As global environmental, social and governance (ESG) assets top $41trillion this year, a new insight from Ninety One has put forward the industry’s most pressing question: are asset owners ready to finance a transition to net zero?
The company’s latest publication, its annual Planetary Pulse report, entitled ‘The rise of transition finance’, ventures into transition finance, what it means for asset owners and its role in averting harmful climate change.
Three hundred senior professionals at asset-owner institutions in the UK, Southern Africa, the Asia Pacific, Western Europe and North America were included in the scope of the report, which covered pension funds, insurers, endowments, foundations, central banks and sovereign wealth funds.
Transition finance is a commercial investment approach that focuses on the real-world impact to enable an investee’s climate-change strategy.
It intends to help reduce carbon while achieving profitable returns and can involve either investing in challenging industries so that high emitters receive the capital and influence they need to transform their operations, investing in new innovations that might not be profitable initially, funding infrastructure transformations or increasing exposure to emerging markets, where emissions continue to grow the fastest and the need for all forms of support is the greatest.
ESG investment strategies
ESG-branded investment strategies, funds and services have come front and centre within the world of investment, with ESG assets forecast to rise to $41trillion this year, nearly twice the value of 2016’s $22.8trillion.
Better yet, by 2025, ESG assets are expected to surpass $50trillion and comprise one-third of total global AUM.
However, many assets which are branded as ESG do not in fact encourage change from brown to green in the real economy. In 2021, more CO2 was released than any other year to date, with coal being the main catalyst behind the rise.
“ESG-branded assets are often designed to show small carbon footprints, but this sometimes means they are not addressing real-world decarbonisation,” explains Nazmeera Moola, chief sustainability officer at Ninety One.
“Portfolios are created that avoid the problem, instead of solving it — often, by simply limiting an investment universe to only the cleanest industries,” continues Moola. “Portfolio purity does not work to solve the climate crisis. It exacerbates the crisis.”
Among companies themselves, some in the fossil fuel industry, for example, have divested high-polluting business units, or contracted polluting processes to third parties, removing the emissions – on paper– from their responsibility, without reducing the real-world impact of the industry.
Investing for net zero?
The report indicates that among the asset owners with climate-related targets, 48 per cent set them at an overall portfolio level, while 46 per cent set targets for specific mandates, portfolios or funds.
Only 28 per cent set their targets at an asset-class level.
The data found that 60 per cent of asset owners say fighting climate change is one of their fund’s strategic objectives, with 51 per cent saying their fund has emissions-reduction targets in place.
These figures show that most are actively responding to climate-related risks and opportunities.
However, the findings are less positive when looking for real-world impact.
Only 19 per cent say they use transition finance to any extent. Fewer still (16 per cent) reported that their fund invests in transition-finance assets in emerging markets, the regions where emissions and populations are growing the fastest.
For the 87 per cent majority, no more than half of their organisation’s assets under management (AUM) fall under climate-related strategies, and 46 per cent have no more than a quarter in these portfolios.
Additionally, only 11 per cent have from half to three-quarters of their AUM in climate-related strategies, and less than one per cent have more than three-quarters.
According to the report, over the course of the next three years, 19 per cent expect to have from half to three-quarters of their AUM in climate-related strategies, and two per cent will have more than three-quarters.
Barriers to transition finance
Of the asset owners that engaged in the report, 55 per cent admitted that their fund is not focused on any goal beyond the risk-and-return performance of their asset
There is an opinion, held by 40 per cent of asset owners, that climate-related investing generates lower returns.
For funds with positive climate outcomes as an explicit objective, short-termism is a challenge. With soaring energy costs in 2022, some of the world’s highest-emitting companies made large profits. Many climate-focused funds will not have owned these companies and would have missed out on associated returns.
However, according to the report, the most cited barrier by 60 per cent of respondents to transition finance is a lack of companies with credible and feasible transition plans.
Fifty-five per cent find it tricky for asset owners to measure or quantify an organisation’s progress in climate strategy or products, though this is likely to improve with the continued enhancements in disclosure and data regulation.
Emerging markets present both an enormous industry challenge and an industry opportunity.
Transition finance will be critical to reaching net zero, and investment can be applied to transform energy production, infrastructure, efficiency, transport and several of the world’s highest-emitting industries.
According to the report, only 16 per cent of asset owners surveyed are invested in emerging market transition finance, and those asset owners appear to have high conviction about the strategy.
While expanding transition finance in emerging markets is a moderate or high priority for 86 per cent of those who have adopted the approach, 53 per cent of respondents say their fund is concerned about the risk-return profiles available in the universe of emerging market transition-finance assets.
Forty-one per cent of asset owners say their fund is seeking to invest in high emitters in emerging markets with measurable, science-based decarbonisation plans.
For Moola, now is not the time for rich countries, their investors, asset owners and institutions to abandon the hopes of emerging markets.
“If an effective ‘buy developed, sell developing’ takes hold,” she says, “emerging markets may be starved of investment capital at the very time they need it to finance their energy transitions.”
Moola urges investors to focus on long-term transition plans consistent with net zero by 2050 for companies and countries, not near-term portfolio emission reductions.
“Asset owners that take a divestment approach to achieve net-zero targets are letting go of some of the most powerful levers in the fight against climate change, as well as return opportunities,” she continues.
“They have the ability to use their capital and influence to catalyse and enable transitions to low-carbon alternatives and move closer to the Paris Agreement targets — a path that can often overlap with the path to long-term growth and responsible risk management.”
Climate won’t wait
Time is of the essence in the fight against climate change.
Yet despite this timely agenda, the report found that 56 per cent of asset owners believe that without greater investment in transition-finance assets, the world will not be able to meet the Paris Agreement climate-change goals.
To meet international, national and organisational climate targets, Hendrik du Toit, the founder and CEO of Ninety One, explains why energy needs to be decarbonised, myriad industrial processes must be replaced with clean alternatives, and why infrastructure must be transformed.
“Transition finance is the legitimate and effective alternative that enables the move from brown to green while meeting standard risk-and-return objectives,” explains du Toit.
“Financing even heavy emitters, as long as they are on a verifiable path to net zero and promising attractive risk-adjusted returns, will reap benefits for investors as well as the planet.
“We must mobilise transition finance alongside green investment. By allocating finance to transition, asset owners can profitably participate in the world’s adaptation to net zero and help mitigate climate change.
“Transition finance is not in conflict with the fiduciary duty of asset owners. It is an attractive return opportunity which at the macro level mitigates the biggest systemic risk of our time.”