'Passive investors could be carbon holders of last resort'

'Passive investors could be carbon holders of last resort'

Investors in passive funds could find themselves the ‘holders of last resort’ in carbon-intensive sectors, a report has warned.

In ‘The Passive Revolution’, Adrienne Buller and Chris Hayes, senior research fellow and senior data analyst at Common Wealth said the ongoing growth of passive investing marks a potentially ‘revolutionary’ change in the ownership and control of the global economy.

The pair said the rise of passive funds, which hit $15tn in assets under management (£11.5tn) last year, has led to a 'transfer of discretion' as fund houses outsource the investment management decisions to the providers of the indexes on which the funds are based.

The houses then use index-tracking rules as an excuse for remaining invested in controversial companies, they said.

“Observers have raised concerns that by yielding their discretion over investment decisions, the rise of the passive investing industry will create inertia in moving capital out of carbon-intensive sectors, making these funds the ‘holders of last resort'," the report said.

Speaking to FTAdviser’s sister publication the FT, Hayes said investors could “influence the activities of fossil fuel firms by divesting from them or by exercising shareholder pressure for change from within”. 

However, “it is now clear that the rise of passive funds is increasingly acting as a drag on the former, baking inertia into the system,” he added.

Passive funds use indexes to determine where to invest funds. These indexes are created by independent companies, such as MSCI and Morningstar, and align to a list of holdings that hold particular criteria (for instance market capitalisation or geography).

Other concerns

The report highlighted two other concerns that have been flagged by academics and civil society groups as a result of the increasingly passive investment sector.

The first is the result of analysis conducted by the Federal Reserve Board that suggests certain passive strategies can ‘amplify’ market swings. 

This has led some analysts linking passive investing to the inflation of stock market bubbles, by pushing up stock valuations.

The other criticism flagged in the report is that passive investing has eliminated most of the agency of the investment industry, across both how capital allocations are made and how shareholders use their positions to influence company behaviour.

“How corporations are owned and governed, and in whose interests, is a structuring force of the global economy,” the authors said.

“The implications of an increasingly concentrated and passively allocated investment system for how decisions are made and governance executed across the economy in the face of systemic challenges like inequality, global justice, and the climate crisis are potentially profound.”