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With divestment off table, passive funds look to retool engagement strategies

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Smoke billows from an oil refinery in Kawasaki, southwest of Tokyo.
Source: AP Photo

A number of fund managers around the world are taking additional steps to work more closely with companies in their passive investment portfolios to assess and tackle climate change and other risks and opportunities related to environmental, social and governance, or ESG, objectives.

Without the ability to divest from companies in those passive funds, the asset managers are instead joining forces on engaging with those companies, more frequently wielding their votes if companies fail to uphold sustainability objectives and crafting new index weighting strategies to encourage disclosure.

"Climate change has become a defining factor in companies' long-term prospects," BlackRock Inc. Chairman and CEO Larry Fink said in a Jan. 14 open letter in which he announced the firm will drop coal-focused companies from its active funds and will offer more products related to ESG objectives.

Fink also acknowledged that, for index-based holdings, "we are essentially permanent shareholders. ... We have a responsibility to engage with companies to understand if they are adequately disclosing and managing sustainability-related risks, and to hold them to account through proxy voting if they are not."

He noted that BlackRock joined the Climate Action 100+ initiative, adding its influence to a group of investors pushing global corporate greenhouse gas emitters to take action on climate change.

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BlackRock CEO Larry Fink participates in a panel during the One Planet Summit in New York in September 2018.
Source: AP Photo

Moreover, "we will be increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices and plans underlying them," Fink wrote.

BlackRock is the world's largest asset manager with more than $7 trillion under management. Before BlackRock joined Climate Action 100+, the group comprised about 370 global investors with more than $35 trillion in assets under management. Through letters, direct meetings with company officials and resolutions coordinated by shareholder advocacy group Ceres, the group is pressing more than 150 major companies in the consumer, transportation, energy, and metals and mining sectors to align their emissions goals with the Paris Agreement on climate change. Participating investors also want companies to assess and disclose climate risks in line with the recommendations of the business initiative known as the Task Force on Climate-related Financial Disclosures, or TCFD, and implement a strong governance framework.

Through the coordinated effort, Climate Action 100+ has in its first couple of years helped influence new climate-related actions at companies such as Royal Dutch Shell PLC, BP PLC, Nestlé SA and Rio Tinto Energy America Inc.

Shifting 'demographic and investment conviction'

Investor interest in sustainable finance is surging globally. Between 2016 and 2018, the amount of money invested in accordance with ESG criteria rose 34% to $30.683 trillion in five major markets Europe, the U.S., Japan, Canada, and Australia and New Zealand according to industry trade group Global Sustainable Investment Alliance.

"Shifts in demographic and investment conviction are driving increased interest in sustainable investing globally, and these forces are likely to accelerate," Fink told analysts in October 2019.

That is creating a unique challenge for passive fund managers: Figuring out how to advocate for clients who are concerned about ESG issues yet are interested in index, or passive, investing, which is generally cheaper than active fund management.

"In some ways, the passive sector should be the perfect place for thinking about ESG and raising those issues," given fund managers' buy-and-hold strategy, said Josh Olazabal, head of sustainability and ESG at CreditSights, a credit research company. "The challenge is that actively working on executing those ideas becomes more difficult in a passive environment" because the ability to divest is off the table.

The third-largest pension fund in the U.S., the New York State Common Retirement Fund, is another manager that has pledged to integrate climate risk assessment and engagement more fully into its investment processes. The pension fund is also part of Climate Action 100+. New York Comptroller Thomas DiNapoli, when releasing the pension fund's updated climate action plan in June 2019, stopped short of opting to divest from fossil fuels in active funds but left the possibility open in the future. The fund is developing standards for thermal fuel followed by other sectors that present climate risks to the fund, the plan said.

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"Divestment is a last resort and should be reserved for specific investments (and not the fossil fuel industry generally) where there is an articulable, serious, and sustained financial risk to continuing the investment and where an economic analysis demonstrates that divesting would not have a negative economic impact" on the fund, the report said. "At this time, broad-based fossil fuel divestment by the [fund] is not consistent with the comptroller’s fiduciary duty, and would not be effectual for either risk reduction or broader climate change mitigation."

A new way to engage

Taking a different strategy, one of the world's largest pension funds, Japan's Government Pension Investment Fund, or GPIF, is using a new weighting process in a pair of "carbon-efficient" indexes to influence wider corporate carbon reporting among its target investments.

"Rather than just divesting from any particular industry, we are actually trying to promote competition for [carbon] efficiency within industries," said Hiromichi Mizuno, chief investment officer of GPIF, which has about $1.6 trillion of assets under management.

When GPIF set out to reshape corporate climate in 2018, it invested about $10 billion in a pair of "carbon-efficient" indexes that overweight companies with small carbon-to-revenue footprints and those that publish information about their emissions. In an ensuing six-month period, corporate carbon disclosures in Japan rose by 10%, according to Trucost, a division of S&P Global that assesses climate risk.

GPIF's investment strategy may not account for the entire increase in corporate carbon disclosures, "but I would suspect that it's helped," Trucost CEO Richard Mattison said.

"I think it made a significant impact in the way they think," Mizuno said of corporate leaders in Japan. "They know we are going to hold their shares for the next 20, 30 years, so they have to be serious."