Climate Change - Part II
Most of the global reductions in carbon emissions between now and 2030 in the net zero pathway come from technologies readily available today. But in 2050, almost half the reductions come from technologies that are currently only at the demonstration or prototype phase
Net Zero by 2050, International Energy Agency (IEA), May 2021
This is Part II of a series of ARP+ papers on “How to Invest in Climate Change”. Part I summarised the opportunity set in public markets while this paper shines the spotlight on private markets. The last paper of the series will investigate what investors should consider when putting a portfolio of climate change opportunities together.
Private investors have a unique and noteworthy role to play as part of the solution to the climate crisis and this is most evident in private markets. Private markets are more conducive for enacting positive change and innovation, often in areas still not available in public markets, increasingly with a quantifiable climate change impact. While the long-term horizon required to invest in private markets may not suit all investors, the longer investment period provides a more feasible horizon for the relevant climate change solution to be met, strengthening the robustness of the target return for investors.
The private market opportunities explored in this paper include private equity (namely venture capital and growth equity), infrastructure, afforestation & reforestation and real estate. While each of the strategies are very different, together they address the main sources of greenhouse gas (GHG) emissions, including energy use in industry, buildings & transport, agriculture, forestry & land use and waste. The majority of the opportunities are strongly reliant on GHG reduction technologies or carbon sequestration technologies and practices, with the circular economy and energy transition facilitators also having a significant role, albeit less prominent.
The climate change investment opportunity set in private markets is still a burgeoning space which will evolve and expand significantly over the next few years and decades. Sophisticated investors should not overlook the potential to participate in the provision of the massive financing required, estimated to be over $100Tn globally through 2050, to mitigate the challenges of climate change, avoiding greenwashing where possible. There is no doubt that the severity of the climate crisis is paving the way for some of the greatest investment and impact opportunities in the decades to come, and private markets will be at the heart of it.
To continue reading...
Private equity, venture capital & growth equity
When global corporations, governments and investors pledge to transition to net zero, to a certain extent, they are betting that climate technology breakthroughs will be found and scaled in such a way that they will transform industries and society. Given that there is a relatively short time frame to meet these pledges, many of the technologies and solutions critical to enable the net zero transformation need rapid commercialisation, with yet more needing to be conceptualised or accelerated out of the lab.
Private equity, particularly venture capital and growth equity, is key in creating the backdrop for these breakthroughs to take place. Bill Gates summarises his take on the link between climate change, private equity and breakthroughs quite nicely in the following statement:
My basic optimism about climate change comes from my belief in innovation. The conditions have never been more clear for backing energy breakthroughs. It’s our power to invent that makes me hopeful.
Many of the most prominent individuals in the world of tech and finance are heavily involved in the space. Bill Gates’ own Breakthrough Energy Ventures (BEV) comprises of Jeff Bezos, Michael Bloomberg, Richard Branson, Ray Dalio, Jack Ma, Julian Robertson, Chris Hohn as Board members and/or investors. Jeff Bezos himself launched The Climate Pledge Fund in 2020 to:
…invest in visionary companies whose products and solutions will facilitate the transition to a low-carbon economy.
This is a much wider phenomenon, though, with global venture capital assets in climate change technologies having risen over 10 times since 2014 (see Exhibit 1).
The large inflows in recent years will not only be creating distortions in company valuations but may also bring back unpleasant memories to private equity investors who lost out in the boom and bust of the ‘Clean Tech’ sector between 2006 and 2011. The Clean Tech space saw venture capitalists invest $25Bn into the sector and lose roughly half of it in a handful of years (Venture Capital and Cleantech: The Wrong Model for Clean Energy Innovation, Gaddy et al., MIT Energy Initiative, July 2016).
Could we be having a déjá vu of the Clean Tech mishap? In short, the answer is yes, but those close to the industry argue that this new wave of ‘Climate Tech’ is much more than the Clean Tech of old. Firstly, it does not only focus on the energy sector, but is a broader concept, focusing on decarbonisation across all sectors of the economy. Climate Tech funding is also seen to be more robust, with funding from a broader range of sources, including corporates (e.g. global consumer goods companies, oil majors and Big Tech), playing important roles as strategic investors to scale approaches. Lastly, some argue that Climate Tech has (in the main) lower start-up costs and clearer paths to scale than Clean Tech.
Most of the opportunities in the Climate Tech space today are in the USA and Canada, followed not far behind by China and Europe in a distant third place (see Exhibit 2).
