The Pensions and Lifetime Savings Association (PLSA) has recommended the use of climate indexes in managing investment risks as part of institutional investors’ portfolio construction.

The organisation’s new Climate Indexes guide explained that investors needed to use all the tools at their disposal as climate-related risks will pose a threat to portfolios’ long-term resilience, with fixed income and equity indexes being particularly important.

Laying out the steps for using indexes to integrate climate factors in benchmarks, the PLSA said the starting point should be to define climate objectives in terms of financial risk, norms and values, and opportunities.

Following this, it recommended that investment institutions move on to choosing standard or custom benchmarks for climate integration, before selecting a climate index construction approach.

The organisation said the applications for these indexes included guiding asset allocation decisions at the policy level, gauging performance of active investment strategies and engaging with other companies in a scalable and transparent manner.

“By using indexes whose methodologies are transparent, investors may convey the message to companies that by following the rules they may become eligible to an index and as a result become eligible to their investments. This practice is often done in combination with a more direct engagement through proxy voting or dialogue with companies,” explained the PLSA.

The guide also noted climate indexes could be used by passive investors to integrate climate objectives in their portfolios by replacing traditional market cap indexes, which the guide said could be appropriate for externally managed asset owners with index-replicating strategies.

Active investors were judged to be more likely to use the indexes as a benchmark for their investment strategies.

The PLSA also pointed out that there are distinct differences between different climate indexes, with low carbon indexes focusing mainly on risk mitigation, while climate transition and Paris Agreement aligned indexes seek to identify opportunities and target different levels of carbon footprint reduction.

The PLSA concluded: “The world is evolving rapidly due to dramatic and significant shifts in climate change as well as social, institutional governance and technological innovation. The convergence of these factors may lead to a large-scale reallocation of capital over the decades to come.

“Investors who continue to ignore these factors could find themselves unprepared for the possible resulting changes.”

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