The rise of the big three: are institutional investors proactive environmental and social change agents?

BlackRock, State Street, and Vanguards' passively managed index funds currently hold nearly one-fifth of the S&P 500, earning their name as the "Big Three." This unprecedented rise spurs the question of how their voting power has impacted sustainable governance decisions and, consequently, carbon emission levels. This analysis explores (i) the rise in ownership by the Big Three, (ii) the pollution emitted by their portfolio firms by year, and (iii) how voting activity has been influenced by these three fund families. In general, my analysis finds that the Big Three are increasingly large shareholders of all public firms, that their voting in favor of environmental and social goals has gone up in recent years, and that this has been accompanied by a drop in average pollution emitted at their portfolio firms.

How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman ii. ABSTRACT BlackRock, State Street, and Vanguards' passively managed index funds currently hold nearly one-fifth of the S&P 500, earning their name as the “Big Three.” This unprecedented rise spurs the question of how their voting power has impacted sustainable governance decisions and, consequently, carbon emission levels. This analysis explores (i) the rise in ownership by the Big Three, (ii) the pollution emitted by their portfolio firms by year, and (iii) how voting activity has been influenced by these three fund families. In general, my analysis finds that the Big Three are increasingly large shareholders of all public firms, that their voting in favor of environmental and social goals has gone up in recent years, and that this has been accompanied by a drop in average pollution emitted at their portfolio firms. How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman iii. TABLE OF CONTENTS ABSTRACT 2 INTRODUCTION 1 Figure I. 2 LITERATURE REVIEW 3 THE BIG THREE’S IMPACT ON EMISSIONS EXIT VS. VOICE POTENTIAL DRAWBACKS 3 4 5 METHODS 6 RESULTS ANALYSIS A. Figure II. Figure III. ANALYSIS B. Figure IV. Figure V. 7 7 7 8 9 9 10 DISCUSSION 11 CONCLUSION 12 REFERENCES 13 How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman 1 INTRODUCTION In recent years, passively managed index funds have taken over an unprecedented amount of public company ownership. Unlike actively managed funds1 that aim to “beat the market2,” passively managed funds are typically tracked against a benchmark such as the S&P 5003, aiming to replicate market performance. The “Big Three” investment management companies BlackRock, State Street, and Vanguard are estimated to collectively own around one-fifth of the S&P 500. Their rising dominance in the market has raised many questions surrounding ethical agency and voting power4. Corporate leaders have expressed growing concerns over whether these funds are sufficiently monitored; while these funds are passively managed, they significantly impact corporate governance decisions. As passive index funds continue to take over a significant portion of corporate America, their impact has the potential to drastically change aspects of the global economy. Further, passive index funds have the potential to revolutionize the sustainable marketplace. A majority of current research on passive index funds in relation to sustainability take a negative stance on their growing popularity. Due to their growing voting power, most commentators worry that, given the possibility that the Big Three lack concern over environmental sustainability, they will use their voting power to avoid environmentally friendly resolutions. While this is a valid concern, the Big Three’s influence could also be used for good. Given the motives of altruism, ethical governance, effective marketing, meeting consumer/corporate demand, etc., these firms have significant reasons to support sustainability 1 An actively managed fund entails a manager or group that determines which investments are within a portfolio, a passively managed fund does not have a professional portfolio manager to do this. 2 “Beat the market” is a phrase referring to earning higher returns on a stock than the industry standard. 3 The S&P 500 is a stock market index consisting of 500 leading publicly traded companies within the United States. 