The Limits of Portfolio Primacy

Abstract

Due to the shortcomings of environmental policy, there is growing interest in the role that private actors can play in the fight against climate change. One of the most important theories in this field argues that large asset managers, and in particular large index funds, can and will undertake the role of “climate stewards” and push corporations to reduce their carbon footprint. This “portfolio primacy” theory is based on the view that index fund portfolios mirror the entire market and therefore have strong financial incentives to reduce market-wide threats, such as climate change.

But how much can we rely on portfolio primacy to mitigate the effects of climate change? In this Article, I provide a conceptual and empirical assessment of the potential impact of portfolio primacy on climate change mitigation by examining the scope of action, economic incentives, and fiduciary conflicts of index fund managers. The analysis reveals three major limits, each reinforcing the others, that undermine the promise of portfolio primacy.

First, the potential scope of index fund stewardship is narrow, as most companies around the world, including most carbon emitters, are private, controlled by state governments or private shareholders, or influenced by major blockholders. Second, index funds internalize only a fraction of the social cost of climate change and therefore have very weak incentives to engage in ambitious climate stewardship. Third, index fund managers advise dozens of index funds with conflicting interests with respect to climate mitigation and therefore face serious fiduciary conflicts that would hamper any ambitious mitigation strategy.

This analysis shows that portfolio primacy cannot become a powerful tool in the fight against climate change. On the contrary, by creating the misleading impression that index funds will have a significant impact on climate change, portfolio primacy may well reduce political support for climate regulation and thus harm climate progress.

Keywords: corporate governance, index funds, climate change, portfolio primacy, corporate social responsibility, ESG, stewardship, common ownership

JEL Classification: D21, G30, G34, K22, Q5