It may come as something of a surprise to investors who have been piling money into the plethora of ESG-based ETFs that have been launched in the past couple of years, but there is a problem with passives and the climate crisis.

Such is the premise for a Request for Proposal from the Hewlett Foundation, a US-based private charitable foundation that supports efforts to advance education around the environment and other areas of social concern.

The aim of the RFP is to generate ideas and solutions to support the development of ESG-driven funds that “remove climate change causing investments from products”.

What the foundation terms as the “passives problem” is that the rise of passives in the US and elsewhere around the globe has come with a “destructive consequence”.

Namely, it is “setting our economy on autopilot and is feeding the climate crisis”.

The RFP goes on to identify five areas where, it suggests, the rise of passive – including ESG-based passives – might actually be doing more harm than good.

The ABC of the passive problem

Delving into the issues, the foundation starts by suggesting that passive investing generally creates a flow of capital into carbon-intensive companies, “artificially (raising) the valuation of these companies”.

The RFP explains by virtue of doing what passive funds do – that is tracking indices or themes – it “bakes in” significant and consistent capital flows for coal, oil, gas and carbon-intensive agriculture and transportation.

“That is why the largest firms offering passive investments are also the largest investors in carbon-intensive companies,” the RFP says. These companies will include such climate crisis no-no’s as fossil fuel reserve holders, deforestation drivers and downstream sectors such as auto manufacturers and utilities.

The second area of concern regards the degree to which passive investing concentrates voting power. The 'Big Three' in the US – BlackRock, Vanguard and State Street – collectively average 25% of the shares of S&P 500 companies, meaning they potentially wield great power. But whether this is aligned with climate goals is far more open to question.

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Indeed, it should be noted here that research undertaken by ShareAction on behalf of the Charities Responsible Investment Network found that the world’s largest fund managers had used their votes against the advice of proxy advisers’ recommendations and voted down ESG-friendly measures at companies.

Indeed, the Hewlett Foundation suggests empirical evidence shows conflicts of interest inherent in the asset management industry often distorts their stewardship incentives.

The next issue is the distortion effect that passive investing brings with it when it comes to the balance between asset owners and asset managers.

“The average asset owner is now so small relative to the total assets under management (AUM) of the largest asset managers that they have little control over allocation strategies,” the RFP suggests. As a result, asset owners can often find their efforts to effect ESG change are frustrated by a lack of action from the larger asset managers.

The index tracking lie

The foundation then moves on to the problem of passive managers often making the case that attempts to screen out companies such as oil and gas simply cannot be done due to the need to follow the index. The lie here is that both index rules and the acceptance of tracking error allow for small to moderate deviations from indices.

This “incorrect assumption” makes it difficult for asset managers to offer mainstream, screened climate-friendly products and for investors to access them. The foundation here cites that recent offerings in the Nordic market from the likes of the Norwegian Sovereign Wealth Fund and Storebrand to offer passive products that both screen out climate drivers and screen in climate solutions.

Finally, the foundation’s RFP suggests passive investing “systematically influences” financial flows to carbon-intensive industries. Here, the exit of active funds (under pressure from investors) from the fossil fuel industry means that passive funds become the “holder of last resort ensuring that these losses will be borne overwhelmingly by average investors, savers, pensioners and retires”.

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The foundation argues ESG-based products offer a “window of opportunity” in satisfying the demand for sustainable investment but warn the current product offering “still contains companies driving climate change”.

In effect, it is throwing down the gauntlet. “Given the speed of change needed to fight climate change, passive investments must recognise the risk of holding assets exposed to greenhouse gas intensive industries,” the RFP suggests.

By embarking on a process of seeking solutions it will “deepen the understanding of the problems of passive investments for the low-carbon transition” and at the same time identify solutions for using passive investments to both shift capital out of greenhouse gas intensive industries and move capital into companies driving real climate solutions, the report concludes.