Unpicking Cambridge’s new fossil fuel expansion index

- Hello, and welcome to the NetZero Investor podcast. I'm Atharva Deshmukh, the head of research at NetZero Investor. In today's episode, we're gonna focus on a story behind an index, specifically the University of Cambridge's new global corporate bond index, which the university says is the first global bond index to address fossil fuel expansion. This episode is aimed at unpacking the story behind its development, how it's structured, what it hopes to achieve, and the value it offers to asset owners. Joining me today are two members of the bond index research team at the University of Cambridge. Lily Thompson, project leader for the bond index research project and a senior research associate at Jesus College. Lily is also currently departmental fellow at Land Economy at the university. Our second guest, Dr. Ellen Quigley, is the academic lead for the project and the co-director of the finance for systemic chain center. Ellen is also a special advisor responsible investment to the university's CFO. Lily and Ellen, welcome to the podcast. Thank you so much for joining us. It is great to have you. So I thought to kick off a conversation today, we could get into the premise behind the index, which seems to be that for fossil fuel financing, debt matters more than equity. Could you maybe unpack that for our listeners? What does the evidence suggest and what are the implications for investors? - Well, I think we were as surprised as others some years ago learning that it's not even close. So some really great work by our collaborators, Teo Cogeano at all. Many years ago showed that around 90% of new capital flowing into fossil fuels actually comes from the debt side. So bank lending, bond issuance, that sort of thing. The rest is really IPOs, new equity issuance. And frankly, it's probably less than 10% now. It's really an overwhelming bond story when you look at that new capital flow. And that's important because that's where you're more likely to see impact or additionality. - And in your 2023 paper, Ellen, you called for a "fossil fuel phase out bond index." And what was your reasoning at the time behind recommending an index? I mean, how does an index combine what you refer to in the paper as the highest impact levels that investors might have access to? - Well, there are a number of other elements of the design that feed into why I proposed this particular project. But the index piece, and I'm really glad that you've kind of picked this part of it out. There are a couple of big reasons to look at that. So first, we are seeing still an increase in passive investment. And if anything, bonds are kind of catching up to equities in this regard. So it didn't feel like there was an opportunity to come in where we knew there was going to be growth in passive products. And yet there was almost nothing there for anyone who was concerned about climate change more generally, but actually especially phase out. So that seemed like a really important thing to attend to. But the other factor is that there are at least three studies on the public equity side, where there's some evidence suggesting that the threat of exclusion from an index can get the companies to actually exceed to the requirements of that index. So we hypothesize that that would actually be stronger on the debt side because you can actually end up with effects on cost of capital, volume of capital raised. I mean, there are more consequences on the bond side, hypothetically, if you can get this sort of thing to become popularized in the minds of investors. - And to the index itself now, it is, as I said, it's focused on the fossil fuel industry, but when I went through its scope, it also includes interestingly, utilities, insurance, and financial sector companies as well. Could you tell us more about the scope of the index? - So the project really started with the academic research that Ellen described, and we then went through a feasibility study and a request for proposals process and ended up working with Bloomberg. And so the parent index for the project is the Bloomberg IG corporate global, which means actually that the scope of the index as a whole is really the whole standard investable universe for investment grade corporate bonds. We're also expecting to do some cuts, probably by currency and duration as well. And we divide that into two parts, what we call the key sectors. The sectors that you just mentioned, so fossil fuels, electric utilities, insurance, and banks, and then everything else. All of the data that we're using for the key sectors here are entirely new to the index world. And really that's because what we're doing there is focusing on corporate behavior instead of on business classifications. So we're particularly interested in behavior that's most concerning from a systemic climate risk perspective, really namely fossil fuel expansionism and failure to face down in a parasolined way. So that's why we've chosen to focus on those four key sectors. - And actually, could I come in very briefly on utilities because there is a reason to be a bit obsessed there for climate change. And that is just that I don't think people recognize the degree to which utilities are still, that it's the top emitting sector globally and it's not close either. And yet we still see literally hundreds of new gas-fired power plants going up in wealthy countries alone right now. So this is an enormous source of potential fossil fuel lock-in, as in these plants are going to run for decades. When we looked at the frameworks available, we could see that in general there was no accounting for new fossil fuel infrastructure in the utilities sector. So you can't even tell using many of the data sources and frameworks available, which companies are building new power plants that lock in those decades worth of emissions. So that's part of what we're trying to do with all of this is to