An inconvenient truth: How passive investing is blocking climate progress

In recent months, leading asset managers like BlackRock and Amundi have multiplied efforts to boost their climate credentials.

From the use of ESG filters to the adoption of fossil fuel exclusion policies and the development of shareholder engagement practices, some have even committed to achieve carbon neutrality. But there is an elephant in the room, an inconvenient truth no one wants to address: what is hidden inside their passive index funds.

Passive’ investing, also referred to as index investing, involves the manager investing in the companies that form an index, such as the S&P 500. Launched initially by US asset managers, the trend rapidly took hold as it makes investing cheaper. But the lower investment fees are paid for in climate damage. 

The International Energy Agency has made crystal clear that achieving carbon neutrality by 2050 requires, notably, that no new fossil fuel production projects are developed. Yet today, the most-used indexes, employed as benchmarks for a large number of funds, are full of companies developing new fossil fuel projects. Herein lies the problem: while more and more asset managers are adopting exclusion policies, especially on coal, these policies are not applied to ‘passive’ index funds.

Reclaim Finance’s recent report on top European and US asset managers shows that less than 25% of all assets under management (AUM) are covered by coal exclusion policies, mainly because of ‘passive’ funds. Legal & General Investment Management manages 75% of its AUM passively, mostly in funds with no coal exclusion criteria. Amundi, which recently announced its plans for an increased presence on the passive market, does not apply its coal exit policy to 60% of its passive funds. BlackRock, similarly, does not apply its coal criteria to the $5trn it manages passively. It’s as if they’re trying to diet, but only on Mondays.

Under pressure for their leading role in supporting the fossil fuel industry, passive managers point to the fact that they regularly launch new ‘green’ or ‘ESG’ funds while protesting that they cannot make all their passive funds sustainable. They argue that responsible investing with these portfolios would be limited to asking companies to improve their performance and voting in shareholder meetings. In sum, ‘our hands are tied’.

Amundi, for example, states in its coal policy that it has “limited leeway” and therefore “cannot apply” exclusions to its index funds replicating standard benchmarks.” Passive managers also point to the responsibility of their clients and of index providers, such as S&P Dow Jones or FTSE, to explain the obstacles. BlackRock often argues that it gives its clients access to the widest range of ESG funds, whilst Legal & General emphasises its sustainable fund range. 

But this plea of powerlessness simply doesn’t stack up: passive investing is a series of active management choices. Firstly, there are no legal requirements for index funds to exactly match the underlying index’s composition; it is a business choice to launch such funds. Second, indexes can change and this has already started happening. Even if many funds being launched are based on better benchmarks, asset managers need to tackle existing “broad market” funds which regroup the vast majority of assets. 

Furthermore, the solution currently put forward by asset managers of launching more “green” or “ESG” funds has failed so far. The lack of standard definition in what asset managers call sustainable has proven a perfect recipe for greenwashing, as states and regulators are belatedly recognising in their creation of green taxonomies. The 20 biggest ESG funds currently hold investments on average in 17 fossil fuel producers. 

Meanwhile, studies show that ‘passive’ investing artificially inflates the valuation of fossil fuel companies, with significant and automatic capital flows for listed fossil fuel companies. Asset managers do not exclude companies from their funds even if they consistently exacerbate the climate crisis, for as long as the company stays on the index tracked. Launching new sustainable funds will fail to move financial flows away from the fossil fuel sector for as long as the ‘passive’ issue isn’t tackled.

Asset managers can go two ways to phase out coal, oil and gas developers from their passive funds: either change the indexes, or apply exclusions themselves. And if the only solution for existing funds is to change standard indexes, then they will need to effectively and collectively engage index providers. When it comes to passive investing, it’s time to get active.

It’s not an issue that can be wished away – if anything, it’s getting worse. Passive funds constituted 50% of investment flows in Europe in the first quarter of 2021, compared to only 32% of the flows in 2020. If they don’t act, ‘passive’ managers won’t just slow down the transition. They will become polluters’ financial holder of last resort and undermine hopes of averting climate catastrophe.

This article is also published by ESG Clarity. Energy Voices is a democratic space presenting the thoughts and opinions of leading Energy & Sustainability writers, their opinions do not necessarily represent those of illuminem.