Green indexes and climate-change indexes: reliable ways to grow your investments and help the global climate?

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Green indexes and climate-change indexes: reliable ways to grow your investments and help the global climate?

Impact investors who seek dependable returns from environmental stocks frequently turn to climate-change indexes, green indexes, and other indexes of green equities. But whose interests do those indexes truly serve? What is their fundamental purpose? And how can individual investors use such indexes wisely, and for the mutual good of their portfolios and a cooler planet?

Equity indexes: a quick refresher

To begin, let’s take a step back and consider exactly what stock indexes are, and what they are designed to accomplish.

Stock indexes are crucial instruments for many investors. They establish criteria for defining market segments, facilitate portfolio construction, and perhaps most importantly allow easy and sustained comparison among companies with easily identified similarities. For example, the most important broad index of US stocks, the S&P 500, considers market capitalization, float, and longevity when deciding whether to include a stock. Other indexes take similar approaches to identifying stocks that operate in specific sectors.

Many exchange-traded funds, or ETFs, rely on indexes both to guide their investment strategies and to make those strategies clear to investors. An ETF that follows the S&P 500, for example, makes its proposition immediately clear to investors while freeing itself of the overhead required of an actively managed fund. More narrowly focused ETFs can use more tightly defined indexes for the same purpose: investors wishing to add renewable energy stocks to their portfolio can easily find ETFs devoted to the renewable energy sector, many of which are informed by renewable energy indexes.

Indexes defined by market cap or sector are relatively stable and easy to understand. But what about criteria like environmental responsibility that are less readily measured? Green indexes and climate-change indexes attempt to answer that question. Not all of them do so compellingly. Let’s take a closer look at green indexes, why they matter, and what you should look for.

The rise of climate-change- and green indexes

Unlike broader stock indexes or those devoted to individual sectors, most climate-related indexes largely serve the interests of institutional investors. This may change as the green economy continues to grow. For now, such indexes tend to focus on two factors, each of them a prominent feature of a different kind of environmental stock index.

  1. Climate indexesClimate indexes tend to emphasize risk management, featuring companies with proven climate-resilience strategies or whose products and services directly address the challenges of a changing climate. They can take several forms, including the following:
    • Carbon-transition indexes seek stable returns based on companies’ ability to anticipate and adapt to new regulatory demands.
    • Low-carbon indexes identify companies whose business practices lead to less carbon emissions than others.
    • Paris-aligned indexes use the Paris Climate Accords as a guide to identifying companies who have oriented their business practice to align with an emissions path that is compatible with global warming not exceeding 1.5 or 2.0 degree Celsius.
    The table below describes examples of these three types of climate index.It is noticeable that, broadly speaking, climate indexes favor those companies that are emitting less GHG emissions than others. The result is that the big tech companies like Apple, Microsoft and Alphabet hold large positions in a lot of indexes, as emissions per USD revenue are low relative to most other companies. But for those wanting to invest in climate pure players, products based on climate indexes are clearly not the best choice.
  2. Green indexesGreen indexes, in contrast, emphasize growth, and feature companies that have explicitly poised themselves to serve the evolving economic needs of a changing planet. Green indexes have a wider appeal than climate indexes, and are far more numerous. They are often themed: some green indexes focus on water security, others on energy generation or emissions control, and so on.
    Companies included in green indexes are far more diverse than in climate-change indexes. They sometimes include climate pure players that make 100% of their revenue from providing solutions for a cooler planet (e.g. such as Tesla or Plug Power), but the majority does not. The NASDAQ OMX Green Economy Total Return index, for example, includes as its second- and third-largest positions IT company Cisco Systems and Danaher, a conglomerate with only some investment in environmental solutions.

How environmentally impactful are green- and climate-change indexes?

As mentioned earlier, the criteria for inclusion in a green or climate-change index are more subjective than those that define membership in more traditional equity indexes. With fewer objective standards for including or rejecting a company, environmental indexes deserve a close look from individual investors seeking to support meaningful climate action.

By focusing on risk management, climate-change indexes tend to feature companies whose environmental practices distinguish them from others in their class. This is often a purely relative measure: the best of a bad bunch may still not be doing enough to reduce its net carbon emissions. The relative nature of most climate-change indexes can dim their appeal to individual investors motivated by environmental concerns, and can limit their viability as tools for long-term risk management.

If greenwashing—the spurious labelling of a product, service, or company as environmentally friendly—is notable among climate-change indexes, it is downright problematic among green indexes. Many “green” indexes pad their numbers somewhat by including companies whose green credentials are questionable. Investors should view investments in any product based on any green index with a healthy dose of skepticism.

Used prudently, green indexes can offer a useful starting point for climate impact investing. Their real value to individual investors, though, may lie in their identification of a focused number of companies, each of which still requires additional research on their real contribution to curbing climate change.

Tools, not panaceas

The first step toward effective use of environmentally oriented equity indexes is to acknowledge that they are designed primarily for institutional investors, and largely serve the interests of risk management and long-term growth. This places some extra—and often unforeseen—demands on individual investors interested in supporting pure climate players.

Those of us who wish to invest in companies who are truly devoted to making positive climate impacts must dig deeper than environmental stock indexes currently allow. I founded Pure Climate Stocks after doing that hard work myself, and developing a methodology that allows me to reliably distinguish pure climate players from pretenders. If you’re ready to invest with real impact, but don’t have all the time in the world to research thousands of companies yourself, I invite you to learn more about it in my quick start guide with 4 tips for starting climate impact that are practical and easy to implement.

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