4 Voting power is a shareholder right to vote on issues that can impact company revenue, performance, or governance. How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman 2 through their voting power. The Big Three have the potential to drastically reduce global emissions and further steps towards mitigating climate change. Encouraging these three firms to prioritize sustainability is arguably one of the most viable corporate solutions to the current climate crisis, as their influence could completely shift corporate governance. The introduction of passive index funds in the 1970’s made it far easier for investors to achieve returns parallel to a market index5 of their choice. Unlike actively managed funds that require a professional portfolio manager, index funds simply track their market index to monitor performance. Investors gravitate towards these funds because they entail less risk, less maintenance, and higher returns. In addition, index funds’ reputation to outperform active funds has made them preferable in comparison to other investing options. As a result of index funds’ growing popularity, the average fraction of shares of U.S. public firms held by the Big Three has increased from 2% to 10% within 12 years (figure I). Figure I. This nearly 8% increase sets a vast precedent for years to come, spurring questions around the Big Three’s corporate impact. As climate change has worsened, pressure on corporations has 5 Market indexes track the performance of a specific group of stocks. Examples of market indexes are: S&P 500, Dow Jones Industrial Average (DJIA), and Nasdaq Composite Index. How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman 3 intensified. Sustainability has risen to the forefront of conversations as quickly as the rise of the Big Three’s holdings. If these firms were to encourage innovative environmental solutions, they could potentially revolutionize corporate America. LITERATURE REVIEW All sources utilized are peer-reviewed financial articles. There is little research on the positive effects of the Big Three’s rise in holdings, however, the most similar source to this research is The Big Three And Corporate Carbon Emissions Around The World by Jose Azar et. al. All sources include a strong sustainability focus and contribute a unique perspective to this paper. THE BIG THREE’S IMPACT ON EMISSIONS The findings of Azar et al. in The Big Three and corporate carbon emissions around the world (2021) are parallel to this paper’s hypothesis. The biggest difference is the relevance of their data in comparison to the data utilized in this study; this paper will analyze emissions data extending until 2020. Another limitation is the potential flaws in Azar et al. findings and this paper; due to the COVID-19 pandemic spreading in 2020, it is difficult to measure the direct cause of the decrease in emissions. Another relevant work by Azar et al. is Anticompetitive Effects of Common Ownership (2018). This piece analyzes the idea that common ownership created by the Big Three’s dominance provides incentive for these firms to care about more than generating profit. This theory is important to consider when taking policy into account, as the Big Three’s impact may be another alternative to slow-acting or imperfect legislation. How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman 4 EXIT VS. VOICE Alex Edmans spurred the initial motivation for this project. His findings in Blockholders and Corporate Governance explored the lack of research on the impact investor voice or exit may have on a corporate social causes: …the absence of significant results may arise, not because activism does not create value, but because these studies cover blockholders whose expertise does not lie in activism or who face barriers to activism. Diversification requirements hinder mutual funds from acquiring the large positions needed to exercise control, and “prudent man” rules constrain pension funds from acquiring stakes in troubled firms in need of intervention” (Edmans, 2013, p.38). Edmans’ research is foundational to the perspective that investors should keep their stake in a company in order to create change. Similar to Edmans’ research, Impact investing is a fundamental part of this project as it relies on the ability of firms and corporations to create change. This research began with the idea of whether it is best to invest or divest in socially costly companies. The Impact of Impact Investing written by Berk et al. found the following: Given the ineffectiveness of divestiture, a natural question that arises is why investors engage in the strategy at all. One possibility is that investors either do not realize that the strategy is ineffective or derive utility from the strategy without regard to its effectiveness…Another possibility is that investors use the strategy to signal “good behavior” (Berk et al., 2021, p. 5). This idea that it is better to hold onto a share that one disagrees with in order to cause positive social change directly influenced this paper. This piece’s theories about voting power spurred How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman 5 the idea to analyze how passive investing may inspire social change, and how it may be a better alternative to active investing for this purpose. Another foundational piece for this project is Harstad’s theory on allocating money towards environmentally negative corporations/industries in order to gain control. Harstad used the hypothetical scenario that it would be better to purchase a coal mine and prevent it from functioning than to completely abstain from the fossil fuel industry