Some of my Mercer colleagues and I recently participated in the United Nations Climate Change Conference of the Parties (COP 27), held in Sharm El-Sheikh, Egypt. Here are some observations on related investment opportunities and the context within which these present themselves that we hope will be useful to asset owners and fiduciaries.
For asset owners focused narrowly on risk and return, there appear to be two main families of investment opportunities associated with climate change.
- First, there are infrastructure projects, including in emerging and frontier economies, that appear to be net-present-value positive in terms of expected future cash flows, and related to which the host governments are trying hard to attract foreign direct investment and associated technology transfer and management knowhow. Many of these involve shifting power generation from more carbon intensive sources such as coal to less carbon intensive sources including renewables. Others are aimed at improving energy transmission and storage to leverage renewable power generation more effectively. One finding I took away from COP is that there is now renewable energy generation technology that is cost competitive, and a huge need for investment to migrate towards that.
- Second, there are a host of technological and other innovations in the clean technology and green technology space, related to which venture capital and early stage growth financing are needed. These span agriculture and building materials, as well as power generation, transmission and storage. The scientists and entrepreneurs that have developed these ideas are seeking management knowhow and help in getting to proof of revenue, proof of NOI, and then scaling their businesses. Besides traditional venture capital and private equity approaches, many of these entrepreneurs are actively interested in partnering with or even being acquired by an established player that can put their innovations into practice quickly, globally and at scale.
I’ve started this summary of observations with these two opportunities, and with a risk/return perspective, because that was the most optimistic part of my personal COP 27 experience.
In my opinion, the private sector, in partnership with donor and host governments, non-governmental organizations and other players that are concerned about climate change, is getting on with pursuing profitable business opportunities, regardless of the pace at which additional progress may be made by governments. As a by-product of this, we have seen progress is being made towards addressing the challenges of climate change.
If we were minded to be pessimistic, we would flag the following:
- First, the nationally-determined contributions (NDCs) of countries participating in COP 27 as relates to future emissions appear likely in aggregate to get us to 2.4 degrees Celsius or higher in global warming against pre-industrial norms, not the 1.5 degrees Celsius that is widely discussed as a goal. These NDCs did not improve by much in aggregate over the course of COP 27, and there is an open question as to whether many countries will actually be able to deliver on their commitments.
- Second, there is a lot of buzz about blended finance or catalytic finance as a mechanism to scale donor funds. The idea is that, rather than being granted or used separately, donor capital can be leveraged to attract private capital both by taking the “first loss” and by creating better alignment with host governments to mitigate the risk that “the rules change” after an investment is made. Near the end of COP 27, following some encouragement from donor governments coming out of the G20 discussions, there was an agreement to establish a Loss and Damage Fund.
For impact investors or values-based investors
Those that look beyond short-term investment risk and return – the same opportunities set out above for narrow risk/return-oriented investors are relevant, and are likely to be deemed even more attractive once a longer time horizon or more holistic lens is applied. Specifically, for impact investors, or any investor that adopts a Universal Shareholder perspective, there is likely to be recognition that both infrastructure investments and venture capital and early stage growth investments produce positive externalities. Especially in the developing world, more abundant and reliable energy generation, transmission and storage will help the broader economy and society – picture businesses, and also hospitals and schools, not having to deal so often with intermittent blackouts or brownouts. Technological innovation and entrepreneurial ventures produce innovation and learning that ultimately is captured by and benefits the broader economy, even when a specific venture fails commercially. I have sat with boards and c-suites of many large asset owners who would agree with a statement along the lines of “If we don’t collectively solve the challenge of climate change, nothing else we do will matter. Whether our assets are set aside to pay retirement benefits, serve as a store of national wealth, or for some other purpose, we can’t achieve that purpose with any investment return, if climate change remains unabated”. I believe impact and values-based investors are likely to give significant weight to the two types of investment opportunities I’ve profiled, beyond their attractiveness to investors that purport to be focused narrowly on risk and return.
So, what about “Net Zero” commitments at the asset owner or investment strategy level?
I heard four main lines of discussion around “Net Zero” commitments at COP 27:
- First, operating companies in the emerging markets are adopted global account standards for emissions and other ESG reporting because they want to be included in the supply chains of multinationals. As supply chain resiliency gets focus post-COVID, and as reporting improves, these entities aren’t waiting for pressure from their shareholders. They are moving to adopt the reporting frameworks because that is required by their customers. They are looking past the B2B relationships in their supply chain to end consumers, and recognizing demand for strong ESG credentials as a precondition to being included.
- Second, there is a lot of concern expressed by more sophisticated parties around not “exporting emissions”. This is often put in terms of “We need net zero in the real economy, globally, not in one portfolio or one strategy”.
- Third, while the jury is still out on whether net zero commitments are driving a meaningful difference in the cost of equity capital, there is growing consensus that for debt financing of companies in the emerging markets, a strong and credible ESG plan backed by commitments is already important as a determinant of cost of capital.
- Last, measurement remains a challenge, especially in the emerging and frontier markets. But, there is a sense that measurement will get better over time, and that nobody who is interested in this space should “wait on” better measurement.
So, my take on this is that net zero commitments by values-based investors and others is having important impacts already on the real economy, in conjunction with consumer preferences for strong ESG credentials, even if these commitments remain non-uniform in adoption
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