BlackRock’s recent statement that it is engaging with palm oil companies to better understand the industry’s challenges related to biodiversity and deforestation marked the first public acknowledgement from the firm of ESG risks associated with this sector. “Our engagements were part of an ongoing, multi-year effort to further our understanding of, and encourage companies to better address, the environmental and social risks associated with the palm oil industry,” the company’s stewardship department said. Despite its acknowledgment of palm oil’s connection to various ESG issues, BlackRock, the world’s largest asset manager with USD 6.5 trillion under management and the top ETF provider, did not articulate a specific vision on how to address the myriad risks that investors in the palm oil sector face going forward. With investor money predominantly gravitating to BlackRock’s passive funds, the company’s engagement with the palm oil industry underscores the limitations of passive funds integrating ESG criteria and accelerating sector-wide advances in sustainability.

In recent decades, there has been a rapid shift from active to passive funds in search of lower costs and the ability to match major market indexes. In the United States, for instance, passive funds account for approximately 48 percent of the stock market, an increase from about 25 percent 10 years ago. This change has prompted questions about the effectiveness of passive investors’ influence on mitigating climate risks. Index providers are third-party actors that establish what stocks will make up an index, and investors hold shares in all of the companies in the index. Therefore, they cannot divest from companies in a fund even if they are performing poorly financially, have not integrated robust ESG policies, or contradict an investors’ ethics. Proper ESG integration requires “active portfolio management, active risk management and active performance evaluation techniques” to take into account inconsistent data and transparency, react quickly to headline risks, incorporate new metrics, and avoid heavy concentration in one sector.

BlackRock’s agricultural holdings

Given its large holdings in the palm oil sector and agricultural commodities in general, BlackRock’s statement is unlikely to quell any criticism of its lack of action on climate. A campaign called Blackrock’s Big Problem, jointly run by the Sierra Club, Friends of the Earth, Amazon Watch, the Sunrise Project, and Divest Invest Network, highlights BlackRock’s holdings in the fossil fuel and agriculture industries. BlackRock first acknowledged deforestation as a climate risk in 2016, but has not articulated a specific, time-bound policy to target zero deforestation. In a recent report on investors under-appreciating climate risks in their portfolios, BlackRock did not mention deforestation, despite it accounting for 15 percent of global greenhouse gas emissions.

BlackRock has engaged with seven palm oil companies — three in Indonesia, two in Malaysia, one in Korea, and one in Liberia, but its overall holdings in palm oil include USD 561 million in 44 companies. The bank has also come under scrutiny for its holdings in Brazil, where deforestation has been on the rise since 2012. BlackRock owns shares in major players in Brazil such as soy traders Bunge (8.8 million shares, 3^rd largest shareholder) and ADM (42.3 million, 3^rd largest), and meat producers JBS (58.1 million, 6^th largest), Marfrig (5.8 million, 10^th largest), and Minerva (945,000, 27^th largest).

Passive funds to offer more ‘sustainable’ products

Managers of passive funds are likely to become more creative in addressing climate risks by excluding certain stocks and incorporating more rigorous ESG analysis. BlackRock’s CEO, Larry Fink, said that within five years, all investors will incorporate ESG metrics. With passive funds, shareholders can still vote and engage management, and index providers can develop new products that are “sustainable” funds. There are, however, limitations to these approaches. For instance, with BlackRock, in 2018, only 2.5 percent of its funds were labeled sustainable and the firm voted in favor of just 10 percent of climate-related shareholder proposals. Still, BlackRock has shown progress in negative screening that could become mainstream for the company across fossil fuel and agricultural companies. BlackRock introduced six new funds in Europe last year that automatically screened out thermal coal and tar sands. As Blackrock’s Big Problem notes, “With its European offerings, BlackRock has proven that it can apply more rigorous screens without compromising performance and attract investors who want cleaner and more responsible investment options.”

Filters and screens, however, can impact costs, and low costs make passive funds attractive to investors. The more screens and filters that are applied, the higher the costs, reducing the competitive advantage of passive funds.

Other asset managers that dominate the passive fund market, such as Vanguard, Fidelity, and JPMorgan, have also come under scrutiny for their agricultural holdings. As ESG investing grows and investors seek to mitigate climate risks, these firms will likely grapple with the same challenges that BlackRock acknowledged in its recent palm oil statement.