By: Rick Lacaille, Executive Vice President and Global Head of ESGEnvironmental, social, and governance (ESG) criteria are a set of standards for a company’s operations that socially conscious investors use to screen potential investments. Initiatives, State Street
The global investment community is starting to act on climate commitments. Research shows that aggregate carbon intensity of institutional portfolios dropped by about a third from the start of 2019 to October 2021. So does that mean if investors continue to divest from brown assets, they can check the box on climate change?
Unfortunately it’s not that simple. Changing the ownership of brown assets doesn’t do anything to move the world closer to net zero and may even make things worse given the huge amount of funding needed to facilitate the global energy transition.
Just look at the numbers. According to the International Energy Agency, investments to transform power sectors in emerging and developing economies alone will need to increase by seven-fold by the end of this decade. And yet the IEA finds that investment across these energy sectors has been falling in recent years.
The answer to closing this enormous funding gap may lie in what is currently unthinkable for many investors — staying invested in brown assets to facilitate the transition to green.
We think this is achievable. Research conducted by Ninety One showed that a sample of investors, once they had considered net zero approaches, were ready to shift from a stance of divesting from high emitters towards staying invested and supporting a transition to net zero.
And rather than procrastination, continuing ownership of brown assets can be part of a genuinely ambidextrous approach to net zero. Taking this path would mean investing heavily in renewable capacity while being responsible owners and creditors of existing hydrocarbon assets as they are wound back.
So how would the mechanics of transition finance work?
While there’s a great need for asset owners, investors, multilateral development banks, investment banks, and governments to come together and iron out individual details, we believe that an overall, transition finance framework includes:
meaningful uptake of ownership risk in brown industries by publicly funded entities;large-scale transition finance provided by both private and publicly funded entities;well-functioning, transparent emissions measurement, pricing and markets;publicly funded investments in basic research;privately funded investments in technology, services, and equipment that will be required for transition; andunwinding public support frameworks as businesses become green.
Within that framework, many different models can be created. For instance, Nazmeera Moola and Nick Robins highlight one that they call a ‘bad-carbon facility’ in a recent article in IPE. A ‘bad-carbon facility’ they explain is an investment fund that operates like the ‘bad bank’ structure sometimes used to hold nonperforming financial assets.
Deploying capital from both public and private investors, the fund would buy up coal power in emerging markets, decommissioning them over time, with cashflows from them used to build renewable-energy assets. In this case, the authors explain that public sector investors would bear most of the financial risk and private sector investors would receive a minimum yield on their investment.
The transition to net zero cannot occur without funding. And funding the transition can’t be done without a collaboration between governments, multilateral development banks (MDBs), insurers, investment bankers, owners, and asset managers.
There are already positive signs of this collaboration at work. The South African coal wind-down deal struck at COP26 is a case in point. France, Germany, the US, UK, and EU pledged a combined $8.5 billion to act in combination with other sources, including private-sector investment, to achieve South Africa’s transition away from coal.
To be sure, the transition will not be easy and faces political, financial, and technical challenges. Today, South Africa has a power deficit, with rolling blackouts causing industry and individual hardship and holding back economic growth. The coal sector employs some 200,000 workers.
However, the South Africa coal deal is widely seen by private-sector participants as a new, potentially repeatable and scalable model for transition finance.
Indeed, the Asian Development Bank has already announced the Energy Transition Mechanism that could achieve something similar for ASEAN nations such as Indonesia, Philippines, and Vietnam. The model is one in which investors will provide equity and debt finance to a special purpose vehicle managed by the ADB that will purchase, report on, and retire the coal-generation assets in an orderly fashion.
Though much needs to be worked out in practice, we believe there is a strong case for creative and positive transition finance. An opportunity awaits.
About the author:
Rick Lacaille is executive vice president and senior investment advisor, responsible for leading the company-wide ESGEnvironmental, social, and governance (ESG) criteria are a set of standards for a company’s operations that socially conscious investors use to screen potential investments. program at State Street.
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