably wouldn’t be big enough to negate the advantage of a general bull market.
• The relevant balance of control at X is not the percentage ownership of individuals versus institutions or even of active managers versus index funds. The most important distinction is between the relative ownership of universal versus undiversified owners. “Undiversified” is a broad and relative term, of course, but might include concentrated “high conviction” active managers and hedge funds. And the most obvious group of undiversified shareholders, interestingly, is the management of the corporation itself.

For a universal owner, things that make the market rise are beneficial. This tautology has important implications for corporate governance and stewardship. And it means that, at least in some cases, rewards should come from beta, not from alpha.

The S&P GSCI, the broad commodities benchmark, declined 10.8% over the month. The poor performance was driven almost exclusively by a major correction in energy prices, as the discovery of the Omicron COVID-19 variant cast a lengthening shadow over demand growth, added further complications to global supply chains, and dampened economic growth forecasts. The release of emergency oil stocks also played into the mix.

The U.S. and other large oil-consuming nations agreed to release emergency oil stocks during the month, a sign of the growing concern among policy makers of rising gasoline prices and the contribution of energy prices to escalating levels of inflation. The coordination came after the Biden administration failed to convince oil producers, including Saudi Arabia and Russia, to produce more oil to meet demand as the world recovers from the pandemic. China has yet to detail its reserve release. News of the release coupled with the emergence of the Omicron COVID-19 variant sent energy prices on a downward spiral over the closing days of the November. The S&P GSCI Petroleum fell 17.7%, while the S&P GSCI Natural Gas declined 17.3%.

Given the turmoil in the energy complex, it was surprising that the other industrial commodities sector, industrial metals, did not fall more steeply in November. The S&P GSCI Industrial Metals fell 2.0%, with the S&P GSCI Zinc suffering the biggest monthly decline, down 5.8% after hitting a 14-year high in October. The worst of the power-related disruption to Chinese refined zinc supply appear to have been resolved, and Chinese demand for zinc has waned.

The S&P GSCI Gold was flat for the month as caution picked up across financial markets, but the U.S. dollar hit a new one-year high. The biggest move came from the S&P GSCI Silver, which fell 4.9%, more in line with the industrial metals space. About one-half of silver demand is industrial in nature.

Within agriculture, while most commodities fell a few percentage points in sympathy with energy, there were two notable outperformers that helped to bring the S&P GSCI Agriculture to nearly flat for the month (down 0.8%). The S&P GSCI Kansas Wheat continued its run from October, moving higher by another 4.4%. The export duty imposed by Russia continued to keep the global wheat market tight. Egypt, the world’s largest importer of wheat, made its biggest single purchase since 2008, buying 600,000 metric ton. The S&P GSCI Coffee was the best performer in the agriculture complex for the month, rallying 12.4%, and it gained 68.2% YTD. Coffee prices hit a 10-year high in November when a perfect brew of catalysts came together. In South America, drought followed by frosts affected the crop, while freight disruptions continued to play a role, as coffee is typically refined in countries outside of the crop’s origin.

The S&P GSCI Livestock bounced back by 2.7% in November. Cattle prices led the way, as demand was strong and outpaced increased supplies. Beef cow slaughter was 9% higher year-over-year in the U.S.

                                        “The dollar is our currency, but it’s your problem.”

Former U.S. Treasury Secretary John Connally (Feb. 27, 1917 – June 15, 1993)

When John Connally uttered the famous words above, exactly 50 years ago today at a meeting of major finance ministers in Rome, it was just three months after the U.S. had unilaterally dismantled the post-World War II global monetary system known as Bretton Woods. The “problem” Connally referred to was a rapidly depreciating U.S. dollar, which threatened the competitiveness of exporters based in the U.S.’s main trading partners.

In the decades since, however, developing countries have faced the opposite challenge. Time and again, a bout of U.S. dollar strengthening has triggered turmoil in emerging economies that predominantly borrow abroad in foreign currencies, usually U.S. dollars. Thus, a strengthening U.S. dollar has increased emerging markets’ debt burden, depressing consumption and economic growth, and consequently leading to dismal domestic equity market returns.

The last such instance was triggered in May 2013, when then-Federal Reserve Chairman Ben Bernanke revealed plans to wind down the Fed’s gargantuan quantitative easing program, setting off a so-called “taper tantrum”: bond yields surged around the world, ex-U.S. stock prices tumbled, and a soaring greenback put severe strain on emerging market economies worldwide. Between May 2013 and December 2015, the S&P Emerging BMI dropped 16% in U.S. dollar terms, underperforming the S&P Developed BMI by 33%. A “Fragile Five” composed of Turkey, Brazil, Indonesia, India, and South Africa were particularly hard hit, underperforming by an average of 44% against the S&P Developed BMI.

