4. Minimizing the active share as an objective function allows the index to achieve its objectives in the most effective way; and the CAP approach includes many climate change objectives, many of which are not immediately linked. Therefore, optimization can be used to determine the selection of index components and weights that effectively achieve these multiple objectives. Chart 1 describes the entries into the euro area`s Paris-Aligned Climate Index Concept (PAC Concept) to achieve climate targets. This document explains how climate goals can be achieved through optimization, while maintaining a performance similar to that of the underlying index in the event of a small tracking error. The result is a broad, diversified index that should work in the same way as the underlying index. Factor analysis shows that there is an inexplicable alpha that can be powered by the climate strategy of the CAP concept. MSCI has expanded its range of climate indices to satisfy investors who want to reduce their exposure to climate risks and meet the 1.5-degree promise of the Paris Agreement on Global Warming. The future intensity of TThG emissions from the underlying benchmark index is unknown. However, we are convinced that an absolute reduction in greenhouse gas emissions is necessary to limit global warming to 1.5 degrees Celsius from pre-industrial levels. Therefore, the 7% decarbonisation target required by the EU CTB and PAB labels compared to the previous year means that the future decarbonisation required is unknown in relation to the underlying repository, as we do not know how fast the repository would be decarbonised (if so). If the underlying benchmark is decarbonized at a rate of less than 7% compared to the previous year, implied decarbonization will increase exponentially relative to the underlying index (lower control table).
Using optimization to minimize the active share helps to reduce the possibility of a high tracking error between the index and its underlying benchmark and can be particularly useful if the overall market does not decarbonize sufficiently over time. In addition, strategies for a certain level of active tracking or sharing errors may determine that their methodology does not solve a solution when the necessary decarbonization increases. Companies in carbon-intensive sectors are increasingly facing challenges due to declining demand for fossil fuels or their carbon-intensive products. Extreme weather events are affecting the assets and activities of businesses in high-risk (and growing) areas. In addition, regulators and civil society are pushing investors to act. In 2017, the Climate Financial Information Task Force (TCFD) issued its recommendations to businesses and investors and stressed the need for climate scenarios. In July 2020, the European Commission proposed regulations2 setting minimum standards, indices must be compliant to be labelled as transitional ue-climate benchmarks (NTCs) and EU benchmarks (PPAs). This means that EDF weighs 225% more in the CAP concept than in the underlying index, while RWE has no weight in the pac without being excluded on the basis of one of the Schedule 20 criteria. Companies with strong environmental policies are probably in a better position to be compatible with a 1.5oC scenario. That`s why we`re making sure that the index has improved environmental policy in relation to the DJI Environmental Score. This score provides an overview of key financial aspects of a company`s climate strategy, environmental policy and management systems, electricity generation, risks and opportunities for environmental companies, low-carbon strategy, recycling strategy, co-transformation and more.
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