highlight kind of collective demand side of climate change because consumer behavior is a very poor lever, but collective demand in the form of large power plants, that sort of thing. That's a really important lever. And that's a sector that's more readily decarbonizable than many others. So there's really no reason it should still be such a source of fossil fuel expansion. And one of the interesting things about the index, I thought, was something you referred to earlier, Ellen, which is its approach to exclusions. Now, fossil fuel exclusions policies have been around in the institutional investor circles for some time, most notably in, let's say, public equity. So investors will not invest in certain companies. Let's see on a revenue threshold or so on. What, according to you, is the drawback of those approaches and how is the approach you recommend different in the index? If you exclude a company based on their business classification on revenue exposure, like the examples that you've mentioned, they've got low to no incentive to change their corporate practice. They'll always be classified as a fossil fuel company. They'll therefore always be excluded. Why would they change? But the science doesn't call for fossil fuel production and infrastructure companies to cease existing right now. It says they cannot continue to expand and they need to face down in alignment with Paris. And right now, there isn't an index that does this, and that's really what we're building. By admitting companies based on their actual behavior, what we hope to do is to create a meaningful carrot and stick for investors to realize their climate ambitions, to protect long-term portfolio value for savers and for citizens alike. And your framework also leaves the door open for the opposite of exclusion, which is re-inclusion, after a company might be excluded. I thought that was really interesting. I mean, why in your view is that important and how common is this for an index? - To our knowledge, we don't have any examples of re-inclusion like this. Although there are individual funds that re-admit companies. For example, the Norwegian sovereign wealth fund just re-admitted a company that no longer is excluded on the basis of their ethical criteria. We don't know of an index that does that, and especially in fixed income. So that's quite exciting. There's a social discourse element in all of this. So we don't want to have these kind of harsh binary exclusions when there is a need for at least some of these companies to either wind down their operations in an orderly way or to transition into something else. But I suppose the other thing to note here is that it's actually really expensive in some cases to put in the upfront investment required to transition. There are some studies suggesting that the default is that a company, as it goes into financial distress, for example, they're not able to raise the capital necessary to do the things that would allow for decarbonization. So if you have that structure in place, you shouldn't be surprised when companies don't decarbonize even when it would make sense hypothetically because their cost of capital will make that more difficult than it would need to be. So this is part of the reasoning. If they're serious, they're not engaging in fossil fuel expansion, they're phasing down, at an appropriate rate, then actually, an influx of new capital can facilitate that transition. However, I will just say this, many of the indicators that people tend to use for transition plans, I don't think, are credible. They often still allow for fossil fuel expansion. Again, the atmosphere does not care about how many solar panels you have. It just cares about how much CO2 equivalent you're putting into the atmosphere. So it's really the fossil fuel expansion piece that needs to be attended to. But if it is, and a company is serious about transition, then that's where you want to actually facilitate it. - And I suppose just to add to that as well, it'll be all well and good having a wonderful, very thought through academic set of rules and a framework against which an index was constructed. But obviously this project doesn't work without both the investor backing that we currently already have and that we're building as we head towards launch later this year, or without a really clear signal to the market about what those expectations are. So the other kind of key components of this approach is a new form of bondholder engagement. We've been developing very closely with a group of global academics. They include IPCC authors, a Spinoza prize winner, really phenomenal group of people with deep expertise in those key sectors. So the fossil fuel production and infrastructure, banking and insurance side. And their role is really to identify and to scrutinize edge case issuers. So these are companies that kind of close to coming into alignment with the index methodology or close to falling out of alignment. And based on the evidence that Ellen's just outlined, we believe that's a really rare and powerful opportunity for quite muscular bondholder engagement. So I guess the big difference being that it's based on a set of clear and public rules. And the role of investors then is simply to communicate the index methodology to issuers and to identify where they currently or may in the future fall short. We hope that that means there's an opportunity for a much more positive and productive form of engagement there. And certainly we tend to research whether that new index level and more rules-based engagement approach might influence the cost of and access to capital as well. - Right, and just on the point of re-inclusion. I mean, as you said, just on the point of indicators and so on, if you'd be looking at credible changes in corporate behavior to re-include a company in the index, so what counts as good behavior and what does that threshold depend on? - It's all about fossil fuel expansion and