in order to help the environment. This concept directly translates to the idea that it may be better for one to invest in environmentally unattractive corporations in order to spur change. Lastly, Exit vs. Voice by Broccardo et al. gives a thorough history of socially responsible investing, discussing its roots as far back as 1758. This work serves as a valuable resource for understanding the motives behind socially responsible finance. In addition, there are many scenarios provided that apply well to this research, including one in which boycotting was the chosen method of action for social change. While this research found that divesting was completely unhelpful, boycotting was slightly better; “Unlike for divestment, there is some evidence that consumer boycotts have an impact on the stock price of targeted companies…” (Broccardo et al., 2020, p.27). However, the conclusion of Broccardo’s research is that it is best for investors to use their voice and avoid divesting in order to motivate change. This conclusion directly suggests that the Big Three – who effectively cannot divest from stocks which are members of their index – must use their voice and engagement to govern portfolio firms. POTENTIAL DRAWBACKS Heath et al. provide a valuable reminder of the potential pitfalls the rise of the big three entails. While the idea of these firms drastically reducing carbon emissions is attractive, it is important to consider the possibility of their ownership wreaking havoc; “...we show that index How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman 6 funds monitor less than the active funds they are replacing. As a result, corporate governance gets worse” (Heath et al., 2021, p.37). This piece provides the argument that passively managed funds are not the most socially responsible option and that the rise of the big three is rather concerning. In addition, Heath et al. suggests that it could be potentially idealistic to rely on these three firms to drastically reduce carbon emissions. Levit et al. expands on how nearly all shareholder proposals are nonbinding and how because of this, many executives feel that they can ignore them. Despite this, stakeholders continue to submit proposals, which suggests that there must be some level of impact by doing so. The reason for this is likely that some stakeholders still falsely believe that submitting a proposal is the most effective way to convey their desires to corporate executives. “…nonbinding voting often fails to convey shareholder views and therefore is disregarded by the company’s management. Thus, shareholder proposals do not always play their advisory role for the management” (Levit et al., 2011, p.30). According to Levit et al., corporate executives are more driven to listen to shareholder proposals if they are aware of the threat of a proxy fight.6 The findings within this piece have implications for this paper as it suggests that standard votes by shareholders such as BlackRock, State Street, and Vanguard may not pose the type of threat that motivates firms to take proposals seriously. METHODS For my quantitative analysis, Data was provided by the David Eccles School of Business on the Big Three’s holdings per year, emissions per year by their portfolio firms, and fraction of yes votes on ESG (Environmental, Social, and Governance) initiatives. Data on the Big Three’s 6 A proxy fight refers to the act of a group of shareholders joining together in an attempt to gain enough votes to win a corporate decision. In other words, this happens when shareholders wish to out-vote senior leaders. How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman 7 holdings of different firms came from CRSP; Data on emissions by portfolio firms came from the EPA’s Toxic Release Inventory data7; Data on voting came from the ISS shareholder voting database. I used Python, a high-level programming language, for my data analysis. For Analysis A., I first imported the given data and extracted it so that I could see how much each individual firm was contributing before averaging their holdings. Second, I averaged the Big Three’s impact within each category, so that I could see how much the Big Three’s portfolio firms were contributing to environmental emissions collectively. Lastly, I compiled these findings into figures I, II, and II. Analysis A. could not provide proof that the Big Three has a direct correlation between their rise in ownership and a decrease in emissions. To address this limitation in Analysis B., I examined the given data used for Figure II. Upon sorting the data, Figures IV and V were made to demonstrate the influence of the Big Three on companies with more shares than average and less shares than average. RESULTS ANALYSIS A. Figure I, as presented within the introduction, demonstrates the preface for this research. It is evident that the Big Three’s fraction of holdings is increasing to shocking levels. However, as the Big Three’s holdings have risen, emissions have significantly dropped. As can be seen in figure II, both 2019 and 2020 show a drastic drop in emissions. 