Based on the climate change ‘challenge areas’ as defined by PwC, currently the largest investments are in Mobility and Transport, accounting for 63% of global investments between 2013 and 2019. While in the US and Europe, Mobility and Transport accounts for 45% and 38% of the deals respectively (see Exhibit 3), in China it accounts for a whopping 99% of deals. Electric vehicles (EVs), micro-mobility (e.g. electric scooter rental platforms), and efficient transport systems (e.g. smart infrastructure for EVs) are the most prominent underlying sub-sectors.
Globally, Food, Agriculture and Land Use (FALU) is the second largest investment area with around 14% of investments between 2013 and 2019, with specific drivers being the growth in alternative foods (such as plant-based burgers and meat alternatives) and precision agriculture.
Energy, the epicentre of investments during the previous Clean Tech wave, comes in at the third place, at just over 8% between 2013 and 2019. Renewables remain the largest investment area within energy, but energy storage (predominantly the development of batteries), is rivalling renewables at 25%. Given the relative maturity of solar and wind, which are now being deployed globally at scale and are increasingly financed through traditional project, debt and other finance, private equity has a less prominent role within renewables.
Novel industrial processes and materials, such as bio-based product alternatives for broad industrial purposes and bio-based and plant alternatives for the fashion industry, are another important area of investments. These more sustainable materials fall within Heavy Industry (at just over 6% over the 7 years to 2019).
Accurate and timely information about the state of our planet (land, oceans and atmosphere) and predictions about our planet’s future is key for protecting the environment and achieving sustainable environmental goals. Venture capital is hence also being deployed in this space with ‘Climate/Earth Data’ constituting approximately 2% of the total funding analysed by PwC.
Although carbon capture and storage (CCS) is one of the key technologies that governments hope will help ‘save the planet’ from global warming, it is still a nascent area with less than 1% of the venture capital identified during the 2013 to 2019 period. Unfortunately, it still remains expensive and complex, resulting in technologies often taking longer to develop, particularly at significant scale.
Sophisticated investors, with the required expertise and capital, can invest directly in specific deals. While returns in this space can be quite high, this also comes with high levels of risk - particularly with an exposure to a concentrated number of deals.
Investors who prefer a more diversified exposure and who can deploy larger amounts of capital often invest in private market funds. There are quite a few climate change related private equity funds on offer, but it is evident that the focus on climate change is still burgeoning and the expectation is that the number of offerings will grow quite substantially over time.
While PwC’s analysis in Exhibit 3 is based on venture capital, the funds on offer to investors are across the private equity spectrum, from venture to buyout. There seems to be a prevalence of funds, however, which are growth equity, where managers believe investors are only exposed to commercial risk and not to technological risk – maybe a lesson learnt from the Clean Tech boom and bust?
Many funds focus only on some of the specific climate change challenge areas in Exhibit 3, while others take a more diversified approach and invest across several. Some additional focus areas which have not been explicitly highlighted in the above discussion include the circular economy (e.g. recycling), green fuels (e.g. green hydrogen) and agtech (e.g. farm drones). As with most private equity vehicles, the term of those funds are typically over 7 years.
Given most of the funds focus on climate change solutions, the United Nations’ Sustainable Development Goals (SDGs) are often targeted. Typically, they include good Health & Wellbeing, Affordable & Clean Energy, Industry Innovation & Infrastructure, and Climate Action.
The energy transition will require substantial investments in infrastructure, with renewable sources of energy at the epicentre, creating new classes of infrastructure. The modernisation of the electrical grid and investment in smart grid technologies is required to manage an increasingly electrified system powered by renewables. Some foresee the conversion of gas pipe infrastructure to transport green hydrogen. Storage of renewable energy is another key component, given the intermittency of the core renewable energy sources. Significant investments in charging infrastructure are needed to support the vast rollout of EVs. IRENA estimates that 1.1 billion EVs will be on the road by 2050, up from 8 million in 2019. Of course, additional investments in renewables will also be required.
The United Nations Development Program also highlights the importance of “deploying both structural and non-structural risk mitigation strategies for the development of climate-resilient infrastructure. Structural measures entail physical interventions aiming at reducing or avoiding the impact of a catastrophic event.” Other infrastructure investments which relate to climate change include waste management (e.g. recycling plants) and clean water (see ‘How to invest in water’ – ARP+ Insights).
BloombergNEF estimates “investment in energy supply and infrastructure amounts to between $92Tn and $173Tn over the next thirty years. Annual investment will need to more than double to achieve this, rising from around $1.7Tn per year today, to somewhere between $3.1Tn and $5.8Tn per year on average over the next three decades.”