phase down. And this is because that's where the vast majority of emissions come from. And I think we forget this sometimes. I mean, the Paris Agreement did not mention fossil fuels by name. So that's actually part of what we're trying to do here as well is to just highlight that as the number one criterion that you need to attend to to assess whether a company is serious. If you wanted to add another one, and we don't have enough data for this yet, but lobbying activity is my other top priority in terms of assessing whether a company is actually serious about their transition. Are they engaging in anticlimat lobbying or not? Is a very, very important indicator. - And just on the point of data, I thought one of the most interesting things about the index itself was that the data sources, the index users are part of its innovative features. So what new data sources does the index draw? Could you tell us more about that? - For sure. And yeah, as I say that they're entirely new, which has led to this project taking longer than we would have liked, but a lot of really worthwhile conversations to get those sources kind of piped into the index system. So we were talking about the key sectors as four key sectors, fossil fuel production, infrastructure, banking and insurance. The first two we grouped together, and there we're working with the German NGO and data provider called Ergewald. They produce the global coal exit list and the global oil and gas exit list. They're really phenomenal, incredibly detailed bottom up data sets where they're identifying where the companies have ceased expanding their production and all their infrastructure development and whether they're facing down in alignment with Paris. And our banking data actually also makes use of Ergewald in that we're interested in bank financing, specifically a fossil fuel expansionist that are failing to phase out. So when mapping some data from Bloomberg New Energy Finance, which looks at the bank financing as a whole against that Ergewald data to identify the absolute total financing of non-aligned fossil fuel companies per bank. And then the insurance side was something I've been kind of scratching my head about for going on three years. We as a team are incredibly keen to ensure, as I think you've already heard, that we're looking at actual corporate behavior as opposed to policy level data and the like, but of course within the insurance world there isn't currently data on actual bilateral underwriting agreements. So here we're building on a methodology developed by Reclaim Finance and we've accepted that currently there's only policy level data and I'm really pleased actually that Bloomberg has then created a data set building on the Reclaim Finance framework, looking at insurer policies on underwriting activity that's available on the Bloomberg terminal independently of the index. And for us it's great that investors can now identify insurance companies that have policies that mean that they're continuing to underwrite projects that we know and have known for many years are out of alignment with the goals of the Paris Agreement. So we're really pleased to see that data set come to life as well. - And turning now to the third piece of the story which is the value proposition to Acid owners. I understand that Acid owners themselves have been involved in the development of the index. Is that right? And what role did that collaboration play in the index development? - Thanks for that question. I'm gonna let Lily answer most of it but I just wanna say that Acid owners are an absolutely critical set of actors in this space. They have a very different set of incentives. They have very different purpose. There's plenty of academic evidence suggesting that they don't have the conflicts of interest that for example shows up in the voting policies of their asset managers. They're a very important player because they are so long-term. Their purpose is to pay out pensions often, many decades from now. They are the ideal partners for academics like us. And because we're so careful about conflicts of interest, that's another advantage to working with them. These are people who tend to share our values and purpose in this work. - And for the bonded index project specifically, we've been working with quite a range of leading Acid owners really all around the world. And they've supported us with everything from very big picture kind of strategic questions of how do we ensure that an index like this has the potential to test the very significant sort of assumptions and propositions that we've been talking about. Right down to kind of digging through really technical questions. We had a chat the other week with an Acid owner about a small spike of turnover in 2021 historical data. What was causing it? What are the counterfactuals? Might tell us something useful about future turnover issues. So we really get into the weeds with them as well, which we hope means that we're able to build an index that of course then meets their needs as well. These are Acid owners who manage against indices day in, day out, or who appoint managers that they expect to be able to manage against this index. So they're really great at getting into some of those kind of very technical specific questions that of course we as a team of researchers and academics are a less well placed to be answering. And I suppose maybe it's useful to name names. We work with quite a long list. And as I say, it's across a big range of countries as well. One of our closest and most longstanding collaborations is with the United Nations Joint Staff Pension Fund. And their involvement with the project has been absolutely critical to getting us to where we are today, as well as their commitment to invest against the index, which of course is really significant at this very early stage before we even have a kind of full prototype. So their trust in the project has been really amazing. We've