7 https://www.epa.gov/toxics-release-inventory-tri-program/tri-data-and-tools How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman 8 Figure II. While this finding is exciting, it should be noted that the pandemic significantly disrupted the economy during this period (i.e. in 2020). It cannot be concluded if this drop in emissions is directly attributed to the Big Three’s voting power, especially considering the all-time high in emissions output in 2018. Another aspect to consider in Figure II is that 2018 was the year the UN climate report released a warning that carbon emissions need to reach net-zero by 2030 in order to secure a sustainable and equitable future. “Without societal transformation and rapid implementation of ambitious greenhouse gas reduction measures, pathways to limiting warming to 1.5°C and achieving sustainable development will be exceedingly difficult, if not impossible, to achieve…” (IPCC, 2018). This report was jarring for the entire planet, especially corporate America. It’s possible that these new findings could have influenced the Big Three’s awareness surrounding sustainable governance and limiting emissions. Figure III shows a continuous increase in votes supporting ESG between the years of 2010 and 2020. How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman 9 Figure III. These findings may reflect the possible influence of the 2018 IPCC report. Regardless, the clear rise in ESG votes by the Big Three demonstrate an increased interest in sustainable development, which could be the product of many factors such as: new money in sustainable startups, good marketing for firms and corporations alike, and more progress towards environmental targets. Overall, the results of this analysis show that the Big Three could have a positive environmental impact. While their impact is not directly clear, Figure III shows a steady move towards ethical voting decisions. In addition, Figure II reveals that it is possible to drastically reduce emissions in a short amount of time, which could further motivate the Big Three to utilize their voting power to encourage sustainable governance. ANALYSIS B. After taking into consideration that there is a loose correlation between the rise in the Big Three and a drop in carbon emissions, an additional analysis was conducted. By sorting the data on emissions by portfolio firms from the EPA’s Toxic Release Inventory8, I was then able to analyze which firms were above or below the mean number of shares held by the Big Three. 8 https://www.epa.gov/toxics-release-inventory-tri-program/tri-data-and-tools How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman 10 Figure IV demonstrates how the firms with fewer shares held by the Big Three experience a similar drop in emissions to Figure II. Figure IV. However, Figure V demonstrates how the firms with more shares held by the big three have an increase in emissions. Figure V. How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman 11 This increase in emissions shows that, when the Big Three hold more shares of a firm, their emissions escalate. This directly contradicts this paper’s hypothesis, Analysis A.’s suggestive results, and Azar et al.s’ theory. Azar et al. were able to provide data analysis suggesting that the Big Three may be a positive force in sustainable change, however, their analysis did not prove a direct correlation; “...while suggestive, our evidence is not enough to demonstrate a causal effect of Big Three influence on corporate CO2 emissions. Further research is needed to establish such a causal link” (Azar et al., 2021, p. 692). This analysis is crucial to this research as it characterizes a large portion (Figure V) of the Big Three’s environmental impact as negative, even if their overall impact (Figure II) is positive. DISCUSSION One of the main limitations within this research is that the Big Three’s impact on the environment, as suggested in Figure II, has been smaller than what would be needed to make drastic change. While the sudden drop in emissions demonstrated in Figure II is impressive, the Big Three would need to demonstrate more of an impact to be certain that they could accelerate American sustainable development. In addition, it is not conclusive that the Big Three’s overall influence was the main motivation for emissions to fall in 2019 and 2020. Additional data on their portfolio firms’ emissions would be needed. Analysis B targets the idea that firms where the Big Three have more holdings will emit fewer carbon emissions. To explore this, the data of portfolio firms was split into two categories: 1. Firms that during 2018-2020 had very large holdings by the Big Three (perhaps because of index weighting) and 2. Firms that during 2018-2020 had relatively small holdings by the Big Three (again, perhaps because of index weighting). If the Big Three’s