A recent leaked report from US bank JP Morgan included the acknowledgement that, in a future of accelerating temperatures, “we cannot rule out catastrophic outcomes where human life as we know it is threatened”. The warning is stark, but not out of place in an industry increasingly mindful of the threat posed by climate change. Finance is not alone – across the world, unprecedented public concern and outcry over the climate emergency is beginning to be matched by ambitious policy ideas, foremost among them the Green New Deal.
The Green New Deal, as advocated by Labour leadership candidates and Bernie Sanders, has become defined by major public investment to rapidly and justly decarbonise the economy, from energy and heating to transport. However, underlying the project is a demand for a more fundamental reorganisation of the economy; indeed, rather than simply eliminating carbon from society, the Green New Deal envisions a new model altogether.
As such, its success will depend on transforming and repurposing the institutions that shape the global economy. Chief among these is asset management, a segment of the financial services industry which currently invests $74trn worldwide on behalf of asset owners, such as pension funds, endowments, and individuals. In particular, the Green New Deal will need to reckon with an increasingly dominant force in asset management: passive funds.
Eschewing the traditional “active” role of the fund manager, passive funds track market indices algorithmically, without needing individual mangers to select the contents of a portfolio. These indices are a hypothetical portfolio of holdings, often comprised of a list of stocks representing a segment of the market, such as the FTSE100, which contains the 100 largest companies listed on the London Stock Exchange. Investors of all sizes, from individuals to trillion-dollar pension funds, are increasingly pouring their assets into passive funds, drawn by their significantly lower fees as well as their offer, on average, of higher and more consistent returns.
BlackRock, the world’s largest asset manager with nearly $7trn in assets, is now encroaching on Legal & General as the largest UK manager, primarily through its substantial advantage in passive fund offerings. This trend holds globally, where index-tracking funds have surged in market share and now represent roughly half of all equity fund assets in the US, as well as 60 per cent of trading activity.
But the growing dominance of these funds has become a source of concern for many, including the mainstream financial press. A 2017 Harvard Law School report highlighted how the shift from active to passive strategies increases risks to financial stability by amplifying price swings and concentrating ownership, making the system “more vulnerable to idiosyncratic shocks”.
Just three passive management giants – BlackRock, Vanguard, and State Street, the so-called “Big Three” – control 80 per cent of the value of index funds in the US, and one of the Big Three is the largest single shareholder in 450 of the S&P 500 companies, owning between 3-7 per cent of shares on average. This trend is expected to continue, with analysis suggesting the Big Three could together control 40 per cent of all shares at major US companies by 2040.
But the rise of passive investment is concerning for another reason: the climate emergency – specifically, what the growing dominance of the passive fund might mean for our ability to break the world’s addiction to fossil fuels. The influence of the asset management industry over the global economy is immense. Large institutional investors dominate share ownership of publicly-listed companies and corporate bonds, among them fossil fuel majors, car manufacturers, electric utilities, and heavy industries such as cement and steel – critical sectors that must rapidly transition if we are to stay within 1.5 degrees of warming and avoid potentially catastrophic climate change.
For campaigners and investors hoping to pull money out of carbon-intensive industries, an important strategy has been to demand divestment from asset owners such as university endowments or pensions. However, index funds represent an obstacle to this strategy, as their portfolio contents aren’t under direct management discretion. Divestment has traditionally been used by investors to signal discontent to corporations, but the nature of index funds means passive investors effectively waive this right.
An alternative strategy favoured by the industry is “engagement”, whereby shareholders try to change the companies in which they’re invested, either through meeting and directly pressuring management, or through filing and voting on shareholder resolutions and other decisions at corporate annual general meetings. Here, too, passive investors fall short: passive managers tend strongly toward voting in line with corporate management on shareholder resolutions, including those related to climate change.