also worked really closely with the California State Teachers Retirement System, CalSTRS, University Superannuation Scheme in the UK, the USS, and the Swiss Federal Pension Fund Publica, amongst of course many others. And it's their input and technical market expertise that really underpins the index. We're hugely grateful to them for that. Speaking of Acid owners, the university itself has said that it will use the index at launch. So what are the university's emissions reduction targets? And how does this index align with them? So the university as a whole and the central endowment both have decarbonization goals. For the endowment, it's 2038 for net zero. For the university as a whole, it's an ambition for 2038, scopes 1 and 2, but 2048 is kind of the hard deadline. I will just say this. So I'm not a fan of portfolio decarbonization honestly. I think it produces on paper results that don't actually translate into real world decarbonization. That said, it makes a little bit more sense for an investor in using the endowment model. So Cambridge uses the endowment model. This is mostly for very large endowments, largely in the US. But Cambridge and Oxford both use it as well. And that means that they've got quite a bit more allocated to private markets and other asset classes in which there is some additionality. So it actually does make more sense with the endowment model than it usually does. However, that endowment model means that what we're talking about for the allocation from the university is out of their liquid fund. That's where they have corporate bonds. I'll also just say this. The university has dozens of pots of money, including at all of the colleges, the trusts, and so on and so forth. So we've been working with a number of those entities for many years to develop this philosophy and approach. And in particular, the bursars at the colleges have been incredibly supportive of this kind of work for many years now. But I will just say that this is something that would make sense actually, even for those who do have a decarbonization goal for their portfolio, even though, again, I'm not a fan of that as an approach. More generally, it does tend to be applied almost entirely to the public equity portion of an investor's portfolio. And that is where you don't really see additionality or impact. And that's something we've seen quite a lot with the pension funds and sovereign wealth funds and the like that we've been talking to. So often, we're talking to an organization that has done quite a lot of work on the public equity side. And they've come onto the corporate bond side and just ground to a hold. Because really, the options, if you want to create real world impact-- and particularly, if you want to manage systemic risk and an alternative portfolio value-- are to build something very costly on your own, on a custom basis, with a fund manager or with an index provider, or to stick in the standard kind of broad-based, very vanilla index that you have been in for the last 50 years. So it's been great to see that kind of question come up of what else could there be, what could be created, and to work with us as owners with that curiosity. To, I think, conclude our conversation today, I thought it might be interesting to end with a summary that might be most relevant to our listeners, which is the value proposition to asset owners. So for each of you, if you were in conversation with, let's say, the CIO of a large global asset owner, and you were to list just one feature of the index that you think will draw in their interest, what would that be? Can I give a couple? Sure. Yeah, sure. So first of all, I would hope that this CIO have a background in fixed income, because then they would understand that what matters most on the fixed income side is downside risk. You just want to get your money back. There really isn't the upside that you can get in public equity. So it's really about risk. And if it's about risk, you should be quite interested in the fact that there's nothing out there that can help identify for you. The companies that are building new fossil fuel infrastructure, in particular, that is a significant source of stranded asset risk, and it doesn't show up in any of the metrics or indicators available otherwise. So that's pretty important. But the other thing is that you can much more easily replace the exposures that you have on the bond side while keeping the same profile overall of your investment. So you're much less likely to deviate from the benchmark more generally, but you can be much more likely to have an impact, but also to avoid stranded asset risk without cost to the portfolio. And I suppose I'd round it off by speaking to the investment side of things. So we've developed this project, as we've discussed, with a group of large global investors who want better for this market and who are looking for alternatives. That means that the index design is very carefully structured to maintain tight tracking error to the parent benchmark and to ensure that the short-term risk and return profile is close to the parent, also while protecting the long-term interests of investors. So what we've really aimed to do there is to ensure that we build an index that is as close to the standard parent as possible whilst addressing the whole host of systemic climate risk challenges that we have spoken about today. Great. I think that's a great note to draw this episode to a close with. Thank you for joining us. To our listeners, we hope you enjoyed this episode as much as we've enjoyed putting it together. If you have any questions, feel free to write to us. But Lily and Ellen, thank you so much for joining us and sharing your perspectives on what is a very, very interesting project and an index. So yeah, looking forward to maybe the next episode. But yeah, thank you for joining us. Thank you. Fantastic questions. And it's great that you really get what we're trying to do.