The Limits of Portfolio Primacy

Abstract

According to a theory that is gaining increasing support among academics and practitioners, index funds have strong financial incentives to become “climate stewards” and to push companies to reduce their carbon footprint. Under this view, by maximizing the value of their entire portfolio (portfolio primacy) rather than the value of the individual company (shareholder primacy), index fund managers are incentivized to reduce climate externalities and therefore should be expected to play an important role in mitigating climate risk.

But to what extent can society rely on portfolio primacy to address climate change? This Article provides an empirical assessment of the limits of portfolio primacy by examining the scope of action, economic incentives, and fiduciary conflicts of index fund managers with respect to climate risk mitigation. The analysis reveals three major limits that undermine the practical impact of portfolio primacy on climate risk.

First, the potential scope of climate stewardship is very narrow, as most companies around world, including most carbon emitters, are private, controlled by state governments or private shareholders, or influenced by significant blockholders; therefore, most firms are partially or totally shielded from the influence of index funds. Furthermore, public companies with dispersed ownership can escape index fund oversight by spinning off carbon intensive assets to private buyers.

Second, index fund managers internalize climate externalities to a very limited degree and therefore have very weak incentives to engage in aggressive climate stewardship. In particular, index fund portfolios are exposed only to producer welfare, not consumer welfare; they are disproportionately invested in richer economies, which are relatively less vulnerable to climate change; and they discount the distant future at a much higher rate than what most experts believe is the social discount rate for climate damage.

Third, index fund managers advise dozens of funds with different portfolios and conflicting incentives with respect to climate mitigation. A numerical simulation shows that, under plausible assumptions, many of the “Big Three” index funds with the largest holdings in Exxon will oppose a climate mitigation measure that penalizes oil companies even if it benefits the stock market as a whole.

Taken together, these limits show that portfolio primacy offers no adequate answer to the crucial threat of climate change. Policymakers should not rely on portfolio primacy as an effective substitute for climate regulation.

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

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