Planet Tracker calls on ETF providers to avoid deforestation risk
Not for profit organisation Planet Tracker has launched a blistering call to arms naming the seven companies that it says are critical to tackling ETF deforestation risk.
The firm writes that with the ETF universe indirectly and often unknowingly enabling deforestation, a handful of institutions controlling the majority of the ETF and index markets holds significant power of change.
John Willis, Director of Research at Planet Tracker explains that his organisation is a sister organisation to Carbon Tracker, which looks for stranded assets in the energy market.
“We are trying to effect change on planetary boundaries on natural capital or nature,” Willis says. “But we are very focused on the financial markets so we attempt to be the intersection of natural capital and the capital markets and to write the research that financial markets would find interesting.”
The organisation has observed that the ETF industry is growing very quickly, writing: ETFs are booming, synthetic ETFs are resurfacing, and semi-transparent ETFs have recently emerged – but their structures hide entrenched deforestation risk from investors.”
Their report identifies the key decisionmakers for each instrument in the growing ETF universe and calls for specific actions from index providers, ETF sponsors, fund managers and investors to eliminate hidden deforestation risk in their holdings or indices.
“Deforestation represents a significantly encroaching environmental and financial risk for global capital markets. Indeed, commodity-driven deforestation and agriculture are the primary causes behind tree cover loss in deforestation hotspots, such as Brazil, Indonesia and the Democratic Republic of Congo – and at the current rate of deforestation, all of the world’s forests could disappear in 100 years.”
Willis comments that ETFs based on synthetics are potentially equally to blame for hidden deforestation risks.
“Synthetics allow you to hide more and there is an innocence about this,” he says. “A physical S&P 500 might hold armaments or deforestation companies but with a synthetic, you have no idea who the counterparty is. What we want to achieve is for people to be thinking about what they are buying and being informed about the potential risks that could be involved.”
Willis likens the purchasing moment as equivalent to buying a cigarette whose packet has a clear warning on it. “What is unacceptable is for the ETF providers to say ‘it’s not our fault – it’s the index provider’. That doesn’t get you off the hook as an ETF provider as you are a major customer.”
Willis says that some providers have moved away from the traditional index providers and gone to bespoke indices that better represent their investors’ requirements.
The report analyses 26 public companies involved in soybean production, processing and with links to deforestation. This report identifies USD 9.3 billion held by equity-based ETFs in these companies, with the top 10 asset managers exposed including Bank of Montreal, Bank of America, Morgan Stanley, BlackRock, Goldman Sachs, Wells Fargo, UBS, Envestnet and Northwestern Mutual.
The organisation writes that while some mutual funds are committing to address deforestation risk, the ETF universe is a different story. “A USD6.7 trillion market which has grown an average 24 per cent per year since 2003, ETFs offer liquid, cost and capital gains-efficient investment products for investors to access a portfolio of underlying companies or track an index. Despite the market’s rising share and significance, ETF sponsors to date have not acted on sustainability statements by structuring instruments to explicitly exclude deforestation-linked equities.
“In particular, the structure of synthetic ETFs leaves investors unable to determine the underlying derivatives used to replicate the ETF-tracked index, exposed to counterparty risk, and with no voting powers to address deforestation risk themselves. Semi-transparent ETFs, too, create a transparency barrier, theoretically allowing asset managers to own shares of a deforestation-linked company without disclosing the fact at the time.”
The growth of these segments of the ETF market, says Planet Tracker, means the ETFs and their investors identified in its report indirectly enable deforestation through investing in indices holding 380 publicly listed deforestation-linked companies.
According to the report, however, the concentration in the ETF and index industries means seven companies have the power to dramatically remediate deforestation risk in the ETF market. BlackRock (iShares), Vanguard and State Street Global Advisors on the one hand, and MSCI, FTSE Russell, S&P Dow Jones and Bloomberg on the other, together have disproportionate power to mitigate deforestation risk (as well as other natural capital risks) in the ETF market, as they control approximately 70 per cent and 60 per cent of the ETF and index markets, respectively, the organisation writes.
“The onus is on these companies, then, to use their individual powers of engagement to ensure that deforestation risk associated with one or several companies is not artificially distributed to the wider financial system.”
The paper calls for ETF sponsors and index providers to issue a public pledge committing to reduce deforestation risk in their holdings or indices.
It also lists a number of specific actions for the ETF industry, aimed at active ETF sponsors, urging them to: Issue their own ETFs which exclude deforestation linked equities; Disclose and publicly label the proportion of holdings that incorporate deforestation assets within qualifying instruments; Publish policies and processes demonstrating that environmental-related issues such as deforestation are factored into the design of ETF products; Vote in favour of corporate shareholder resolutions addressing deforestation activities, risks or exposures and exert stewardship pressure on index providers to design indices excluding stocks linked to deforestation.
For passive ETF sponsors, the organisation urges them to disclose and publicly label the proportion of holdings that incorporate deforestation assets; Vote in favour of corporate shareholder resolutions addressing deforestation activities, risks or exposures; Exert stewardship pressure on index providers to design indices excluding stocks linked to deforestation.
Planet Tracker says that failing that, passive ETF sponsors could issue their own ETFs which exclude deforestation linked equities. “This could be achieved by mirroring performance using synthetic structures.”
For index providers, Planet Tracker urges them to disclose the proportion of indices that incorporate deforestation assets; Work with ETF sponsors towards the exclusion of deforestation-linked companies in indices and launch deforestation-free indices.
The paper also recommends actions for investors, including engaging ETF sponsors to target a fast reduction of that proportion across their investment portfolios; Publicly disclosing and labelling deforestation risk products or using tools such as Deforestation Free Funds to check the proportion of the ETF holding that incorporates deforestation risk.
Importantly, the report points out, the same principle applies to all natural capital risks (whereby the degradation of natural resources leads to a financial impact) within ETF portfolios.