What made the “Fragile Five” particularly vulnerable? Factors included low foreign exchange reserves as a percentage of their external debt, and high current account deficits as a percentage of their GDP. Having perhaps learned their lessons, four out of the five have since made significant economic readjustments: India and South Africa swung from a current account deficit to a surplus, while Indonesia and Brazil cut their deficit by 87% and 49%, respectively. Turkey, on the other hand, remains highly vulnerable as the current account deficit barely budged, while the country’s FX reserves plummeted by 36% as a percentage of total external debt between the end of 2013 and 2020. India also increased its FX reserves significantly, from 70% to 105% of total external debt, while South Africa, Indonesia, and Brazil registered moderate decreases between 8%-14%.

As the Fed gets ready yet again to “taper,” the U.S. dollar has entered another round of strengthening. Since the start of June 2021, the Dow Jones FXCM Dollar Index, which is designed to measure the broad performance of the U.S. dollar against four developed market currencies, has risen 4%. Emerging market equities have also come under pressure, but a few of the former “Fragile Five” have fared considerably better than last time, particularly India. Since June 2021, the S&P India BMI is up 10%, compared to a 14% decline in the S&P Turkey BMI.

International allocators may be wise to heed the Greek historian Thucydides and distinguish between those currency regions well-positioned to weather the storm, and those more at risk from a rise in the dollar: “The strong do what they can, and the weak suffer what they must.”

“Code red for humanity.” That’s how the imminent effects of climate change were described by the UN.¹ Human-induced global warming stands at 1.1°C above pre-industrial levels, and will likely reach more than 2.7°C by 2100.² If the world is to achieve the goals of the Paris Agreement and limit global warming to 1.5°C, decarbonization is the answer. The S&P PACT^TM Indices (S&P Paris-Aligned & Climate Transition Indices) aim to align with the Paris Agreement goals and be compatible with net-zero emissions by 2050.

Carbon pricing encourages companies to reduce greenhouse gas (GHG) emissions, accelerating the transition to a low-carbon economy. Growing carbon prices have been observed within the EU Emissions Trading Scheme, whose price has surged 126.58% in one year.³

To curb global warming to 1.5°C, carbon prices would likely need to increase dramatically over the upcoming decades, much more than if that target were pushed to above 2°C. However, the uncertainty surrounding that increase is huge. Naturally, this translates into potential financial risk, as companies would have to either absorb the additional cost of their carbon emissions or pass it on to consumers—the so-called carbon price premium.

Using S&P Global Trucost’s Carbon Earnings at Risk dataset, we test whether the eurozone S&P PACT Indices show more financial resilience to a growing carbon price, or rather, if we observe lower portfolio earnings at risk, relative to its benchmark. Trucost developed the following three carbon price pathways.

1. Low carbon price reflecting countries’ NDCs⁴
2. Medium carbon price assuming a 2°C goal, but with short-term action delayed
3. High carbon price aligned with the 2°C goal of the Paris Agreement

Sectors have different exposures to this transition risk, with Utilities and Materials being some of the most vulnerable to soaring carbon prices, given their operational nature.⁵

We examine the proportion of the eurozone S&P PACT Indices earnings at risk from potential rising carbon prices, as a percentage of earnings before interest, tax, depreciation, and amortization (EBITDA). Both the S&P Paris-Aligned (PA) Index and S&P Climate Transition (CT) Index carbon earnings at risk were lower than the underlying S&P Eurozone LargeMidCap under each scenario from 2020 to 2050.

If the world aligns with the Paris Agreement goals and adopts a high carbon price (shown by the dark purple bars and yellow lines), that implies both the PA and CT indices have 8.99% and 6.50% less portfolio earnings at risk by 2030 relative to their underlying index, respectively.⁶ When looking at 2050, that increases to 15.86% and 11.36%.

Trucost’s models suggest that the eurozone S&P PACT Indices are more financially robust on a forward-looking basis than their underlying market-cap-weighted index. The magnitude of their potential climate resiliency would be dependent on the specific climate trajectory the world ends up pursuing.

¹ UN Secretary-General António Guterres’ statement on the Intergovernmental Panel on Climate Change (IPCC) Working Group 1 report on the physical science basis of the sixth assessment, available here.

² Based on the Nationally Determined Contributions (NDCs)and pledges submitted as of 2020, the world is on track for 2.7°C of warming, according to the contribution from Working Group I on the IPCC AR6 Report: Climate Change 2021: The Physical Science Basis.

³ As of Sept. 30, 2021.

⁴ NDCs form the basis for countries to achieve the objectives of the Paris Agreement. They contain information on targets, policies, and measures for reducing national emissions and on adapting to climate change impacts (UNFCC, 2021).

⁵ Please note Trucost’s Carbon Earnings at Risk dataset only includes Scopes 1 and 2 of GHG emissions.

⁶ All data as of Sept. 1 2021.