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Keeping Promises? Mutual Funds’ Investment Objectives and Impact of Carbon Risk Disclosures

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Abstract

In response to Morningstar’s release of carbon risk (CR) scores in May 2018, (environmentally) sustainable mutual funds in the U.S. showed a greater reduction in their portfolio CR relative to conventional funds. The observed causal impact of this third-party disclosure is consistent with the funds’ primary investment objectives. Differences in fund names, potentially driven by marketing considerations, appear irrelevant to the behavior of sustainable funds. Conventional funds that are signatories to the UN’s Principles for Responsible Investment (PRI) or those with secondary sustainability mandates behave more like other conventional funds rather than sustainable funds. These funds appear relatively insensitive to disclosures as their sustainability considerations are superseded by other primary investment criteria. Fiduciary and legal bonding influences fund managers’ response to sustainability disclosures. Sustainable funds lower their CR score by reducing exposure to fossil fuels, not by increasing exposure to renewables.

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Notes

  1. Mutual funds are mandated by the U.S. SEC to detail their primary investment objectives and investment strategies in their fund prospectuses (Form S-1). Violation of the stated objectives and strategies constitutes a breach of contract and fiduciary duty that could result in litigation. For example, in 2015, the U.S. appeals court reinstated a class action lawsuit against Charles Schwab Corporation as the managers of the Schwab Total Bond Market Fund failed to adhere to the fund’s fundamental investment objectives of tracking the Lehman Brothers U.S. Aggregating Bond Index and not over-concentrating its investments in any one industry (Stempel, 2015). The portfolio managers were accused of investing more than 25% of the assets in non-agency mortgage securities and collateralized mortgage obligations causing the fund to lag behind its benchmark.

  2. While sustainable funds may also pursue other ESG criteria, our definition of “sustainable funds” only reflects the consideration of environmental criteria as our study focuses on CR scores, an important metric for gauging environmental performance. Morningstar’s data is widely disseminated and used by investment advisors, wealth managers, and various investment websites. Thus, it would be reasonable to expect the mutual fund industry to be cognizant of them. Morningstar is the only widely available public (free to view) source of data on mutual funds’ sustainability profiles to date. Fund managers that fear breaching any fiduciary duty to their investors and/or want to focus on climate sensitive investor clientele are likely to be sensitive to the CR release. Morningstar calculated CR scores using Sustainalytics carbon risk stock specific scores that were released simultaneously.

  3. While sustainability criteria are broader and include environmental, social, and governance (ESG) criteria, we focus exclusively on the consideration of environmental sustainability criteria as they are consequential for funds’ carbon risk scores.

  4. While we control for funds’ prior returns, given our ability to observe funds’ primary investment objectives, we abstain from linking past returns to inferring potential “green-washing” behavior. While one may argue that under-performing funds with secondary sustainability mandates may be green washing to attract fund flows, it could be argued that these fund managers are incentivized to pursue other investment criteria more aggressively to improve their fund performance as their fund flows are unlikely to be driven primarily by “green” clientele.

  5. The analysis surrounding the third-party CR disclosure can be viewed as the initiation of a tournament. The interplay between the two dimensions (sustainability and returns) from a repeated tournament perspective is beyond the objective and scope of this study. Exploring this potential future avenue for research would require an analysis of inter-temporal changes in asset allocation confined to an extended post-disclosure period.

  6. We provide evidence for this in our analyses.

  7. Hale (2018) mentions that carbon footprinting (i.e., measuring greenhouse gas-GHG emissions attributable to holdings) suffers from several shortcomings. GHG emissions may be incomplete, inaccurate, or independently unverifiable. Also, footprinting does not typically measure indirect emissions that occur in the upstream and downstream value chain (i.e., Scope 3 emissions). While carbon footprinting is a good starting point for measuring the magnitude of carbon risk, it fails to consider the financial materiality of a company's carbon risk exposure or its mitigation strategy. Morningstar’s carbon risk scores consider both exposure and management of carbon risks and, as such, evaluates the degree to which a company’s economic value is at risk in the transition to a low carbon economy.

  8. Morningstar considers companies to be involved in fossil fuels if they derive at least an aggregate 5% share of total revenue from the following activities: thermal coal extraction, thermal coal power generation, oil and gas production, and oil and gas power generation. Companies deriving at least 50% of their revenue from oil and gas products and services are also considered to have fossil fuel involvement.

  9. \({Flow}_{i,t}={TNA}_{i,t}-{TNA}_{i,t-1}(1+{Ret}_{i,t})\).

  10. Our empirical design follows the prior literature. To investigate whether increased transparency increases myopic corporate investment behavior, Agarwal et al. (2018) use a difference-in-differences design around a regulatory shock that increased the transparency of fund managers’ portfolio choices. They define treatment (control) firms as firms with high (low) ownership by funds impacted by the regulation.

