Executive summary

The report explores the Passives Problem and how the trend of passive investing is setting the global economy on autopilot while also pumping capital into carbon-intensive companies. This trend is concentrating power with a shrinking set of asset managers, hindering progress in mitigating climate change, and exacerbating risks of market instability. The report suggests possible solutions to the problem.

Background: The passive investment wave

Passive investing first appeared in 1976, and since then, it has grown exponentially. Today, passive equity investments have surpassed active equity investments. However, this trend has a malignant side effect which has emerged, setting the economy on autopilot and endangering the environment by pumping capital into carbon-intensive companies.

The market is broken

Today, 1,200 asset managers control 70% of the assets under management (AUM) for public equity. These managers have a limited set of incentives to act on climate commitments despite the increasing pressure from investors.

The problem with passive investing

Passive investing is passive in investors’ proxy voting, dictating that the asset managers control the voting unless investors opt-in to cast their votes. Passive investing also artificially raises the valuation of carbon-intensive companies, limiting shareholder action on climate. Passive investing blunts asset owner pressure for change, tipping power from owners to managers and increasing systemic financial risk from climate change.

Barriers and potential solutions

The report suggests potential solutions, including:

• Opt-in vs Opt-out: Investors could opt-in to exercise their voting rights if they wish to support change.
• Addressing tracking errors: Rebalancing funds that have exceeded index limits to avoid tracking errors.
• Standardized definition of ESG funds: Establishing universal standards for ESG funds to ensure they are genuinely sustainable and resolute in climate-related investments.
• Changing the index: Modifying passive investment vehicles to consider environmental and social factors.
• Addressing market concentration: Encouraging more competition in the market to prevent over-consolidation.
• Awareness and investor demand: A large, unified movement that will increase pressure on fund managers.
• Fiduciary duty: Asset managers must respond to their fiduciary duty, considering the client’s best interests, and prioritising climate change concerns.
• Asset Manager action: Managers should review the funds they manage and consider divesting from fossil fuels and transitioning to more sustainable investments.

State of play: What’s being done to align passive investment with Paris goals?

Some asset managers are starting to offer carbon-free investment products and are requiring their clients to opt-out actively if they wish to maintain fossil-fuel-heavy portfolios. In Europe, regulators are establishing universal standards for sustainable investments, and American regulators could follow this model. Other potential solutions involve divesting from fossil fuels and using tactics such as worldwide boycotts, shareholder activism, and legal campaigns.

ESG alternatives alone won’t solve the problem

Currently, the ESG market includes investments that support carbon-intensive companies, soft commodities, and companies directly involved with deforestation. Standardization and enforcement could make all ESG worldwide portfolios consist of genuinely sustainable investments. In a recent survey, 72% of respondents indicated an interest in ESG investments, pointing to a growing demand.