Portfolio Primacy and Climate Change

Climate change is a quintessential market failure. Individual companies do not have economic incentives to reduce their carbon emissions and therefore produce more emissions than is socially desirable. However, according to a theory that is gaining increasing support among academics and market players, large asset managers (and, in particular, index fund managers) can become “climate stewards” and force companies to reduce their impact on climate change. This view is based on the premise that index fund portfolios mirror the entire economy and, therefore, internalize climate risk. According to this theory, by maximizing the value of their entire portfolio (portfolio primacy) rather than the value of the individual company (shareholder primacy), index fund managers have strong economic incentives to steer companies towards decarbonization. This Article offers the first systematic critique of this theory. First, it demonstrates that the composition of investment portfolios can distort the incentives of index funds with respect to climate risk. In particular, it shows that index funds’ incentives are strongly aligned with the interests of carbon emitters, rich countries, and large companies, but weakly aligned with the interests of firms and countries that are more vulnerable to climate change. Second, it shows that the stock market is a highly imperfect mechanism to address climate risk: stock prices do not accurately reflect future climate damages; private investors discount the distant future at a higher rate than the correct social discount rate; and public companies represent a limited (and increasingly smaller) portion of the economy. Therefore, index funds inevitably underestimate the costs of climate change and the benefits of mitigation measures. Third, it examines the agency problems and fiduciary conflicts of index fund managers, and it argues that even if index fund portfolios benefitted from climate stewardship, fund managers would have very weak incentives to take on such a role. The analysis of this Article reveals that portfolio primacy offers no adequate answer to the crucial threat of climate change. If policymakers want to use corporate governance as a tool to fight climate change, they should change the incentives of individual companies rather than trust the portfolio incentives of index funds.