The growth of exchange-traded funds and passive investing should be a focus of policymakers working at the intersection of climate change and financial markets according to new research from the University of Oxford’s Smith School of Enterprise and the Environment.
Christian Wilson & Ben Caldecott said in a working paper, ‘Breaking the Bond: Primary Markets and Carbon-Intensive Financing’, that financial institutions need to decarbonise primary market transactions in order to align capital flows with the aims of the Paris Agreement.
The study analysed US corporate bond ETFs using a new metric, Primary Market Carbon Exposure (PMCE), which measures the proportion of primary market transactions that occur in carbon-intensive sectors. The ETFs in the sample had a PMCE of 14% between 2015 and 2020, indicating that they systematically partake in carbon-intensive primary market transactions. High yield ETFs had a higher PMCE than investment grade ETFs as they provide more financing to the upstream oil & gas sectors (see charts).
Wilson & Ben Caldecott said ETF providers need to reduce PMCE in line with Paris Agreement carbon budgets to avoid becoming capital providers of last resort for carbon-intensive sectors if active investors step back. They recommended that ETF and passive fund providers should use their flexibility to only finance carbon-intensive companies with robust transition plans, while continuing to develop and promote low-carbon passive funds.
The study said: “For policymakers, not only can passive funds contribute to carbon lock-in, but ETFs directly bought by central banks are financing carbon-intensive sectors.”
For example, ETFs bought by the Federal Reserve in 2020 had a PMCE of 13%.
“Policymakers need to support the development of low- carbon indexes and their use by asset owners,” added the paper. “In addition, planned disclosure requirements for financial products and institutions can be extended to include metrics that capture primary market investments.”
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