  11. To further verify the parallel trends assumption for our difference-in-difference empirical design, we use the following extended version of Eq. 1: $${CR}_{i,t}= \sum _{J=2}^{4}{\beta }_{Pre,-J} {D}_{Pre,-J}+\sum _{J=1}^{4}{\beta }_{Post,J} {D}_{Post,J}  +\gamma {Sust}_{i}+ \vartheta T+\mathrm{\Gamma }\mathrm{{\rm X}}+{\varepsilon }_{i,t}$$, where T refers to a vector of time dummies, X refers to a vector of control variables, and D is the interaction of Sust dummy with a time dummy for each quarter. The reference period for the interaction dummies, D, is the first quarter prior to disclosure without any potential information leakage (i.e., last quarter of 2017 that can be denoted as Pre,-1 subscript) and has been dropped. With the minor exception of $${D}_{t-4}$$, we find that the coefficient for $${D}_{t-3}$$ and $${D}_{t-2}$$ are statistically insignificantly different from zero implying that the interaction terms pre-disclosure are no different from each other. This confirms the parallel trends assumption for the difference-in-difference research design. As a reconfirmation of the general trend observed during the post-disclosure period (captured by the negative coefficient for Sust*Post dummy in Eq. 1), we find that the interaction terms denoted by $${D}_{Post,J}$$ are all significantly negative with the minor exception of $${D}_{Post,+2}$$ as negative, but statistically insignificant. We also successfully verify parallel trends for our main propensity score matched sample analyzed in Column 1 of Table 5.

  12. The results for this test have not been reported to conserve space and are available upon request. The negative coefficient for sustainable funds in the randomization test is consistent with the investment objectives of sustainable funds. Also, the post dummy for the random release specification illustrates that there is a trend toward lowering carbon risk, irrespective of any disclosures.

  13. Given the nature and construction of the CR scores, any activism/engagement role is unlikely to be reflected in the carbon risk scores during the short duration of our study. Morningstar only identified about 19 funds of 98 sustainable funds that actively engage on ESG issues. If sustainable funds engage more actively in activism than conventional funds, our results regarding the relevance of disclosures in relation to sustainable funds are perhaps understated. Funds that mention engaging on ESG issues often simultaneously screen for ESG criteria while investing. As such, the relevance/intensity of activism is hard to gauge from the fund documents.

  14. We have a tight match with the difference between the propensity score for our quasi-treatment group (i.e., sustainable funds) vs. our quasi-control group (i.e., conventional funds) as almost zero, on average, across all quarters. Our results are also robust to identifying matches by conducting propensity score matches for each sustainable fund every quarter.

  15. PRI signatory commitments are signed at the asset manager (i.e., fund family) level as opposed to the individual fund level. Unless there is consensus among all fund managers within a fund family, being a PRI signatory may not be a consideration. Platforms that provide information on mutual funds to investors do not display any indication of the fund family as a signatory to UN-PRI. Information on being a PRI signatory is available on the PRI website, but it is the funds themselves that determine whether they should advertise their status. Since sustainable funds are already able to attract a clientele with a strong preference for sustainability, being a PRI signatory may have little relevance. As insiders in the industry, mutual fund managers likely know what their colleagues/competitors are doing. Sustainable funds likely suspect/ that a signatory maybe associated with greenwashing and therefore prefer to bond themselves to sustainability in more legally binding ways.

  16. By specification, conventional non-signatory funds are the reference category. Sust_PRI (Sust_NotPRI) takes a value of one for sustainable funds belonging to fund families that are (not) PRI signatories and zero otherwise. Conv_PRI (Conv_NotPRI) takes a value of one for conventional funds belonging to fund families that are (not) PRI signatories and zero otherwise.

  17. Recent studies suggest limited engagement by institutional investors that are UN-PRI signatories. Dyck et al. (2019) find that U.S. domiciled PRI signatories do not engage companies on ESG issues. Gibson et al. (2021) confirm that PRI signatories that do not incorporate ESG considerations in portfolio construction also engage less with their portfolio companies on ESG issues.

  18. We manually checked fund names and excluded certain matches unrelated to sustainability, such as sustainable momentum, social media, green owl, or green square. Inclusion of sustainable related terms is more prevalent for fund families that offer ESG funds as one-off funds. Many asset managers incorporate ESG considerations across all of their fund offerings and choose not to include related language in the names of each of their funds. For example, Calvert Research and Management, a part of Morgan Stanley Investment Management, offers funds without any sustainability related terms in their fund names as the entire fund family has long been associated with responsible investment strategies. Another example is the Praxis Growth Fund that specially mentions that all investments will be screened for environmental, social, and governance (“ESG”) practices in line with their stewardship practices.

  19. Fund families identified as sustainability specialists in our sample include the following: Aspiration Fund Adviser, Boston Common Asset Management, Boston Trust Walden, Calvert Research and Management, Green Century Capital Management, Parnassus Investments, Impax Asset Management, Saturna Capital, and Serenity Shares Investments.

  20. For details regarding the definition of fossil fuel involvement, refer to Footnote 2. We define renewable energy to include products and services that support power generation from renewable energy sources. Renewable energy refers to energy derived from sources that are continuously replaced, such as solar power, wind, hydropower, biomass, geothermal, or wave energy. It does not include fossil fuels or waste-related products from fossil fuel sources. Green transportation includes green transportation vehicle production, green transportation services, green transportation infrastructure, or technologies/services used to manufacture green transportation vehicles that are based on waste-recovery energy, rather than fossil fuel sources.

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Acknowledgement

This research was supported by the Katie School of Insurance and Risk Management at Illinois State University.

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  1. University of Alaska Anchorage, Anchorage, USA

    John R. Nofsinger

  2. Illinois State University, Normal, USA

    Abhishek Varma

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Correspondence to John R. Nofsinger.

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Nofsinger, J.R., Varma, A. Keeping Promises? Mutual Funds’ Investment Objectives and Impact of Carbon Risk Disclosures. J Bus Ethics 187, 493–516 (2023). https://doi.org/10.1007/s10551-022-05264-1

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