Here are two strategies that most people would agree constitute breaches of fiduciary duty:
1) Tilting your portfolio in favour of companies with a higher number of vowels.
2) Tilting your portfolio in favour of companies where the CEO has a strong German accent. (Crucially, different from German companies with a CEO without an accent! This is a very nuanced strategy, mind you!)
Why are these strategies breaches of fiduciary duty? Because they are not aligned with the interest of the ultimate beneficiary, and thus breach the duty the fiduciary has vis-à-vis that beneficiary.
Why are they not aligned? Because there is no reason to believe such a strategy would drive any sort of financial or non-financial benefit (unless my beneficiary is particularly partial to French accents and would like to divest from German accents).
Which leads me to low-carbon benchmarks and the funds built on them. If fiduciary duty requires fiduciaries to “act in the best interest of the client”, do these investment solutions fit the bill?
At first glance, this may seem like a subjective question and indeed, that is how we have treated the matter to date. Not least because the universe of funds that typically fall under this category are not homogenous.
“Low-carbon benchmarks” were once simple exercises in tilting in favour of companies with a lower carbon footprint. A simpler (albeit less sophisticated) time, as many index designers will attest.
Benchmarks and funds these days use a range of indicators, including but not limited to financed emissions levels, requirements around emissions reductions, company targets, fossil fuel exclusions and green capex. They are, to varying degrees, designed to support investors in reducing climate transition risk and/or transitioning to a low-carbon economy.
Both of these objectives, I hope we can all agree, are at least in theory consistent with an investor’s fiduciary duty (unless your ultimate beneficiary happens to be a right-wing attorney-general).
Our work, and that of others, surveying thousands of retail investors and ultimate beneficiaries around the world proves that point! As do the countless legal advice documents that asset owners have solicited to prove their strategy.
The problem here is that this advice and research typically only asks whether the objectives – the ends – are justified. Not whether the means actually contribute to the ends.
And this is where things get murky!
Let’s assume you have a purely financial objective to minimise your exposure to transition risk. Surely such a strategy should reflect the empirical and theoretical evidence that financed emissions are a poor proxy for transition risk, as shown by previous research from the Sustainable Finance Observatory, Schroders, Mirova and academics (notably Laurent Millischer and Tatiana Evdokimova).
We don’t really need elaborate studies to make the point. High-emission companies may have emissions linked to green industrial solutions. They may have regulated returns. Okay, but what about “emissions reductions”? Surely that must be good for reducing transition risk.
Sure, in theory, but many strategies don’t prioritise companies’ absolute emissions reductions, instead achieving portfolio emissions reductions through turnover. In the worst case, this leads them to prioritise companies that reduce emissions intensity as a result of financial biases rather than absolute emissions reductions.
The kindest thing one can say is that emissions may be a weak proxy for some transition risks. And that it is just one indicator among many.
But is that indicator adding value? After all, such indicators are not a “free lunch” for investors. They add to turnover, they probably add costs and they dilute the efficacy of the core strategy.
Another objective some benchmarks seek to serve relate to fossil fuel exclusions. In research conducted by the Sustainable Finance Observatory, out of a list of 31 exclusion “themes”, coal barely cracked the top 50 percent. Oil exclusions scored 25 out of 31 issues in terms of being “very important”.
I don’t mean to suggest that fossil fuel divestment does not matter to a significant share of beneficiaries, and that it is, in and of itself, inconsistent with fiduciary duty. But at the very least this research shows that such a divestment approach is, at best, an inconsistent application of fiduciary duty.
Let us come to the final line of defence: maximising (exposure to) real world emissions reductions!
If these strategies really were focused on that topic, why do so many of them start with a 50 percent lower emissions baseline? (I hope not for transition risk arguments!) Surely, if I want to “maximise” emissions reductions, I need to maximise the amount of emissions I am influencing and driving towards reduction? Or at the very least not pre-emptively filter them.
What is worse, once I have my “universe”, I would think I should focus on investing in companies that maximise real-world emissions reductions. Spoiler (actually not a spoiler because I already covered this earlier): that is not what most of these products do!
Double-digit turnover of many of these indexes highlights that this “emissions reduction” is not achieved by “picking decarbonisers”, but first and foremost by acts of financial alchemy – a moving of Titanic deckchairs.
Anecdotal evidence from companies suggests that even when their actual emissions performance is considered, they get penalised for financial volatility causing havoc with their emissions intensity – poison for effective signalling.
Crucially, the critique outlined here obviously does not apply to all strategies in the market. There are strategies that minimise transition risk by focusing on metrics and approaches that the theoretical and empirical literature demonstrates drives transition risk, and that focus on picking decarbonising companies with strong financial characteristics.
There are strategies informed by meaningful dialogue with beneficiaries about the divestment prioritisation of that beneficiary pool. And finally, there are strategies where the improvement in the climate performance of the fund or index seeks to maximise real-world rather than paper emissions reductions.
For most RI professionals, the fiduciary duty debate is settled. So why talk about this? Because, unfortunately, some of the strategies designed in the service of those objectives don’t serve them.
And when they don’t, we are violating our fiduciary duty.
Jakob Thomä is co-founder of Theia Finance Labs (formerly Two Degrees Investing Initiative), research director at Inevitable Policy Response and professor in practice at University of London SOAS.
