Passive net-zero fund: coal exclusion, proxy votes and lent shares
A €2bn global developed-market passive equity fund tracks a broad market index. The fund has a 2040 net-zero commitment and holds 0.9% in thermal coal miners and 4.2% in integrated oil and gas. The index provider's default voting policy abstains on most climate resolutions, but the fund's proxy adviser recommends for a resolution at an oil major that would require an annual transition-plan vote. The fund lends about 15% of its securities, and the largest oil holding is currently on loan. Trustees are split: some want immediate exclusion of all coal and oil, others fear tracking error and the loss of engagement access. The manager's three-person stewardship team engages 120 companies a year and reports under the UK Stewardship Code. A client has asked for a separate Paris-aligned share class. Current WACI is 145 tCO2e per $m revenue against 118 for the index, and financed-emissions coverage is 78%.
1. Advise on the coal and oil holdings: divest, engage or something in between? Set out criteria and how you would handle tracking error and the Paris-aligned request.
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- Coal and oil are not the same engagement case. Thermal coal miners face structural decline, limited transition optionality and weak engagement leverage; an exclusion policy with a revenue threshold is defensible and consistent with a 2040 net-zero commitment. Integrated oil majors have capital-allocation choices, transition plans and management access, so engagement can still change outcomes. Divesting them now would remove both the votes and the dialogue.
- Set criteria, not slogans. For oil: a transition plan with capex alignment, Scope 3 targets, a climate-competent board and a say-on-transition-plan mechanism. Escalate if milestones are missed over two to three years. For coal: exclude above a defined revenue threshold and disclose the threshold.
- Tracking error. Quantify it ex ante: the coal exclusion alone is small at 0.9%; excluding all oil and gas would be much larger. Offer the client a separate Paris-aligned share class using PAB-style exclusions (coal at any revenue share, oil above 10% of revenue, gas above 50%, power generation above 100 gCO2e/kWh) rather than converting the broad fund, which has a different mandate.
- Consistency. A net-zero commitment with no interim targets and no exclusion policy is not credible, but divestment is not a substitute for real-world emissions reduction. Combine exclusion, voting, engagement and policy advocacy, and report all four.
- Document the decision. Record why the fund retains oil exposure, what milestones apply and when the position will be reviewed.
2. How should the manager vote and handle securities lending on the oil major resolution?
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- Vote on the merits, not by default. The resolution asks for an annual transition-plan vote, a governance mechanism rather than a demand to stop producing oil. If it is framed as advisory and consistent with the company's own disclosures, voting for it is consistent with long-term value. Do not simply follow the proxy adviser, and do not simply adopt the index provider's abstention policy: the manager has discretion and should apply its own published policy.
- Securities lending. Recall the shares before the record date if the position is material to the vote. A 15% lending pool is normal, but the policy should specify automatic recall for material resolutions, who decides, and how the revenue trade-off is managed. Failing to recall can leave the manager unable to vote shares it is accountable for.
- Conflicts of interest. Lending revenue and client relationships can create pressure to abstain or to follow the index provider. Document the decision, the rationale and any conflict.
- Disclosure. Report the vote, the recall policy and the outcome in the stewardship report, and explain any abstention. If the manager abstains because the resolution is poorly drafted, say so and engage on the drafting instead, rather than hiding behind the index provider.
3. Design interim targets and reporting that reconcile the net-zero commitment with the passive mandate.
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- Use more than one metric. WACI (tCO2e per $m revenue) is sensitive to revenue and sector mix; absolute financed emissions (tCO2e, using EVIC and PCAF) capture size; coverage tells you whether the number is meaningful. Report all three with data-quality scores.
- Set interim targets that cannot be gamed. For example, a 2030 WACI reduction against a 2019 base, an absolute emissions reduction, a coverage target (say 90% of financed emissions by 2028) and a green/brown share indicator. A WACI fall caused by coverage falling or by a sector rally is not progress; explain the attribution.
- Reconcile with the passive mandate. The fund cannot choose the index, but it can choose the index provider, vote, engage and offer a Paris-aligned share class. Disclose tracking error, the exclusions applied in that share class, and the difference between the broad fund and the Paris-aligned version.
- Report to trustees and clients. Align with TCFD and ISSB S2 and the UK Stewardship Code: governance, strategy, risk management, metrics and targets, plus engagement and voting outcomes. Independent verification of the emissions data, and a clear statement of methodology and limitations, will do more for credibility than a single headline target.
- Governance. Assign responsibility for the targets to a named committee, review them annually, and explain any missed milestone rather than restating the baseline.