After a relatively long period of tentatively committing to environmental, social and governance (ESG) criteria, the world’s large institutional investors have been moving forward up the ESG curve with much greater intensity in recent years. And European funds are at the forefront.
The world is on a one-way path towards transitioning to clean energy, but the road is by no means smooth. Despite the advances in related technology and the lower costs of producing and storing renewable energy, there remain numerous political, regulatory and financial hurdles. What is increasingly evident, however, is that institutional investors – asset owners and managers – are now firmly in the driver’s seat steering the process. At this stage, more so than governments or energy and industrial players. And well ahead of banks.
After a relatively long period of tentatively committing to environmental, social and governance (ESG) criteria – some with more scepticism than others, dipping the toe rather than actually jumping in the water -- the world’s large institutional investors have been moving forward up the ESG curve with much greater intensity in recent years. And European funds are at the forefront. To a large extent, this is because their clients’ heightened demand for green and ethical factors for their investments. According to Morningstar, in 2019 ESG funds pulled a record EUR 120 billion in Europe, where there are now over 2,400 sustainable investment funds. The end of the year was particularly dynamic, seeing a 76% quarter-on-quarter surge in new ESG funds.
Currently, there are over 2,200 investors and other market participants which signed the UN Principles for Responsible Investment. What is especially relevant is that, increasingly, the narrower segment of the large global asset managers is moving into ESG mainstream investing. At the start of the year, the world’s largest asset manager, BlackRock, publicly announced that it is joining other 370 global investors in the Climate Action 100+, an initiative to ensure the world’s large greenhouse (GHG) polluters take necessary action on climate change. In his CEO Letter, Larry Fink, the company’s Chairman and CEO, stated that “we will be increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices and plans underlying them”. Now that BlackRock is in, it is expected that other large US asset managers will join the initiative.
Energy transition is a subset of ESG investing
One important area of ESG investing is energy transition, namely shifting from fossil fuels to clean renewable energy sources. At this time the opportunities are limitless, as 95% of energy still comes from fossil fuels, as opposed to renewables like wind and solar power. However, even within the conventional energy production there are sizeable investment opportunities into switching to cleaner resources. For example, moving from coal to natural gas, which releases about 60% carbon less than coal.
Experts identify two broad categories of energy transition projects: production and transmission/storage. Regarding production, there are three key drivers for investments. First, the need to address the climate change challenge. The key goal remains that set by the 2015 Paris Agreement, of limiting the rise in temperature to 1.5°-2°C compared to pre-industrial levels. For that to happen, emissions need to be reduced by 33% by 2030.
Second, as the cost to produce renewable energy has dropped considerably in recent years (e.g. producing solar power), energy transition projects are becoming more economically viable. Which means that they no longer rely primarily on government subsidies, thus stimulating private investment more so than in the past. Third, consumers are increasingly attracted to clean energy, as shown by the fast growth in demand for electric vehicles (90% up in 2018).
With respect to energy transmission, there are sizeable investment needs to connect renewables project to the electrical grids, this resulting into the drive to replace existing power distribution networks. Regarding storage, the need is for investment in batteries production – both ion-lithium and newer technologies like iron-flow.
According to recent research by Schroders, some USD 120 trillion of new energy-related investment will be needed globally between now and 2050. Circa 40% of that going towards improving energy efficiency, 30% for clean power generation, and the rest for other projects, like transmission and storage of electricity.
Investing in energy transition is becoming profitable
According to McKinsey, there are now instances where renewables are produced cheaper than fossil fuels. Germany has already reached that point, and other European countries are bound to follow. The forecast is that solar and wind power generation will grow five to ten times faster than any other power generation technology in the near future. Analysts point out that investing in renewables is only now becoming profitable. Indeed, one major index, the MSCI Global Alternative Energy Index, started generating returns over 5% only from 2017 (from flat or slightly negative before that). The forecast is for such returns to keep growing gradually.
This means that investment opportunities in clean energy will balloon in future years and decades. Again, it is the private sector, namely asset owners and managers, which are in the driver’s seat for this. First, we should expect to see more ESG-dedicated funds to be offered, with a large energy-transition component, with significantly more assets under management. Second, we should also see an increasingly visible shift of outstanding funds into ESG-friendly assets, especially with the world’s largest asset managers being committed to sustainable investments.
And third, investor scrutiny of issuers’ ESG commitment and implementation is likely to become “mainstream” rather fast. In fact, 2020 should be a flagship year in this respect. In its 2019 progress report - the first since its inception at the end of 2017 -, Climate Action 100+ focuses on its achievements to date in changing the behaviour of the large GHG emitters towards reducing carbonisation. One aspect on how investors work with these issuers is engaging with their top management and boards: meetings, investor roundtables, supporting shareholder resolutions on climate risk, voting for the removal of directors who failed in their climate risk accountability or against unsatisfactory company accounts, or making joint statements with the company.
Growing issuance of green bonds
Green bonds are an increasingly attractive opportunity for fixed income investors. USD 377 billion were issued in 2018, some 40% of this amount going to European investors. More than a third of green bonds are funding energy-related assets and projects. However, the green bond market could be scaled up more significantly if some persisting hurdles were addressed. A recent survey of green bond investors and issuers by Climate Bonds Initiative flags some of these hurdles. For example, at the top of investors’ wish list is the need for better standardising definitions (e.g. on green assets) – with a preference for stricter criteria -- followed by preferential capital treatment of low-carbon assets and mandatory climate-related financial disclosures and also tax incentives.
Regarding issuer disclosure, the preference is for companies to follow the framework recommended by the Financial Stability Board’s (FSB) Task Force on Climate-related Financial Disclosure (TFCD). The survey highlights that nearly 60% of responding issuers are committed to climate-related disclosure but are still waiting for more guidance before proceeding. Almost 25% of respondents are already engaged in disclosure. Interestingly, the sector with the largest number of TFCD disclosure is banking.
Banks are still behind investors (for now)
Until recently, ESG-related concerns about banks were kept on the back burner by investors. But this is changing, which in turn is pushing the banking sector to be more pro-active on this front. Especially in Europe, where at least for now both customers and investors are more attuned to ESG issues than in other regions of the world, including the US.
And yet, at this time it is primarily the institutional investors, including some which are in fact subsidiaries of banks, and not the banking sector which are financing energy transition and other environment-related projects. To a certain extent, the banking industry after the financial crisis has been more focused on complying on regulatory requirements, and thus has been waiting for more regulatory guidance on ESG topics. This is now being addressed by regulators, primarily in Europe, and banks are very likely to integrate ESG aspects into their compliance practices. Besides, the bank supervisors themselves are only slowly adjusting to the new world, for example debating the possible inclusion of ESG factors into stress tests.
Across Europe, countries where bank supervisors have been more forthcoming on climate risks are the UK, Netherlands, and France. But others are also following. Last year, the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) – established two years ago at the initiative of Banque de France and currently having 36 members and five observers – issued six recommendations for regulators and policymakers aiming at the transition to a low-carbon economy. More vigorous supervisory guidance for banks on this area can be expected. Also, as mentioned, on balance banks have engaged into TFCD disclosure more so than other sectors.