Flying blind in climate change investing
The lack of empirical evidence on the performance of low carbon infrastructure and clean tech is acting as a brake on private sector investment – that needs to change, quickly
Last month, thousands of schoolchildren across the globe walked out of classes in protest against a lack of action by politicians in halting climate change. As climate activist Greta Thunberg put it: “our house is on fire” and action needs to be taken now. The main focus of anger so far has been elected representatives, but with governments facing budget constraints, it’s the private sector that will make or break the Paris Agreement. So why have investors so far failed to put in the capital required?
Green investment in the form of low carbon infrastructure and clean energy has experienced a steady rise in investor interest over the past decade. New investors such as pension funds, private equity funds, sovereign wealth funds and insurance companies have initiated allocations to this relatively new alternative asset class. For example, Norway’s sovereign wealth fund doubled its maximum allocation to renewable energy infrastructure only a few days ago. This increase has helped drive the rapid growth in renewable energy adoption, with renewable electricity generation increasing worldwide by more than 185 per cent from 2010 to 2017, and $280 billion being invested into clean energy technologies in 2017.
Why are we locked in a seemingly endless loop of soundbites about the need to scale up finance to meet the Paris Agreement targets?
This is complimented by a push from major European politicians to meet the Paris Agreement’s 2°C target. The German Chancellor, Angela Merkel, stated in 2017 that “climate change is an issue determining our destiny as mankind”, while the French President, Emmanuel Macron, has been keen to highlight the need to “act together to foster innovation, boost transformative projects, gather public and private investments, and deliver on our promises for the next generations”.
With this political and societal pressure to tackle the problem of climate change, the obvious question is where’s money? Why are we locked in a seemingly endless loop of soundbites about the need to scale up finance to meet the Paris Agreement targets?
Our research suggests the lack of empirical evidence on the performance of this novel “asset class” is one of the main barriers to investors increasing their exposure to the low carbon theme. Empirical studies of the investment characteristics of this low carbon and climate-resilient infrastructure are severely limited in both quantity and quality. Of the evidence-based analysis that does exist, most has been done to assess risk-adjusted performance and portfolio diversification benefits of listed securities. Financial returns in private markets and among state-owned enterprises (where much of the action needs to be) is a data black hole. To date, only a few studies on unlisted low carbon infrastructure have been carried out, resulting in highly fragmented results.
It is vital to reach a sound understanding of the roles of investment actors and sources of finance
This is a particular problem within the renewable infrastructure sector. It is estimated that 70 per cent of the investable market for renewable infrastructure built between 2018 and 2030 will be away from the public markets. The absence of a clear benchmark for measuring investment performance is seen by many as one of the main barriers to investors increasing their exposure to low carbon infrastructure and clean tech.
Key questions going forward
Our research agenda at the Centre for Climate Finance & Investment is driven by a recognition that huge volumes of private sector capital will not flow to low carbon and clean tech until the historical track record for investors is made clearer. But that will not be enough. Investors face an unprecedented level of uncertainty about the size and shape of the global energy sector going forward. So, the work of capital markets researchers seeking to support the energy transition must address the following key questions:
- What are the major risks in low carbon infrastructure investment and how should these risks be priced into the cost of capital?
- What constraints do different players in the private sector (corporates, banks and institutional investors) and the public sector (development banks and finance institutions) face?
- What is the depth and breadth of the low carbon infrastructure market? What are the instruments (debt/equity) and vehicles (corporate/banks/funds) that can deliver the required volume of low carbon infrastructure finance?
- How does the systemic and idiosyncratic risk exposure of low carbon infrastructure compare to the market portfolio? In what contexts are low carbon infrastructure investments low beta investment and in which contexts are they high beta?
- For institutional investors, what is the potential role of low carbon infrastructure in a liability-driven investment context? What are the inflation hedging properties of low carbon infrastructure? What about deflation protection?
- How should investors incorporate physical and transitional risk into their sustainable investing mandates?
To scale up private investment in climate-positive infrastructure, it is vital to reach a sound understanding of the roles of investment actors and sources of finance. This includes the differences between traditional actors such as utilities and commercial banks, and non-traditional ones such as institutional investors and private equity funds. Understanding the appetites and needs of these actors in terms of risk and liquidity in investments, and their capacity to finance potentially complex and large-scale infrastructure assets, is key to delivering the financing required.
As for those striking schoolchildren, let’s hope at least one or two grow up to become high-performing (climate) fund managers. The world will most definitely need them.