Investing in climate change: Private markets key to real impact

We see the headlines all the time. Frequent floods, increased droughts – the drastic consequences of climate change for the natural world are evident. Unchecked though, climate change could trigger a matrix of interlinked risks that cascade into every community on the planet, and emerging markets are most at risk.

Schroders has written extensively on five major trends that we expect to shape the medium-term investment outlook, referred to collectively as “regime shift”.

One of these five trends is to see the global response to climate change accelerate materially in the next seven years. Countries are likely to rapidly step up the decarbonisation of power generation particularly, as emissions need to fall by more than 40% as a vital interim step toward net zero by 2050.

The shift to net zero emissions represents a new key structural trend for the global economy, calling for a radical change in the energy system and in other important sectors of the economy. Achieving this will require incentivisation via policy measures – such as carbon pricing and more severe climate regulation – that we expect to put upward pressure on inflation and drag on economic growth.

However, it will also drive greater investment in green technology over the next decade. Higher investment in clean energy is on the way, and this is likely to further boost activity across the entire value chain and create large opportunities for investors.

Companies in these segments will seek to capture this capital and convert it into new earnings and cash flow growth. Companies investing in technology such as carbon capture and storage, new transport infrastructures, smart grids, and sustainable hydrogen are all likely to be targeted by investors.

Here, we explain why private capital in particular can be so effective in delivering on climate ambitions.

Private investment can help address the funding gap we face. In fact, it’s vital.

Estimates vary on the full scale of investment needed to contain climate change and prepare the world for the extreme weather events already on the rise. According to the International Renewable Energy Agency (IRENA), to keep average global temperature rises to below 2 degrees Celsius, investment in the energy system alone would need to reach $110 trillion by 2050. That’s around 2% of average annual GDP over the period.

This investment in infrastructure, as well as transport, is vital to climate mitigation. According to the International Monetary Fund (IMF) though, “the relative financing gap is even greater for adaptation purposes, particularly for water sanitation, irrigation, and flood protection, where investment is almost non-existent.”

Public finances are in a perilous state globally, especially in at-risk emerging economies. Covid-19 is a fresh memory, and left many governments overburdened with debt. Central banks are walking a very fine policy line between curbing inflation and stifling growth.

A huge proportion of the investment capital needed will have to come from the private sector, with returns appropriate to encourage the level of investment required. This is a crucial point. Climate investing is not philanthropy, it is a confluence of investment opportunity and critical need.

Private capital engages with the full scope of sustainable development

Climate change investing funnels capital towards projects, initiatives, and technologies that directly address climate change and its surrounding issues. And it’s important to stress the “surrounding issues”. Effective climate investment must acknowledge the societal impact of climate change, especially on the most vulnerable people.

For example, while climate action needs to rapidly increase at the global level, emerging economies are far more susceptible to the effects of severe weather events. This is the adaptation element we mentioned earlier.

Lloyd’s of London estimates that the average insurance penetration rate in developed markets is twice as high as in emerging economies. That underinsurance leaves a significant threat to climate resilience, but also represents significant opportunities in rapidly growing markets like agri-insurance.

This is not an area investors can so easily support using traditional, liquid asset classes.

Similarly, many of the technologies needed to tackle climate change and accelerate development are brand new. These innovations require capital at the seed and venture stages. New and disruptive business models are often supported by private equity funding through venture capital allocation.

These are only two examples. Natural capital investment is set to be a crucial part of the mitigation equation through carbon sequestration, but is also vital for protection from soil erosion and flood risk, habitats for wildlife, pollination and spaces for recreation and wellbeing.

Experts on our real estate team are also finding impactful ways to improve the environmental characteristics of buildings we manage.

Crucially, without the use of private capital, investors are unable to access a slew of the most impactful opportunities to contribute to sustainable development and fight climate change.

Private capital’s role in creating and tracking impactful change

Private asset investors have a high level of influence on their portfolio companies. By holding larger ownership stakes, competing with fewer co-shareholders and using active ownership and engagement, private asset investors can create investment value and measure the positive change.

Impact assessment should, at a very high level, very follow a three phase format:

• Intent
• Contribution
• Measurement

Where investors intend an investment to work towards a real world problem – such as those outlined in the UN’ssustainable development goals (SDGs) – it should be established at the outset. Ideally, the target investment - company or project - will be cognisant of its contributions towards specific societal or environmental goals already.

The next stage should be establishing how the intention will be met. From there is should be measured using core impact KPIs and sustainability metrics. This should be applied to all investments made with climate positive intent, and across the portfolio if an entire strategy if appropriate.

Sharing expertise through engagement is critical to the contribution phase, and private ownership can foster highly productive engagement given the proximity to the asset. In addition, private ownership allows for investors to ensure that any sale of an asset is to a party sharing the same intention to continue to build towards societal or environmental value.

This can be established during the due diligence process, and indeed is specifically referenced in the Operating Principles for Impact Management (OPIM) framework. This is something that is harder to achieve with liquid assets.

Why now?

Private assets are a critical component to developing and furthering the technologies and agendas supporting the transition to net zero. However, access to private markets has been difficult for many investors without the significant scale and resources needed to meet high minimums and structural complexity of private asset investment.

Recent developments have gone a long way to changing this; “democratising” private markets by designing new fund structures which overcome issues of minimum ticket size, liquidity, fee structures and suitability.

The long term asset fund (LTAF) structure in the UK is a prime example. The LTAF structure is a new category of authorised open-ended fund structure that offers institutional investors access to invest efficiently in long-term assets such as private assets.

The launch of LTAFs is timely. The need to mobilise private capital against climate change is urgent, and now a greater number of investors have the right tool.