- ESG funds have two ways to influence corporate behavior: voice and exit
- Exit denies capital to firms with bad behavior
- Exit encourages firms to compete with each other to qualify for the fund's capital
- Exit only influences firms close to qualifying — the worst firms don't have a reason to improve
- Exit's influence is limited by other funds that try to arbitrage ESG-screening strategies
This is Part 1 in a series on how ESG index funds influence corporate behavior. Here's Part 2.
What are ESG index funds?
ESG index funds track indexes that take into account environmental, social, and governance considerations. Most commonly, ESG indexes exclude firms that have low ESG scores. One example is State Street's ACWI Low Carbon Target ETF (LOWC). The index excludes firms, like ExxonMobil, with high carbon emissions or large fossil fuel reserves.
Academic researchers have identified two ways funds can influence behavior of firms. The power of exit involves denying capital to misbehaving firms. "Exit" refers to exiting a position — selling the shares of a company — but it can also describe a fund declining to purchase shares of a company. A fund exerts the power of voice when it uses its position as a shareholder to push for reform.
This blog post describes how the power of exit works, highlights conditions that make it more effective, and identifies some key limitations.
Exit in action
Funds like LOWC are popular among investors concerned about climate change. Avoiding firms that contribute to global warming allows investors to sleep at night knowing that they are not profiting from the destruction of the climate. More importantly, denying capital to firms based on their emissions can induce firms to compete with each other to reduce their emissions.
Let's create a hypothetical index fund to see how this might work. Our fund will rank the firms in each industry by how much revenue they generate per megaton of carbon emissions produced. The fund will only invest in the top 50% of firms in each industry by this metric.
Let's see how this fund would invest in a hypothetical electric power industry:
(billions USD/megaton %)
|David's Utility Co||40||2000||2|
Because Anne and Barry run the most efficient firms based on the revenue to emissions ratio, our fund will only invest in these two companies.
The next quarter, Carly's investors set up a performance plan for the CEO. If Carly can increase her share price, she'll take home a big bonus at the end of the year. Based on our indexing strategy, Carly realizes that if she can cut 22 megatons of emissions, her Revenue/Emissions ratio will increase to 15.1% — putting her above Barry! She decides to install carbon capture technology on three of of her coal plants to meet this target.
Her plan works! At the end of the quarter, our fund sells all its shares of Barry and buys shares of Carly. Carly's share price soars into the now-slightly-cleaner atmosphere.
Can index funds really change corporate behavior via Exit?
For ESG indexing to change corporate behavior, two conditions have to hold. First, enough money has to be in funds with similar indexing strategies to make it worthwhile for companies to compete. Second, there must be technologies available for companies to lower their emisisons. These conditions are related: if there is more capital, the technology doesn't have to be as cheap. If the technology is cheaper, there doesn't have to be as much capital.
It's difficult to see if those conditions hold today. BlackRock claims that 750 billion USD are invested in sustainable funds. Certainly not all of this is invested in index funds with a rigorous indexing approach like the one described above.
Some studies have shown that renewable sources of electricity are very competitive and in some cases cheaper than coal. Utility companies might be able to justify investments in renewable energy if doing so will qualify them for ESG capital.
Limitations on the power of Exit
The example above also shows one of the limitations of ESG indexing strategies. The biggest emitter (David) is by far the least efficient of the bunch. Maybe David is a very old utility company running on old technology in an area that isn't suited to wind and solar power.
David would have to cut his emissions by a 86% to be able to compete with the other firms! To do so would be quite expensive. Even if there were some low-cost technologies available to reduce, say, 10% of his emissions, our fund would not give David an incentive to invest in them because he would still not be anywhere close to qualifying for capital.
In short, ESG-screened index funds can only create competition among firms close to the threshold. The worst-behaved firms have no reason to change their behavior in response to a ESG fund. These firms are the ones that need to change!
Another limitation of ESG index funds, is that, by using criteria other than pure profitability to select investments, they may allocate capital inefficiently. Other investors can take advantage of this inefficiency by allocating more capital to the firms that are screened out of ESG funds. One fund, called the Vice Fund, is already doing exactly this. By exclusively investing in the companies that are denied capital by ESG funds, the Vice Fund cancels out some of the positive effects of ESG screening.
One way to address some of the limitations discussed above is for the ESG fund to change the way it weights firm in the index based on ESG metrics. Instead of excluding firms with low scores, the fund could allocate more of its capital to better behaved firms.
Continuing our example above, let's say that our fund has 100 million to invest in the utilities sector. The fund could use a rule like: add up the Revenue/Emissions ratios of each firm, and call this T (T = 20 + 15 + 14 + 2 = 51). For each firm, invest 100 million times each fund's ratio divided by T. The fund would invest 39 million in Anne (100 million * 20 / T), 29 million in Barry, 27 million in Carly, and 4 million in David.
With this rule, David and Anne now have a reason to invest in lower emissions. If David can cut 10% of his emissions, the fund will increase its investment by 7%.
The main downside to weighting based on ESG scores has to do with index fund mechanics. The largest expense for an index fund is purchasing and selling shares. Most index funds are weighted by market cap because this minimizes the number of trades a fund has to execute. Weighting by ESG scores requires the fund to buy and sell shares whenever the scores update, which will make the fund more expensive for investors.