Most pressing, however, is the sheer extent to which index funds are invested in carbon-intensive industries, particularly fossil fuels, due to the companies’ widespread inclusion in mainstream indices. For companies owning fossil fuel reserves, meeting the world’s climate change targets will mean the vast majority of fossil fuel assets are left “stranded” – in other words, valueless. The sheer scale of fossil fuel reserves likely to be stranded – either through regulatory shifts, competition from renewable energy, or a price collapse – has led many to warn that global financial markets are carrying a vast “carbon bubble”, with company valuations falsely inflated based on assets that are, in effect, valueless. When the bubble bursts, it could wipe trillions in value from the global economy, and risk triggering a global financial crisis.
Passive funds both help create and bear the risk of this bubble. The mainstream indices used by most passive funds choose companies based on attributes such as market capitalisation, sector, or where they are based, taking no account of long-term concerns about a company or industry’s viability. Consequently, fossil fuel companies are a regular fixture, despite consistent underperformance and the looming risk of stranded assets.
By channeling funds to these companies, passive indices contribute to further capital expenditure on fossil fuel production and exploration, prolonging – alongside tremendous state subsidies – the lifespan of the industry. This consistent influx of cash, coupled with a lack of pressure to decarbonise from the companies’ largest shareholders, helps create a state of deep inertia within the fossil fuel industry and financial markets. The former is investing little in transitioning to low-carbon alternatives (barely two per cent of oil majors’ capital expenditure was spent on green energy in 2019), while finance firms continue to invest in companies that must transition or decline if the world is to meet its climate targets. The Big Three, for instance, hold hundreds of billions of dollars in fossil fuel investments through their funds.
This inertia is particularly marked among passive funds. One study comparing the thermal coal holdings of active and passive portfolios operated by the world’s largest managers found BlackRock’s passive portfolios to be substantially more “coal intensive”, meaning that – dollar for dollar – index funds held more coal than their active counterparts. While active managers begin to pull out of carbon-intensive industries – beginning with coal – in recognition of the collapsing financial case for holding such shares, passive funds are stuck. For instance, BlackRock’s recent announcement of a partial divestment of its assets from thermal coal producers applied solely to the company’s active portfolios.
Passive funds thus provide no clear route to mitigate risks from climate change, nor to reduce their contribution to it by cutting funds available to fossil fuel companies. Given that passive funds may also exacerbate risks to financial stability more broadly, their continued inflation of the carbon bubble could spell devastation.
What, then, to do? As major long-term asset owners such as pension funds continue to shift their assets into this low-cost strategy, the risks to financial stability, to our pensions, and crucially to the climate will continue to deepen.
Ambitious policy proposals to tackle the climate emergency tend to focus on investing in the new; the Green New Deal platform is no exception to this. However, any policy programme to combat climate and environmental breakdown must also examine the structures and systems driving and deepening the crisis in the first place, and which must be tackled in order to address the problem at its source.
Tackling passive investing’s relationship to fossil fuels will necessarily be part of this. Managing the carbon bubble will require a coordinated and proactive policy response such as debt transfers and government guarantees. However, rather than solely mitigating harms, states should explor how passive investing might be harnessed to serve the needs of society and drive decarbonisation.
As prominent US judge Leo Strine argues, passive funds’ reliance on relatively stable, market-spanning indexes somewhat counterintuitively makes index funds, at least in theory, “uniquely long term”, in contrast to the high turnover and return-seeking which characterises conventional active mutual funds. This, in combination with the long-term investment needs of pension funds and their human investors, means there is little reason for index funds not to invest with a view toward the long-term sustainability, not only of their returns, but of the broader economy itself. Enforcing this longer-term view, for instance through fiduciary duties, might mitigate serious harm.
Financial institutions shape the future through their investment and lending decisions. Unfortunately, that extraordinary power continues to drive us deeper into climate emergency – and with the continued rise of passive funds, we risk sleepwalking into disaster. A Green New Deal must therefore mean more than a step-change in public investment; rather, it must include a plan to transform the institutions that define our current economic model, so that the change it secures is both sustainable and deep.