Best-in-Class, Tilting and Climate Benchmarks: ESG Leaders, SRI, Paris-Aligned and Climate Transition Rules

What you will learn

• How best-in-class selection (ESG Leaders, SRI) keeps a fixed share of each sector.
• What ESG tilting does differently from selection.
• The minimum rules of EU Climate Transition Benchmarks (CTB) and Paris-Aligned Benchmarks (PAB).
• How to calculate weighted average carbon intensity and a 7% yearly decarbonisation path.

Explanation

Lesson 3 removed companies. This lesson covers methods that select or re-weight them, and the EU's two regulated climate index types. Market-cap weighting itself is covered in the course "ETFs, Funds & Long-Term Investing".

Best-in-class selection

A best-in-class index keeps the highest-rated companies in each sector until a target share of the sector's market capitalisation is reached, so the sector mix stays close to the parent: a best-in-class world index still contains energy and materials, just the better-rated names. MSCI publishes two families (rules per methodology documents from around 2021–2022; check the current version):

The 25% target makes SRI indices far more concentrated than their parents; buffer rules for existing members reduce turnover.

Tilting

A tilted index keeps (almost) all companies but changes their weights: higher-rated or lower-carbon companies are over-weighted, others under-weighted, usually with a cap on how far any weight can move. Tilting gives lower tracking error than selection but a smaller ESG improvement; many "ESG Enhanced" indices work this way.

EU Climate Transition and Paris-Aligned Benchmarks

The EU Benchmark Regulation created two protected labels, detailed in Delegated Regulation (EU) 2020/1818. An index may only call itself "EU CTB" or "EU PAB" if it meets minimum standards:

• Carbon intensity reduction versus the investable universe: at least 30% for a CTB and 50% for a PAB, measured on Scope 1, 2 and (phased in) Scope 3 greenhouse-gas emissions.
• Self-decarbonisation: the index's carbon intensity must fall by at least 7% per year on average.
• No escape into low-carbon sectors: the index must keep at least the same exposure to high-climate-impact sectors as its universe.
• Exclusions: both exclude controversial weapons, tobacco and UNGC/OECD violators. A PAB additionally excludes revenue of 1% or more from hard coal or lignite, 10% or more from oil fuels, 50% or more from gaseous fuels, and 50% or more from electricity above 100 g CO2e/kWh.

Hence a CTB can hold oil and gas producers while a PAB largely cannot. Intensity is measured as a weighted average carbon intensity: WACI = Σ (weight × emissions per € million of revenue or enterprise value, depending on the methodology).

Worked example

Hypothetical example: an invented investable universe with six sector blocks. Carbon intensity is given in tonnes CO2e per € million revenue.

Step 1 – universe WACI = 60 + 40 + 30 + 9 + 4 + 24 = 167 t CO2e per € million.

Step 2 – maximum starting intensity: CTB = 167 × 0.70 = 116.9; PAB = 167 × 0.50 = 83.5.

Step 3 – trajectory for the PAB: 7% per year compound. After five years: 83.5 × 0.93⁵ = 83.5 × 0.6957 = 58.1. After ten years: 83.5 × 0.93¹⁰ = 83.5 × 0.4840 = 40.4.

Step 4 – the sector rule: the index may not drop Energy and Utilities to zero; it must keep the universe's exposure to high-impact sectors and instead pick lower-intensity names within them.

Assumptions: Scope 3 ignored, no data gaps, no enterprise-value adjustment; administrators publish the exact formula.

Common mistake

Practice activity

On paper: a universe has WACI 240 t CO2e per € million. (a) What is the maximum starting WACI for a CTB and for a PAB? (b) What must the PAB's WACI be after three years of the required trajectory? (c) A sector in the parent index has five companies with weights 30%, 25%, 20%, 15% and 10% and ratings AAA, BB, A, B and AA. For an ESG Leaders-style selection (50% coverage target, pick by rating from the top), which companies are selected?

Key takeaways

• Best-in-class keeps the top-rated part of each sector (Leaders about 50%, SRI about 25%); tilting re-weights instead of removing.
• CTB: at least 30% lower intensity; PAB: at least 50% lower; both must decarbonise 7% a year and keep high-impact sector exposure.
• Only the PAB carries strict fossil-fuel revenue exclusions (1% coal, 10% oil, 50% gas, 50% high-carbon power).
• WACI = Σ weight × intensity; a 7% path means roughly 30% lower after five years and 52% lower after ten.

Next step

Next you will learn what the EU's SFDR Article 6, 8 and 9 labels do and do not mean, how principal adverse impact indicators are calculated and which words a fund may carry in its name.