- Investor interest around Environmental, Social and Governance (ESG) investment started taking off in 2018 and momentum continues to be strong, possibly enhanced by the COVID-19 pandemic.
- Citi analysts believe the world has reached the “green tipping point” where global climate policy activity is accelerating alongside renewed green commitments from businesses, investors, and consumers.
- However, there remains a substantial gap between the US$3-$5 trillion level of annual green investment likely needed to meet the 1.5°C limit on global warming by 2050 and the nearly US$600 billion of total climate finance invested in 2017/2018.
Climate change is a defining challenge of our time
Record temperatures and increasingly extreme and frequent droughts, floods, wildfires, and storms bear clear testimony to global warning. Climate change requires extensive climate mitigation and also climate adaptation.
Climate mitigation to achieve the Paris Agreement goals – remaining within 1.5 degrees Celsius (1.5°C) from pre-industrial levels – requires staying within a carbon budget of ~420-580 GtCO2e. This means present greenhouse gas (GHG) emissions of ~53 GtCO2e need to be cut in half by the 2030s, and reach net zero by midcentury. Net negative emissions could further help as part of ongoing climate restoration.
Momentum for climate change was already underway before COVID-19, but is now accelerating and reaching a tipping point. Governments are putting net zero emissions targets and stronger climate policies in place for mid-century, notably the European Union (EU) and China. The US has rejoined the Paris Agreement in 2021. Corporations and investors are joining the “net zero club”, while individuals are embracing climate considerations in lifestyles and consumption. Meanwhile, the oil and gas sector is also adapting to the wider energy transition.
Many investors now recognize the embedded risk that climate change represents in their portfolios and are looking to deploy capital to align with their values or participate in the energy transition. Renewable energy funds, particularly solar, had incredibly strong growth in 2020, with several providing returns of more than 100%.
Strong investor interest is critical as demand for private funding to finance the transformation to a 2°C or ideally 1.5°C world is likely to remain after the COVID-19 crisis subsides. More governments around the world are making policy and legislative commitments to net zero targets and will need to fund them.
The 2025 UN Intergovernmental Panel on Climate Change (IPCC) calculated that to reach a 1.5°C world, the average annual investment in transitioning the global energy system to reduce greenhouse emissions needs to be approximately US$2.4 trillion per year between 2016 and 2035.
Investor Attitudes have Shifted
ESG funds under management continue to grow, demonstrating continuing interest on the part of both investors and corporates to participate in the green asset revolution.
Green bond issuance has increased substantially each year. The Climate Bonds Initiative’s analysis of annual green bond and loan issuance for 2019 showed US$266.1.9 billion that met internationally accepted definitions of green were issued, up 52% from 2018. Despite the impact of COVID-19, US$222.8 billion of green bond/loan issuance was reported for 2020, crossing US$1 trillion in cumulative issuance.
The seemingly insatiable appetite among investors for green bonds is an illustration of the shift in investor attitudes. More asset owners want to see corporates aligning their business models with Paris targets. Increasingly, asset managements are also responding by re-shaping investment strategies to enhance exposure to greener assets and sending strong signals to corporate issuers that they need to address the climate risk on their balance sheets.
Sustainable factors have emerged as a new nexus for risk and increasingly, a driver for alpha. Investors are realizing that ignoring societal or environmental impacts of the companies they invest in, could result in additional risk.
Nevertheless, the hurdles to investing in green projects are significant for corporates, banks, and investors. For corporates, the return on capital typically produced by green assets is over a longer time period and may have a lower internal rate of return than more traditional energy and infrastructure investments have historically.
The need for longer-term financing may also deter banks from providing the requisite capital for these projects. Banks also may have industry, country and credit quality concentrations that create upper limits on exposures.
Realistically, investment in green assets, while achieving a societal goal and potentially yielding strong returns, can also be more risky. Project approvals are subject to environmental and historical impact assessments and public consultation periods can be lengthy and not always end with approvals.
While some technology is well-proven and has been commoditized (e.g. photovoltaic systems and wind turbines), other technology like batteries and plastic recycling, are still being commercialized.
A lack of agreement on what is “green” can also create uncertainty for investors. While policymakers are slowly developing classification systems for what a “sustainable investment” looks like, there is not yet a globally consistent interpretation.
The EU Taxonomy for Sustainable Activities is an important step in the right direction, but even the passage of such a comprehensive classification system into law could create uncertainty. Nonetheless, it appears likely that the EU Taxonomy could be one that becomes the most widely adopted by investors.
Citi analysts think this decade could see three major transformations related to ESG data: 1) standardization of corporate reporting, 2) introduction of global regulations to govern how capital markets facilitate sustainable finance flows and risk transfers; and 3) reengineering of buy-side and sell-side data architectures to incorporate ESG data. These need to happen quickly to achieve the climate change targets.
Decarbonizing the world requires nothing short of a great transformation of the global economy, with no single silver bullet but a whole portfolio of mitigation.
There remains a massive investment gap that needs to be closed to meet climate goals, perhaps as much as US$3-$5 trillion per year. Public sector investment is crucial, but so is private investment.
New ESG investing approaches have begun to transform the investment management industry and investors are increasingly engaging with the companies they own to drive positive change, in some cases demanding incremental targets to achieving large-scale emissions and waste reductions.
Ignoring ESG factors can also be an expensive mistake, with sustainable factors such as environmental impact or social responsibility emerging as a driver for returns. Investors could potentially be assuming additional risk simply by ignoring these factors.
All in, Citi analysts are of the view that investors and businesses can improve their image, bottom line and environmental and social impacts with a focus on the major unstoppable trends that are now remaking our global economy.