Exchange Traded Funds are directly financing fossil fuel companies at large scale

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Financial institutions with over $70 trillion in assets have pledged to achieve net zero portfolios and loanbooks by 2050, including meeting ambitious interim 2030 targets.

However, new research by the Oxford Sustainable Finance Programme reveals that passive funds not only hold fossil fuel assets, but directly finance them by buying large quantities of new bonds issued by fossil fuel companies.

To track and manage transactions that are channeling capital flows directly into fossil fuels, the Oxford researchers propose a new metric, Primary Market Carbon Exposure (PMCE). PMCE measures the proportion of securities bought in primary market transactions, for example shares at IPO or new bond issuance, from fossil fuel companies.

They find that between 2015 - 2020, 14% of the value of new bond issues bought by U.S. corporate bond Exchange Traded Funds (ETFs) were in fossil fuels.

For example, the largest bond ETF, the iShares Core U.S. Aggregate Bond ETF with $88 billion in assets, had a PMCE of 14% in corporate bonds, while the iShares iBoxx USD Investment Grade and High Yield ETFs, with $39 billion and $22 billion in assets, had PMCEs of 9% and 20% respectively. The researchers also apply this metric to ETFs bought by the US Federal Reserve in 2020, resulting in a PMCE of 13%.

During the Covid-19 crisis, in absolute terms, fossil fuel financing by the ETFs examined in the research - accounting for nearly half all of ETF US corporate bond holdings in terms of asset under management - increased sharply, by 72% year-on-year. While this is supported by AUM growth over that time period (+36%), this sharp increase demonstrates the ability of passive funds to provide capital on demand to carbon-intensive sectors.

"Climate conscious financial institutions need to be much better at tracking primary market transactions that directly support fossil fuel companies. It is when new bonds or shares are issued in primary markets and bought that capital actually flows from the financial system to the real economy. Financial institutions need to know how they are contributing to capital flows that could help or hinder tackling climate change," said Dr Ben Caldecott, co-author and Director of the Oxford Sustainable Finance Programme at the Smith School, Oxford University.

While passive funds such as ETFs may need to hold carbon-intensive assets to reduce tracking error relative to an index, ETFs have flexibility regarding which companies they finance in primary markets, providing scope to avoid financing carbon-intensive companies without credible transition plans.

Christian Wilson, lead author and a researcher at the Oxford Sustainable Finance Programme said, "Passive investors are channelling capital into fossil fuels. In response, policymakers should integrate metrics that track primary market capital flows into climate-related financial disclosures. Central banks should also consider how they contribute to climate change, with passive ETFs held by the Federal Reserve channelling 13% of new issue bond purchases into fossil fuels."