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Outside the Box: Money-management firms face loss of revenue as clients apply pressure over climate change

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U.S. asset managers are caught between a rock and a hard place.

Those doing business around the world are caught between clients who are clamoring for them to incorporate climate-related financial risk in their investments, and another set of clients who want them to do just the opposite.

European and Canadian investors are particularly vocal. New regulations require asset managers to disclose how they are addressing climate issues with their portfolio companies, in the hope that large investors can work toward mitigating the dire effects of climate change. But in some parts of the U.S., clients including pension funds in energy-producing states would rather have money managers remain neutral.

This divergence is creating substantial climate-transition risk for asset managers.  This risk is real and urgent, as it represents a potential loss of revenues, clients and reputational damage. 

I propose, below, a simple solution to this conundrum.

Conflict of interest

BlackRock
BLK,
+1.10%
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for instance, faces this conflict of interest acutely, being responsible to a vast swath of asset owners with widely varying preferences.

The world’s largest asset manager, BlackRock has taken a proactive stance on climate-related risk. The New York-based firm’s 2020 client letter clearly states that “[g]iven the groundwork we have already laid and the growing investment risks surrounding sustainability, we will be increasingly disposed to vote against management when companies have not made sufficient progress.” 

Fast forward to January 2022, when West Virginia State Treasurer Riley Moore announced that the Board of Treasury Investments dropped BlackRock money market funds from its portfolio because the firm is urging companies to embrace “net zero” investment strategies that would harm the coal, oil and natural gas industries. 

Two days later, Dan Patrick, the lieutenant governor of Texas, asked that BlackRock be placed on a list of companies to be boycotted by Texas. “As I have stated before, if Wall Street turns their back on Texas and our thriving oil and gas industry, then Texas will not do business with Wall Street.”

While West Virginia’s public pension assets were less than $20 billion at the end of 2020, those of Texas were more than $200 billion as of December 2021. Facing the threat of divestment, BlackRock responded that it would continue investing in and supporting fossil fuel companies, including those in Texas.

ESG implications

How did asset managers including BlackRock end up in this situation? The root cause is that the firms are fiduciaries, not the owners of the assets. The second facet here is that ESG issues often have political implications. The asset manager — BlackRock being merely an example — faces a clear and imminent risk of loss of revenues and reputation among part of its clientele in dealing with climate change.

This is transition risk for asset managers, manifested very differently than is usually highlighted. The focus has been almost exclusively on the risk for portfolio holdings, such as stocks and bonds of companies that face climate-related risk. 

Political and regulatory risk is another dimension, but usually refers to costs of reputational loss, or costs associated with regulatory changes. Asset managers are potentially experiencing a very real risk of loss of clients and associated revenue precisely becausethey are trying to deal with the urgent consequences of climate change.

Possible options

What are the options for asset managers? Asset managers are being asked by clients to take on responsibility that would be more appropriately handled by regulation, thereby removing the conflict of interest. The positive trend is that regulation is indeed fast evolving, with Europe and the U.K. requiring disclosure and carbon targets. The U.S. Securities and Exchange Commission is moving in this direction as well.

Another practical solution I propose is to create a suite of investment products that are explicitly structured for clients who wish to incorporate a comprehensive climate-change response in their portfolios. Those products and strategies would run the gamut from assessing transition risk of individual companies to active advocacy for disclosure and a climate strategy response. 

This solution would create a bifurcated asset-management philosophy — advocating both for fossil fuels and against them in the same investment firm. However, it would provide much needed transparency and authenticity both for asset managers and their clients and shareholders. A parallel can be drawn with asset managers that offer both actively managed funds and index funds, a product mix now widely accepted in the industry. 

Climate change is a politically charged issue. The divergence between asset owners in their attitudes to the transition to a lower carbon economy is creating substantial climate-transition risk for asset managers. How they deal with it will be the crucial determinant of their engagement with companies in the carbon transition.

Gita R. Rao is on the faculty in the Finance Group at the MIT Sloan School of Management and associate faculty director of the MIT Sloan Master of Finance program.  

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