Index Funds Have No Way To Manage Climate Risk, Expert Warns

Index funds and the investors who own them face an unmanageable risk from climate change, according to the director of Stanford University’s Sustainable Finance Initiative. Many of those investors are pensions.
Alicia Seiger told members of the U.S. House Financial Services Committee last week that index investors are less able to manage climate risk because they’re less able to monitor it.
“Recently I worked with the $210 billion New York state pension plan to help the fund better prepare for climate-related risks and opportunities,” Seiger said. “Their investment team has taken many leading steps to address climate impacts on their portfolio already, and yet a lack of transparency into the climate-related impacts of their equity portfolio—which is largely composed of passively managed index funds—remains an unmanageable risk.”
Many pension funds join the New York State Retirement Common Fund (NYCRF) in preferring index funds because of their low cost. Low cost has helped index funds outperform managed funds since their inception in 1976. Broad diversification has also helped, but that’s where climate risk enters.
“Like most large pensions, to limit costs, NYCRF is heavily invested in passive index funds. In other words, they own the market, along with any mispriced risk or systemic failure.”
Seiger cited the sudden bankruptcy of Pacific Gas & Electric Company as an example of such a failure. On paper, PG&E might have looked like a good buy for savvy investors. It outperformed other utilities in Environment, Social and Governance (ESG) assessments.
But those assessments failed to anticipate the climate risk that forced the company to seek bankruptcy protection this year: increased heat and drought, shifting land-use patterns, lapses in safety measures. PG&E equipment sparked wildfires that killed dozens of Californians, destroyed thousands of structures and scorched hundreds of thousands of acres. The company faces $30 billion in liabilities.
Few PG&E investors had done the research to prepare for that, Seiger said, but index investors had no way to prepare.
“Passive index investors had no warning, and even few active investors tracked the foreseeable consequences of California’s devastating wildfires on the utility’s share price.”
Earlier this year, Morningstar reported that nearly half of U.S. stock fund assets are now invested in passive index funds—$4.305 trillion.
NYCRF is better prepared for climate change than most pension funds, Seiger said. It has embraced recommendations, invested in climate solutions, created low-carbon investment products, pressured companies for disclosure. But it remains highly exposed to climate risk through its index funds.
“In the absence of high-quality climate-related financial disclosures, NYCRF is a passive taker on a bet wagered with insufficient information.”
If that bet goes wrong, she said, the effects will reach beyond New York.
“Not only does this bet increase the risk of financial loss for New York state employee pensioners, but it poses a systemic risk in that a majority of state pensions also rely heavily on passively managed index funds. A shock to the public markets from an abrupt or disorderly transition will smash nest eggs across the country.”
In her written testimony, Seiger urges mandatory climate related financial disclosure and a “comprehensive, science-based climate policy” which, she says, is needed to make the disclosure useful.
Read more and watch the hearing in its entirety:
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