How investors can help finance a green recovery

The transition to net zero is central to investors’ investment decision-making.

The race is on to get to net zero by emissions reduction, carbon sequestration and offsetting programs. The research shows the transition to a net zero world is also central to investors’ investment decision-making today.

Making progress on net zero and decarbonization is unlikely to be without its challenges for both corporates and investors. Companies should undertake robust scenario planning to help understand the potential implications of a range of climate outcomes and stress-test the current risk management and strategy processes within their business. At the same time, investors should engage with companies on the requirement to recast their organizational strategies to incorporate decarbonization, and environmental, social and governance (ESG) factors. They should also have a strong grasp of each industry’s pathway to decarbonization, founded on comprehensive quantitative data analysis.

While the transition to a net zero carbon economy can present significant material challenges, efforts by governments to encourage the transition could be an opportunity for investors. Many investors appear to be already capitalizing on the opportunities, with 92% of investors surveyed saying they had made an investment during the course of the preceding 12 months because they saw that target benefiting from the green recovery.

Investors also see this transition continuing, with 88% of respondents saying it is likely that they will increasingly target green-focused investment opportunities following the COVID-19 pandemic, as they seek opportunities that are more resilient to global crises and able to provide sustainable long-term value.

For example, one area that has significant potential is nature-based sequestration. Nature-based solutions to climate change, sometimes called “natural climate solutions,” involve conserving, restoring or better managing ecosystems to remove carbon dioxide (CO2) from the atmosphere. Examples include allowing forests to regrow, restoring coastal wetlands and switching to restorative agricultural practices such as cover crop rotation that support healthy soils.1

According to the UN’s inaugural State of Finance for Nature report, if the world is to meet its climate change biodiversity and land degradation targets, it will need to close a US$4.1t financing gap in nature by 2050. To achieve this, investments in nature-based solutions would likely need to triple by 2030 and increase four-fold by 2050.2 This acceleration would equate to a cumulative total investment of up to US$8.1t and a future annual investment of US$536b. The report found that about US$133b a year currently goes toward nature-based solutions; 86% of it is public funds with the remainder made up of private capital. As more companies emerge with compelling business models in this space, it is an area that is likely to receive growing investor attention.

However, there is some concern that the green recovery opportunity could become a victim of its own success. The concern is that with the industry’s interest in environmental issues surging, the result could be too much capital potentially chasing too few opportunities. The EY 2021 Global Institutional Investor Survey shows that investment managers are concerned that demand is outstripping supply, as the industry looks to invest in projects across areas such as renewable energy, electric vehicles and plant-based food:

1. Seventy-seven percent of investors surveyed said that with high demand for green investments, many investors will find limited investment options because of a relatively small number of equities meeting their environmental criteria.
2. Seventy-six percent of investors surveyed said that shortage of supply in suitable green investments will lead to some investors overpaying for green assets, creating the risk of a market bubble.

One important issue that appears to be driving concerns of a market bubble is whether the sustainability or green claims of companies – either established players or innovative new players in green technologies – are credible. A common concern, for example, is whether large and well-resourced companies can talk up their sustainability credentials and, as a result, whether ESG-labeled investment products consist of organizations that are less sustainable.3

The scale of the issue is reflected in the fact that regulators are making moves to deal with this problem. For example, the EU’s Sustainable Finance Disclosure Regulation (SFDR), which came into force on 10 March 2021, is designed to introduce more transparency and essentially categorize investment products into sustainable and non-sustainable.3

At the same time, investors looking to get into emerging green technology companies should establish whether claims made about the potential of these technologies – and the potential for future revenues – stand up to rigorous examination. This could be important in helping to identify whether companies and the projects they invest in will survive in the long term beyond the initial wave of enthusiasm. This in turn means having deeper insight beyond the stated claims and reporting of companies. Investor analysis should seek to understand whether an opportunity really is sustainable and viable in the long term.

There are two issues that could dampen the threat of a market bubble:

1. First, the sheer volume of finance required to achieve renewables goals. Based on the International Energy Agency’s Current Policies Scenario, around US$7.7t is committed to renewables, but US$12.9t is required under the Sustainable Development Scenario. This means there is an estimated US$5.2t of additional investment required. The International Energy Agency’s Sustainable Development Scenario outlines a major transformation of the global energy system, showing how the world can change course to meet the three main energy-related Sustainable Development Goals simultaneously.4 Clearly, there is a significant gap to be filled.
2. Second, emerging green technologies are only part of the race to net zero. As institutional investors begin to align more with net zero, it is likely they will try to invest in low-carbon and net zero initiatives, such as the new technologies that can help the move toward a decarbonized economy. However, a huge amount of funding will likely be required to decarbonize many industry sectors.

As a result, a significant amount of equity capital will likely need to flow to those organizations that are currently in the emissions-intensive sectors. Companies demonstrating a clear strategy to capitalize on the net zero transition could develop a way for investors to allocate capital and avoid the growing reputational risks of supporting emissions-intensive sectors.

In other words, as well as investing in the green, it could also be important to green the brown industries. For investors, this could mean a focus on engagement rather than divestment, working in partnership with companies to reduce carbon and make the energy transition.