voting behavior was How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman 12 indeed the driving force behind the drop in emissions in Figure 2, then Group 1 firms (where the Big Three had larger holdings) should have a larger decrease in emissions relative to Group 2 firms. The findings in Analysis B directly contradict this hypothesis. In fact, Analysis B suggests that firms with fewer holdings by the Big Three emit fewer emissions. This directly addresses the impact of voting by the Big Three as well, as Analysis B suggests that the Big Three’s extensive voting power has an adverse impact on environmental issues. Despite the Big Three’s overall impact on emissions falling short, Levit et al. found that the Big 3's support for ESG proposals went up over the last 12 years, which is initially promising for their ability and dedication to make change. As per Levit et al. findings, the number of governance-related proposals has spiked to from 270 per year in 1997-2002 to 400 per year in 2003-2006. In addition, more voters are “for” supporting these proposals and tend to “withhold” support when directors are unresponsive to shareholders’ opinions. However, another limitation to consider is the impact of binding versus non-binding shareholder proposals. “The main difference of nonbinding voting from the conventional binding voting mechanism is that the vote tally does not, at least directly, determine the outcome. Instead, the manager has the discretion to decide whether or not to accept the proposal, even if the majority of shareholders support it” (Levit et al., 2011, p.30). Because executives are not obligated to accept nonbinding proposals, many choose to dismiss them unless there is the known threat of a proxy fight. Meaning, if a majority of shareholders are not on the same side as the proposer, it is highly unlikely management will enact the proposed change. How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman 13 The Big Three’s potential drawbacks are a necessary consideration. While it may be exciting to see rapid environmental change caused by these firms, there is also the potential for other areas of governance to fall short due to a lack of monitoring. This would include the need for proper research, ethical and reliable environmental solutions, and strategic allocation of funds. If the Big Three were to improve monitoring, however, their impact could be even greater than without thorough monitoring practices. CONCLUSION The findings of this research are important because of its ability to expand one’s perception of sustainable governance and ethical investing. In addition, it provides a potential solution to one of the world’s most pressing issues: climate change. The Big Three could be the innovative solution the world is looking for. In particular, the Common Ownership hypothesis has attracted attention in the last few years, and suggests that the Big Three might be uniquely placed to encourage policies that take broader considerations than just profits into account. “...in theory, common ownership can also have efficiency-enhancing effects” (Azar et al., 2018, p.39). Azar et al. acknowledge the idea that the Big Three could provide rapid and drastic change if the Big Three were to prioritize environmental wellbeing. The implications of this theory on this research could be revolutionary in terms of economic and sustainable development. It is recommended that the Big Three, government regulators, and corporate executives consider the findings of this research and find ways to incorporate this new perspective into their own solutions. The Big Three should consider voting for more sustainable solutions and aim to reduce their emissions further. Investors should take away the knowledge that divesting can be less effective in many circumstances, and that utilizing their voting power for good can create How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman positive change. The everyday consumer should acknowledge that the problem contains the solution, and that boycotting may not always lead to a desired outcome. As climate change becomes more pressing, the Big Three have the opportunity to set the example for sustainable governance. If these firms were to better support ESG initiatives, rapid and positive change could take place. 14 How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman 16 [V. Masson-Delmotte, P. Zhai, H. O. Pörtner, D. Roberts, J. Skea, P.R. Shukla, A. Pirani, W. Moufouma-Okia, C. Péan, R. Pidcock, S. Connors, J. B. R. Matthews, Y. Chen, X. Zhou, M. I. Gomis, E. Lonnoy, T. Maycock, M. Tignor, T. Waterfield (eds.)]. In Press. Azar, Schmalz, M. C., & Tecu, I. (2018). Anticompetitive Effects of Common Ownership. The Journal of Finance (New York), 73(4), 1513–1565. https://doi.org/10.1111/jofi.12698 How The Big Three Passive Index Funds Can Guide The World Towards Net-Zero Emissions - Rachel Kleinman Name of Candidate: Rachel Kleinman Date of Submission: 11/14/2022 17