Stewardship and engagement: the passive funds conundrum

Asset owners are expressing growing dissatisfaction with fund managers who backtrack on their climate promises. 

A recent report by Carbon Tracker revealed that major asset managers have increased their exposure to the oil and gas sector, even though they have set net zero targets.

Notably, the top three asset managers with the largest positions in oil and gas firms — Vanguard, Blackrock and State Street — are all passive fund providers. While Vanguard and State Street have maintained their average position size in oil and gas since 2021, Blackrock has increased its share from 6% to 6.6%, according to Carbon Tracker's analysis.

Furthermore, both Blackrock and State Street are members of the Net Zero Asset Managers alliance. 

However, despite setting net zero targets, they have increased their stakes in firms that plan to increase their oil output. This includes funds marketed as "Green" or "energy transition" funds that still hold significant stakes in companies like Chevron, Exxon Mobil, Total, Shell, or BP, leaving fund managers vulnerable to accusations of greenwashing.

Carbon Tracker's research shows that among 110 funds marketed as ESG funds, $3.75 billion of their market value was still invested in oil and gas companies, with 74% of these funds being passive funds.

Passive fund providers are not the only ones investing in fossil fuels. Some active fund managers have made even larger bets on fossil fuels relative to their total assets. 

Berkshire Hathaway, for example, increased its stake in fossil fuels from 0.4% to a significant 6% between 2021 and 2022, accounting for over 14% of its overall position. 

However, passive fund managers still hold a dominant stake in terms of overall ownership of fossil fuel firms.

Rising share prices have been a compelling reason to increase stakes in oil and gas firms. As global commodity prices surged over the past two years, so did the share prices of oil and gas companies. 

For instance, Chevron's share price more than doubled from just over $75 in March 2020 to over $180 by the end of last year. Exxon Mobil's share price also rose from $32.7 to over $118 during the same period.

Although stocks in other sectors also experienced net growth during that period, their rate of growth was not as steep. Since most benchmark indices tracked by passive funds are market-cap based, the relative share of oil and gas companies in these indices has increased over the past two years. 

This trend is particularly evident in UK equities, with the FTSE100 being relatively heavy on energy. The share of energy in the FTSE100 increased from 8.76% in 2020 to just over 13% by the end of 2022. 

This may be good news for returns, as energy companies have paid significant dividends during this period. However, it poses challenges for investors aiming for net zero targets, as energy companies have downscaled their climate ambitions and increased their oil output targets in the last two years.

Where do passive fund providers stand on stewardship?

One counterargument is that by holding a significant stake in oil and gas firms, passive fund providers such as Blackrock, State Street, and Vanguard have a unique position to engage with these companies and convince them to adopt more ambitious climate targets. 

While there is considerable attention on activist shareholders, their actual stake in the company is dwarfed by the proportion of money invested by passive managers.

For example, the asset owners supporting the recent court case against Shell's directors had a combined stake of about £12 million, significant but relatively small compared to Shell's total market capitalization of $163.15 billion. 

In contrast, Blackrock alone owns more than 9% of Shell. Similarly, Vanguard, State Street, and Blackrock combined hold a stake of over 18% in Exxon Mobil, a pattern that extends to other oil and gas firms. This positions passive fund managers well to have a seat at the table with chief executives of these firms.

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However, when it comes to supporting resolutions on climate change, the asset management giants overwhelmingly side with the board and vote against activist proposals to enhance energy transition targets. 

Over the past two years, Blackrock, State Street, and Vanguard have consistently voted against such resolutions.

In its outline of the 2023 stewardship priorities on climate change, Blackrock stated that it differentiates between Scope 3 emissions and Scope 1 and 2 emissions, and while it welcomes commitments to disclose Scope 3 emissions, it recognizes the challenges in establishing data on these emissions. The asset management giant also views some resolutions as "too prescriptive" and stresses that it is not inclined to support resolutions that appear to micromanage companies. 

But Blackrock also says that it assessed resolutions independently of whom they have been filed by and judges resolutions based on their content rather than the authors.

Blackrock's stance contrasts with that of activist climate investors who are pressuring oil and gas firms to adopt clear interim Net Zero targets and binding Scope 3 emission targets. 

These investors emphasize that Scope 3 emissions account for the majority of oil and gas pollution, and without clear targets for Scope 3 emissions, it becomes difficult to assess a company's overall impact on the climate.

Where does this leave fund investors?

This situation presents a challenge for institutional investors seeking to achieve net zero targets. Many investors have chosen passive or index-based mandates or pooled fund solutions to implement their developed market equity strategies. 

However, this raises the question of whether the stewardship of these assets is effectively outsourced. 

What happens if a pension fund's ambitious net zero targets do not align with the stewardship efforts and asset allocation decisions of the underlying fund manager? It is likely that a mid-sized UK master trust has little influence when negotiating Blackrock's or State Street's stewardship strategy.

More recently, Blackrock has taken over the management of some of the UK’s largest defined benefit schemes, the British Airways Pension scheme and the £8.8bn Royal Mail Pension Scheme. In other cases, DC Master Trusts such as Now: Pensions or The People’s Pension have the bulk of their growth portfolio invested in pooled index funds offered by State Street or Blackrock.

At the same time, national regulators are increasing reporting requirements for trustees of pension funds. For example, UK pension funds now have mandatory climate reporting standards for their Statement of Investment Principles. The UK pensions regulator also takes a dim view of "vague and generic" pledges in these statements.

The regulator has made it clear that being invested through a passive strategy does not absolve asset owners from stewardship efforts on climate change. They suggest that trustees may consider the use of alternative indices if they wish to maintain a passive approach, as market-cap weighted indices usually reflect business-as-usual scenarios and may overweight high carbon sectors, for example oil and gas. 

As passive funds continue to gain a larger share of global equity markets, asset owners committed to net zero goals may scrutinize stewardship and engagement efforts more closely in the future.

This article has been updated on 23/5.2023 to clarify Blackrock's stance on supporting climate resolutions.