We might think it’s the role of governments to police the natural world, but now the world’s largest asset manager, BlackRock, is also throwing its weight around. The firm’s latest “investment stewardship” guidelines, published this month, are striking for their pronounced emphasis on “natural capital”.
According to BlackRock, companies which depend on fisheries, forests, mineral deposits and so on face both regulatory and reputational risks. How exactly these companies deal with those risks, they argue, will have a major impact on their share prices over the long term. “We consider biodiversity preservation, deforestation risk management, oceans and freshwater protection to be potential drivers of long-term value,” BlackRock notes..
That’s not all. Blackrock says it will vote against the re-election of directors of companies that are deemed have failed to have effectively managed, overseen or disclosed these “natural capital” risks. BlackRock also underlines its support for shareholder proposals addressing natural capital risks if they “believe a company could better manage such risks or report on its approach”.
The idea that companies should start disclosing their so-called ‘climate risk’ has previously attracted support from the likes of Mark Carney, the former governor of the Bank of England, and John McDonnell, the former shadow chancellor. Nor is a focus on environmental risks new for BlackRock itself. The company has long called on the firms it invests in to do more in this area. Larry Fink, the company’s CEO, regularly addresses this in letters to investors, arguing “climate risk is investment risk”.
The latest threat to start opposing the re-election of boards, however, suggests BlackRock is now preparing to really flex its considerable muscles. Through its various funds, BlackRock controls almost $9 trillion worth of assets, making it among the largest shareholder of many companies around the world. As a result, there is a real chance that companies whose management does not comply with these new guidelines could find themselves voted out of the job by a shareholder revolt led by BlackRock.
Is this all just a cynical PR? After all, BlackRock regularly comes under fire for having fossil fuel companies in its many funds. These new guidelines may be an attempt to temper this criticism. On top of this, the asset manager is acutely aware of investor concerns about ‘sustainability’, reflected in the increasing popularity of ESG (environmental, sustainable and governance) funds.
However, the new stewardship rules also make sense when you consider the ways capitalism is being transformed by the rise of so-called “passive investing” – and it’s a potentially concerning change.
Over the past few decades, increasing amounts of investor money have moved into passive index funds. These funds buy every stock in the market they track, so their returns simply mirror the movement of a particular stock market index. So, for example, you can invest in index funds that track either the UK’s FTSE 100, the US’s S&P 500 or Japan’s Nikkei 225. These funds buy each share in the index they track in proportion to the percentage each company represents. So, if Apple is 4% of the S&P 500, an S&P 500 tracker fund will give the investor a 4% exposure to Apple.
That contrasts with actively managed funds, which have managers and researchers striving to pick stocks that will generate the biggest returns. If active management is looking for a needle (a good stock) in a haystack (other stocks), passive investing is just picking up the entire haystack, knowing that the needle is in there somewhere.
The most successful providers of index funds are the so-called Big Three: BlackRock, Vanguard and State Street. As a result, these companies now find themselves as the biggest owners of nearly every large company in the US. The average combined stake in S&P 500 companies held by the Big Three has gone from 5.2% in 1998 to 20.5% in 2017. Europe is slightly behind in this, but the trend towards passive funds of a handful of asset management giants is still the trend.
While big fund houses existed in the past, passive index funds are more conducive to economies of scale than traditional active funds. As a result, the Big Three control a much larger proportion of the market than asset management firms of old ever did. This concentration of ownership has afforded the Big Three huge power over companies in America, and to a lesser extent the rest of the world.
However, the nature of passive index fund ownership is also significant here. Previously, much of the world’s capital was in actively managed funds. These funds bought shares they expected to perform better than other companies in the market. In theory, these funds engaged with the management to enact proposals seen as beneficial to the company in question. If disagreement arose the fund would usually sell their stake.
But with the rise of index funds and the Big Three, some argue that has changed. Index funds are supposed to own every stock in the market and have no traditional manager sifting through the accounts and business plans of companies in the fund. That makes meaningful engagement as a shareholder very difficult. Owning every stock in the index also means there is less incentive to engage with companies in this way. As a result, passive fund houses, such as BlackRock, have been accused of poor corporate governance, often in regard to climate change.
This distinction probably relies on an idealised version of the quality of active fund corporate governance in the past. However, the criticism that index funds struggle to meaningful engage with individual companies is true – it is unreasonable to expect BlackRock or Vanguard to be familiar with each and every company in their vast portfolios, at least when it comes to their index funds.
As a result, companies such as BlackRock have resorted to taking a more “macro” view of corporate governance and shareholder engagement. Rather than try to tell specific companies what they should do, they have tried to formulate more general corporate governance policies that, in theory, can apply to all companies. BlackRock’s latest guidelines, including the threat of voting directors out of companies, is the latest – but with more teeth to it than those before.
This sort of macro-level engagement also makes total sense from the perspective of large asset managers with exposure to every company in the world. If you are BlackRock and you own a slice of almost every company in the world, you are not concerned with how one company’s shares perform, but all companies together. You want the market, in aggregate, to provide returns. Taken to its logical conclusion, this means your primary concern is the overall health of the global economy.
We can put BlackRock’s “natural capital” proposals in this context. For right or wrong, BlackRock believes that climate change and natural resource depletion is a major risk to the health of the global economy. A threat to the health of the global economy is a threat to the market, in aggregate. Therefore, it makes sense to pressure each and every company to take steps to try and address whatever this concern is. This is BlackRock taking a macro-view, as a shareholder of every company in the world.
The problem, however, is that this macro-view can quickly bleed into the realm of politics. The outcome is asset managers starting to think of corporate governance in terms of what can start to look like economic policy. Forcing all companies to disclose certain risks is the sort of thing a democratically accountable state would have done historically. BlackRock, however, owing to the logic of owning every stock in the market, has decided to take up this task. BlackRock, and other fund houses, now have both the motive and the means to enforce wide, sweeping change upon companies in aggregate – or, put differently, the economy. This raises questions about democratic accountability.
This is not to have a go at BlackRock. Their approach makes total sense from their own perspective and may even be a good policy to enforce on companies. But it raises troubling questions about who should have such power over the policy and behaviour of businesses. This is perhaps the inevitable outcome of the structure of passive fund ownership. Passive investing is not going away any time soon – so how we address this new concentration of power in a handful of asset managers should be seen as one of the pressing questions of capitalism in the 21st century.
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