We take a deep dive as why institutional investors are not set up for climate investing (part 1), why retail investors are better suited (part 2), and the impact for the transformation of the industry (part 3).
Institutional investors are not set up for the long-term horizon.
You may have heard the backlash that happened after Stuart Kirk, HSBC’s head of Responsible Investment, outlined “why investors need not worry about climate risk” during an FT conference (link here). Commentators have called him “irresponsible”, “amoral”, or “a representation of HSBC's cynical culture”. Yet, his main point is correct (setting aside his optimism about humanity solving climate change): current financial institutions are not incentivized to seriously consider climate change.
“HSBC average loan length is 6 years” mentions Kirk in his speech. Indeed, most financial institutions are set up or have their products set up on a short to medium-term horizon. Bank loans for small businesses in the US are usually between 3 to 10 years and the average corporate bond maturity is 12.4 years (OECD). They need to price risk per these time horizons.
Similarly, VC or PE funds, funding engines for growing businesses, have to return money to investors in an 8 to 10-year horizon (close-ended funds). In comparison to climate change effects, this means they need to bet on companies that are likely to succeed tomorrow. To mitigate this ‘tragedy of the horizon’ (Mark Carney), there has been a recent uptick in open-ended or evergreen funds, funds with no end date. Yet, those are insignificant compared to the rest of the industry.
Even the largest asset managers which could be incentivized to think in the longer term (BlackRock, Fidelity, State Street,…) have other perverse incentives hampering them:
- First, they are closely knit with the companies they invest in. Institutional investors usually have business ties with S&P 500 companies through retirement plans and are more likely to vote in favor of management the greater the relationship is (Davis & Kim)
- Second, large institutional investors have limited interest to act. Most of their products are passive indexes. They are only following the market and get the same fee whether the market goes up or down. There is no incentive to engage with companies in better governance or greater integration of climate risks. As Barzuza, Curtis, & Webber put it: “It is striking that firms that each hold more than seventeen thousand portfolio companies and control 20 percent of the S&P 500 have fewer than one hundred individuals charged with dealing with corporate governance issues at those companies.” (link to paper).
Because of these elements, Stuart Kirk’s speech resonates more as a warning than cynicism or climate denial. Current incentive structures, poorly fit regulatory environment, and discrepancies in time horizons are curtailing institutional investors from radically shifting their strategies, leaving ESG investing as a marketing tool to its stakeholders: clients, regulators, and employees.
Sign-up to stay up to date.