Governments around the world are taking action, with for instance President Biden’s bipartisan infrastructure bill proposing $65Bn to “upgrade our power infrastructure, including by building thousands of miles of new, resilient transmission lines to facilitate the expansion of renewable energy, including through a new Grid Authority” (The White House). There is a large number of other infrastructure proposals such as over $50Bn for water infrastructure and $7.5Bn for EV infrastructure.
Again, as with private equity, sophisticated investors may invest directly in deals. For investors who prefer a more diversified exposure and meet the minimum asset requirement, there are a number of energy transition focused infrastructure funds available. As typical with infrastructure, contracted cash flows tend to be a substantial component of the return.
However, as the space has evolved, in some instances there is a fine line between what constitutes infrastructure and private equity, as the managers enter each other’s territories. Given the nature of the underlying investments, fund offerings tend to have a term of least 10 years, although some firms do provide more liquid offerings, potentially creating an asset/liability mismatch. The United Nations’ SDGs usually highlighted include Clean Water & Sanitation, Affordable & Clean Energy, Industry, Innovation & Infrastructure, and Climate Action.
Afforestation & Reforestation
An eyewatering 420 million hectares of forest are estimated to have been lost globally since 1990, according to the FAO. Research from University of Maryland suggests that, in 2020 alone, the planet lost an area of tree cover larger than the United Kingdom, including more than 4.2 million hectares of previously undisturbed primary tropical forests (the world’s most biologically diverse ecosystems). This degree of deforestation represents a clear crisis for climate stability and biodiversity. The destruction of primary tropical forests is estimated to have released 2.6 billion tonnes of CO2, an amount equivalent to the annual emissions of 570 million cars!
Given the carbon sequestration properties of trees, deforestation is basically removing these natural carbon sinks from our planet. According to Global Forest Watch, forests collectively absorbed around 15.6 billion tonnes of CO2 from the Earth’s atmosphere annually between 2001 and 2019, while deforestation, fires, and other disturbances released an average of 8.1 billion tonnes of CO2 each year. Netting these two figures, forests absorb close to 7.6 billion tonnes annually, equivalent to roughly 1.5 times annual CO2 emissions of the United States.
As an investor, in order to attempt to be part of the solution of deforestation, it is crucial to understand what the causes of deforestation are. Unfortunately, the drivers of deforestation are several and they vary by region (see Exhibit 7). The glaring negative feedback loop evident in Exhibit 7 as it relates to wildfires is extremely disturbing and highlights the immediate urgency of addressing climate change. Increased global emissions lead to higher temperatures, which in turn create drier, more fire-prone conditions and with more fires comes more emissions - perpetuating the entire cycle.
As countries develop new programmes to implement their national climate goals, protection and restoration of forests and other biodiversity-rich ecosystems in what are called Nature-Based Solutions (NBS) and Natural Climate Solutions (NCS) are gaining prominence. Research by Nature Conservancy and 20 other institutions indicates that NCS can provide up to a third of the cost-effective, near-term mitigation potential needed by 2030 to stay below 1.5°C of warming. Exhibit 8 provides some more colour on how this could be achieved. Alongside emissions reductions, NCS have other benefits, such as improving soil productivity, cleaning our air and water and maintaining biodiversity.
Not all players are as positive on the ‘planting trees’ aspect of NCS. In ‘How to Avoid a Climate Disaster’, Bill Gates maintains that although planting trees as a way to capture CO2 from the atmosphere may sound like a simple, cheap and low-tech idea, it is a lot more complex and not really a feasible solution. He argues that if you make a number of assumptions, including that the average tree can absorb 4 tonnes of CO2 over its lifetime and that trees in snowy areas cause more warming than cooling (because they are darker than the snow and ice beneath), you need around 50 acres’ worth of trees, planted in tropical areas, to absorb the emissions produced by just one average American in his/her lifetime. If you multiply this by the population of the United States, you need to plant trees in more than 16 billion acres, roughly half the landmass of the world! And this is just accounting for the emissions of the United States. Basically, he concludes that there is no practical way to plant enough trees to deal with the current climate crisis, with “the most effective tree-related strategy for climate change is to stop cutting down so many of the trees we have already”.
