Felix Goltz (Scientific Beta): "Integrating climate risk considerations into portfolios is a key concern of institutional investors around the world"

• This interview has been initially edited and published by EDHEC-Risk Climate Impact Institute : https://climateimpact.edhec.edu/climate-risk-integration-global-investor-concern

Scientific Beta has more than ten years of experience in the integration of Environmental, Social, and Governance considerations into indexing. How did this start and how have your integration principles and approaches evolved over the years?

Since its launch in 2012, Scientific Beta has put ESG investing at the centre of its index solutions. Our early ESG research assessed ESG portfolio construction methodologies and evaluated the relevance of different types of ESG data. These research efforts have had a strong impact on Scientific Beta’s index offering. From the start, we provided client-specific ESG exclusions. As early as 2015, we provided carbon intensity reduction for all Scientific Beta indices. In 2019, we extended options available to investors for ESG and Low Carbon filters. And in 2021, we launched a climate index series.

Scientific Beta has been supporting investment research at EDHEC Business School since 2019. What is the place of academic research in your strategy and why does it make sense for a financial institution that produces its own scientific research to associate with an academic research centre?

Scientific Beta was set up by EDHEC-Risk Institute, which was part of EDHEC Business School, in order to transfer know-how to the industry. Academic research has always been at the heart of Scientific Beta’s investment approach. Scientific Beta’s academic origin provided the foundation for its strategy: to offer smart beta solutions that are proven scientifically with full transparency of both the methods and the associated risks.

When Singapore Exchange (SGX) acquired a majority stake in Scientific Beta in 2020, it wanted to maintain the strong collaboration with EDHEC, and the principles of independent, empirical academic research. We gain from cooperation with academic researchers from EDHEC because it allows us to complement and challenge our own research results and to remain at the cutting edge of developments in academia.

Over the years, the thematic focus of your support has shifted from factor investing to ESG investing to Climate investing, how do you determine focus areas and how do you decide when it is time to move on?

Our constant focus is on offering evidence-based solutions that provide answers to investment problems faced by pension funds and other long-term investors. Rather than shifting between different product categories, we try to develop reliable methodologies that allow investors to achieve their objectives. For example, when addressing ESG and climate objectives, investors still need to address traditional risk and return objectives.

Our index strategies aim to reconcile financial performance and non-financial objectives. For example, for our Low Carbon option, the objective is to preserve the factor and diversification characteristics of our multi-factor indices, while reducing both their carbon footprint and their climate transition risks. Our ESG and Low Carbon filters can be integrated into smart beta or cap-weighted offerings in line with the financial objectives targeted by the investor. Recent research will allow us to complement these tools with additional ESG metrics that are forward-looking but – unlike commercial ratings – remain tractable and transparent.

What insights have you gained from the work to date and how has it impacted your product offering, if at all?

Our research has documented severe shortcomings with standard investment approaches used in ESG and climate indices that are popular among investors.

First, in line with a growing body of academic literature, we have documented that ESG information per se is not necessarily a source of outperformance. This implies that ESG investing products, which only account for ESG information and do not consider financial performance in portfolio design, are unlikely to meet investors’ financial objectives in the long term.

Second, we have documented that there are important trade-offs between different ESG objectives. For example, climate scores of companies are almost unrelated to scores on other environmental dimensions, such as waste management or water resources. This implies that investors need to choose their priorities carefully. These research insights heavily influence our product design, i.e we offer factor indices that reconcile ESG and financial objectives.

We also offer climate indices, which set a clear priority on firm’s climate performance and avoid diluting this objective with an overemphasis on unrelated ESG objectives.

Scientific Beta and EDHEC-Risk Climate Impact Institute have announced the establishment of a research chair on “Upgrading Climate Scenarios for Investment Management", why is this a key topic of interest to you and what do you expect from this cooperation?

Scientific Beta is supporting EDHEC-Risk Climate Impact Institute in its effort to bring climate-risk modelling tools to the next level. Integrating climate risk considerations into portfolios is a key concern of institutional investors around the world. We hope to be able to pass on the fruits of this research to our clients in the future by allowing them to integrate new measures of climate risk into their index.

Scientific Beta has been at the forefront of developing tools for climate-conscious investing, exemplified by the Climate Impact Consistent (CIC) Indices, what is unique about these indices and to what extent are these indices aligned with the recommendations or expectations of net-zero investing coalitions?

The Climate Impact Consistent Indices (CICI) allow investors to implement the Net-Zero investment coalitions’ recommendations for portfolio construction. In particular, the Paris Aligned Investment Initiative (PAII) Framework states that one of the key elements of stewardship is to develop an engagement strategy with a feedback loop to portfolio construction. The CIC indices provide a tool to implement this approach where engagement and portfolio construction are mutually reinforcing. The portfolio construction methodology makes sure that weights of stocks in the portfolio are consistent with engagement on climate issues. As we like to say, the CIC indices allow investors to “put their money where their mouth is.”

Does the establishment of the research chair signal a pivot towards climate integration for risk management’s sake? Do you see a tension between climate objectives and financial objectives?

Risk management is at the core of Scientific Beta’s investment philosophy. The ESG and Low Carbon options within our multi-factor indices allow investors to benefit from the exposure to rewarded factors and from diversification of unrewarded risks, and at the same time, achieve an ESG or Low Carbon objective. It is unrealistic to assume that there will be no conflicts whatsoever between climate objectives and financial objectives in investors’ portfolios. Our goal is to be able to identify the trade-offs that investors face and to allow them to position their portfolios efficiently in line with those trade-offs.

The asset management industry rightly comes up with new products that address climate objectives. However, it would be dangerous for investors to rely on information on climate and ESG issues alone and to ignore all other information. The challenge we are addressing with our research and products is to fulfil climate and ESG objectives while maintaining attractive risk-adjusted performance.

In your opinion, what are the key challenges and opportunities facing institutional investors in respect of climate change integration; and how are you positioning to assist your clients in these respects?

A key challenge for institutional investors will be to integrate climate transition risk into their portfolios. Carbon emissions data currently suffers from severe limitations. This data is backward-looking and does not account for decisions of companies to reduce future emissions. Also, two companies with the same level of emissions intensity might face very different levels of transition risk, for example when facing different challenges to introduce cleaner production methods.

We are currently working on a new measure of transition risk that extracts information from market prices via a climate-transition risk (CTR) factor, which captures variations of returns due to transition risks. Such a metric is forward-looking because it integrates the market’s assessment of how companies are affected by the transition. It avoids using the discretion and error-prone data collection that plagues commercially available ratings of climate transition risk. We thus hope to provide clients with indices that integrate climate considerations in a tractable and transparent way.