working paper

Beyond Net Zero

How To Mobilize Passive Investing towards Paris Alignment with a Focus on the United States

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1. Introduction

Governments, regulators, companies, and investors have prioritized achieving the targets of the 2015 Paris Agreement. To achieve the agreement’s goal of limiting global warming to well below 2°C and pursuing efforts to limit it to 1.5°C, all actors in the global political and economic system will need to be involved, including the private finance sector (UNFCCC 2015).

Sustainable investing in the private finance sector has exploded during the past decade, increasing from US$13.6 trillion of assets under management (AUM) in 2011 to $35.3 trillion AUM in 2020 in key economies (GSIA 2012, 2021). The increasing popularity has facilitated the product development of different investment strategies, including environment, social, and governance (ESG); impact; sustainable thematic; and socially responsible investing (O’Dwyer 2021). Although these strategies vary in terms of asset class and investment thesis, this working paper targets one of the largest investment products in the market: passive index-tracking public equity funds.

Passive equity funds have grown in popularity in the United States over the last decade, with $6.2 trillion AUM at the end of 2020, or $0.9 trillion more than U.S. active equity funds (Bloomberg Intelligence 2021). Passive products have gained market share from 42 percent in 2015 to 54 percent in 2020 because of the wide acceptance of the efficient market hypothesis, the relatively lower costs, and the evidence of underperformance of active managers (Anadu et al. 2020; Bloomberg Intelligence 2021). However, of the U.S. passive equity funds, only $48.6 billion AUM, or less than 1 percent, consider ESG factors and criteria to align with the Paris Agreement (Bryan et al. 2020). Most funds merely reflect the market segments around which they are built, with no consideration for ESG factors or criteria to align with the Paris Agreement.

Creating affordable, Paris-aligned passive investment products that consider material ESG factors and climate risks will shift capital toward a Paris-aligned future and can provide better risk-adjusted returns for investors, including people saving for their retirement. More than $1.5 trillion in passive equity assets are owned by U.S. defined-benefit and defined-contribution retirement plans (Walker 2019). However, less than 3 percent of 401(k) plans—a major type of defined contribution plan in the United States—offer an ESG fund, and only 0.1 percent of total plan assets are in those funds (Wall Street Journal 2021). Although retirement plans are not required to consider climate change or ESG factors as part of the investment process, there is growing evidence that passive ESG and fossil-free funds do not have financial trade-off in the returns of their traditional non-ESG counterparts and may outperform (Belsom and Lake 2021; Bullard 2020; Morgan Stanley 2019; Whelan et al. 2021; Zhou et al. 2020).

This working paper provides a framework for Paris-aligned passive investing, which currently lacks a standard market definition. Section 2 presents the context for sustainable investing products, their opportunities, and the challenges in the United States. Section 3 then describes the approach of developing the Paris-aligned framework and data for analyzing a small sample of sustainable funds. In Section 4, we use the approach and data to analyze the performance of these funds against the framework, and Sections 5 and 6 discuss the key takeaways, implications, and recommendations.

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