Although ‘planting trees’ will never solve the climate crisis on its own, it should be one of the pieces of a very complex jigsaw. But afforestation (the establishment of forests where previously there have been none, or where forests have been missing for 50 years according to UNFCCC) and reforestation (the replanting of trees on more recently deforested land), if unsustainably managed may be controversial as they may lead to the destruction of original non-forest ecosystems (e.g. natural grasslands). Much research is being conducted on best practices, such as which trees to plant where and the implications for the whole ecosystem. For instance, a 2018 study published in the ‘Proceedings of the Royal Society of London’ found that “a diverse forest stores twice the amount of carbon as the average monoculture.”
Fund managers have recently been exploring natural climate solutions, mainly afforestation and reforestation. As of today, there are limited funds in the space, but several of the bigger timberland managers are in the process of launching related products. Some of the managers seek to generate additional income from the sale of carbon offsets. These funds typically involve long terms of 15+ years. The most relevant United Nations’ SDGs are Climate Action and Life on Land.
Real estate is an important piece of the jigsaw in addressing the climate change crisis and should not be overlooked by investors. Buildings and construction contribute a hefty 35% of global energy use and 38% of emissions (see Exhibit 9). Further, according to UNEP, the construction and operations of buildings account for nearly 40% of waste and approximately 12% of water usage.
Although the energy intensity of the building sector has recently been improving by 1.5% annually, given the rise in new buildings, UNEP suggests that the sector’s energy intensity (a measure of how much energy buildings use) will have to improve by 30% to meet the goals of the Paris Climate Agreement. If action at scale doesn’t occur, CO2 emissions from buildings are expected to double by 2050.
The negative outlook for the sector is reflected in the disappointing trajectory of the Building Climate Tracker (see Exhibit 10). The current view of the ultimate goal for a building is that it should be net zero carbon (including embodied carbon), meaning that the building produces enough renewable energy to meet operations annually and offset the carbon emitted from construction.
According to a report by the World Green Building Council, under 1% of all buildings worldwide are net zero today, requiring “a monumental and coordinated effort by businesses, governments and non-governmental organisations to bring the building sector within striking distance of Paris Agreement targets”. Over 25 cities around the world have signed the C40 Cities pledge to make all new buildings zero carbon. This transition should present opportunities for investors, but how can investors participate in it?
Since most building-related CO2 emissions come from energy use (see Exhibit 9 again), arguably the most effective step in addressing emissions will be to reduce energy consumption through greater energy efficiency. This is the angle taken by most fund investments in the space. While you may instinctively assume real estate fund managers would choose to focus on the more cutting-edge side of the new build spectrum, the majority of funds in the space focus on refurbishments of existing stock. Real estate managers argue that since 75% of the 2050 real estate stock is already built (Carbon 4, 2019), decarbonising the global building stock is therefore crucial to meeting climate goals. Furthermore, because of the significant embodied carbon impacts of new buildings, any savings from operational energy use would not necessarily compensate for the initial emissions (see Exhibit 12).
These funds typically focus on buildings with a strong potential to improve the efficiency of the building (offices and other) through refurbishment. The strategy also tends to involve letting out the buildings, stakeholder engagement and ensuring ongoing management and reduction of energy waste. Examples of efficiency improvements include improved heating, ventilation and air-conditioning (HVAC) systems, insulation, double glazing, LED lights, rainwater toilets, solar panels, smart meters, sensors, energy management optimisation systems, solar panels and kinetic lifts (vs. motor lifts).
The environmental impact of these type of funds can be quite tangible with the GHG emissions of the assets held by the manager explicitly being reduced over the period they are held. Funds do not necessarily include the United Nations’ SDGs in their material, but they could be considered to be contributing to the Sustainable Cities SDG. While the structure of these funds tends to be long-term in nature, some form of shorter-term liquidity is typically available to an investor wanting to redeem.
The opportunity set is currently quite limited but given how core real estate is to solve the climate crisis, the range of investment opportunities in the space should increase substantially over time. Innovative schemes, such as where landlords are incentivised to erect and maintain air purifying towers on top of buildings to reduce pollution, are precursors of more to come in this space.
Each of the climate change strategies covered so far, both in public markets (Part I) and private markets (this Part II) are different in terms of the strategy itself but also in terms of return, risk, liquidity, impact, fee level, ease of access, etc. How do investors decide which of the various climate change strategies to allocate to and how much?
The answer will be specific to the appetite and constraints of each investor. However, given the complexity in addressing the climate change crisis, a number of additional pillars need to be considered in the portfolio construction process. More on that in ‘Climate Change - Part III: How to Construct a Climate Change Portfolio'.
Alison Major Lépine
3 November 2021