The Limits of Portfolio Primacy

Abstract

Climate change is one of the defining challenges of our time, but governments around the world are failing to deliver adequate responses. Given government inertia, many observers have suggested that large institutional investors can be expected to use their shareholder power to push companies toward decarbonization. In particular, according to a theory that is gaining increasing support among academics and practitioners (“portfolio primacy theory”), index funds have strong financial incentives to become “climate stewards” because their portfolios mirror the entire economy and therefore internalize, at least in part, the social costs of climate change (“climate externalities”).

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

First, the potential scope of climate stewardship is narrow, as most companies around world, including most carbon emitters, are private, controlled by state governments or private shareholders, or influenced by significant blockholders. In particular, my analysis of the ownership structure of oil, gas, and coal companies in the FTSE Global All Cap Index—one of the broadest equity indices tracked by index funds and fairly representative of the global stock market—reveals that most publicly-traded carbon emitters are partially or totally shielded from index fund stewardship.

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 funds are interested in maximizing the welfare of large producers, but not necessarily the welfare of small firms and consumers; index funds 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 mitigation.

Third, index fund managers advise dozens of funds with different portfolios and conflicting interests with respect to climate mitigation. I show through a numerical simulation 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 is not an adequate substitute for climate regulation and might even make things worse by creating a false sense of security that could reduce the political capital for government intervention. The Article suggests that climate regulation should remain the primary goal for those concerned about climate risk and provides a basic framework to assess capital market policies aiming at strengthening the role of private actors in climate risk mitigation.

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

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