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Portfolio perspectives | Article - 5 Min

Targeting the energy transition through investment in private assets

DC pension schemes are playing a crucial role in financing the transition to a net zero economy, but investments in private markets could help them more effectively achieve their goals.

Recent extreme weather events, such as devastating droughts and floods, have highlighted the urgent need to tackle climate change by cutting the carbon emissions that cause it.

Almost all developed countries have committed to the 2015 Paris Agreement to keep global warming limited to 1.5°C above pre-industrial levels, which would require governments to reach net zero emissions by 20501. However, the pace of change has been slow, and many governments may not meet their targets.

One of the most effective ways for governments to hit their net zero goals is by making progress on the energy transition, reducing their reliance on fossil fuels and embracing renewable energy sources2. This is a huge challenge and will involve considerable investment in new technologies and infrastructure.

The amount of investment required to meet the 1.5°C target is enormous, it is estimated by the UN’s Intergovernmental Panel on Climate Change to be in the range of $1.6 trillion to $3.8 trillion per year. However, current investments represent just a fraction of this amount, between $608 billion and $622bn, according to the Climate Policy Initiative3. As such, there is a huge role for private capital to play.

However, investors face significant barriers to greater participation in green finance.

The lack of standardisation for methodologies and data is a major challenge, standing in the way of investors being able to measure the impacts of their investments. While regulators around the world are trying to improve the situation, it will take time to resolve.

Investments that are good for the environment should also be good for investors in the long run. However, it is difficult for them to understand the long-term value of investments using traditional valuation metrics, such as discounted cash flow models.

Another challenge is that the investment time horizons can be incredibly short – based on quarterly earnings cycle – compared with the long-term resolve required for the energy transition.

So, what can investors do?

A role for DC schemes

In recent years, growing awareness of climate change has fuelled investor appetite for ESG and climate-aligned strategies that target better environmental as well as social outcomes. As some of the largest institutional investors, DC pension schemes will play a crucial role in helping to finance the transition in the coming years4.

ESG is already very well-established in public equity and bond markets, where it has been responsible for driving awareness of the environmental-related costs of doing business and encouraging more sustainable practices. The asset management industry has launched a range of products and strategies aimed at solving many of the world’s environmental and social challenges, with varying degrees of effectiveness. Some asset managers have been dogged by accusations of ‘greenwashing’, with their funds failing to influence companies or deliver ESG outcomes.

Many DC schemes have turned to passive index-tracking investment solutions for their public market allocations due to their low cost. However, there may be better strategies for driving the transition to a net-zero economy. Passive ESG strategies typically make extensive use of exclusion-based screens, which may give them a smaller carbon footprint but means they may not always effectively facilitate the energy transition.

While ESG in public markets has recorded some successes, listed markets only cover a small fraction of the businesses and projects involved in driving the energy transition. This is where private market strategies are set to play a bigger role.

How private markets can mitigate climate change

Private markets have become an increasingly important and popular asset class for investors in the low-rate environment of recent years, helping to make portfolios more diversified and less volatile by offering alternative sources of return.

While the low-rate tailwind that fuelled the popularity of the asset class has subsided, private market strategies remain a key investment tool for investors that have become comfortable with their restricted liquidity profiles and longer lock-up periods.

This year there have been important moves to encourage more DC pension scheme investment in private market assets – such as the Mansion House reforms and the introduction of the Long-Term Asset Fund (LTAF) – which should channel far more money into the sector.

With a better understanding of the asset class, more pension schemes are looking at how their existing private market allocations can help them to achieve their net zero goals and play a more active role in the energy transition. Private markets managers are also embracing ESG in greater numbers, with many signing up to the UN’s Principles for Responsible Investment in recent years.

Private markets are highly versatile and cover a broad range of underlying assets that have a direct and long-term impact on reducing emissions and enabling the energy transition. Such strategies have the potential to offer schemes a wider range of climate-aligned investment solutions, both liquid and illiquid. These can include thematic equity strategies, green bonds, green private debt opportunities, renewable infrastructure and forestry.

Infrastructure is one key element of the energy transition, and it can be difficult to get direct exposure through listed markets, particularly for assets such as solar or wind farms. However, building the infrastructure required for the energy transition will initially generate a lot of carbon, which can negatively impact schemes’ carbon intensity. In the long run, these assets are likely to be some of the most effective contributors to the energy transition, but other low-carbon technology or financial stocks may score better.

Private equity and venture capital are also important areas for the energy transition, as many innovative technologies underpinning the energy transition are currently in the start-up stage and therefore pre-IPO. These companies will require significant amounts of capital to implement and scale their technologies. However, they are illiquid, and their future revenues are often unproven. Such holdings can be volatile, but diversification across holdings can help smooth the ride.

The benefits of diversification

At BNP Paribas Asset Management, we believe private market strategies should be part of a diversified portfolio and can play a key role in reducing carbon emissions. Many of the traditional barriers to entry in private markets for schemes – including illiquidity, high fees and long lock-up periods – while always considerations, are no longer quite so insurmountable.

A diversified pool of private market assets would also be able to offset some of the volatility traditionally associated with exposure to individual assets. Such an approach can offer greater cash management efficiency and relative value over time, as well as reduced opportunity costs and enhanced flexibility.

The energy transition is one of the biggest challenges of our lifetime and it isn’t all just about climate change. Moving towards more sustainable energy resources can also have a considerable benefit on biodiversity, helping to prevent species loss. As well as the physical risks of climate change, there are also considerable political and social risks, such as war and famine, that could significantly impact the world.

While it is not too late to try to slow the rate of global warming, it will require a concerted effort by all. Private markets can play a key role in the process, while offering investors exposure to a diversifying and long-time horizon asset class.

References

[1] Professor Sarah Bracking, Kings College London, November 2023

[2] BNP Paribas Asset Management, November 2023

[3] Climate Policy Initiative, December 2020

[4] BNP Paribas Asset Management, November 2023

Disclaimer

Private assets are investment opportunities that are unavailable through public markets such as stock exchanges. They enable investors to directly profit from long-term investment themes and can provide access to specialist sectors or industries, such as infrastructure, real estate, private equity and other alternatives that are difficult to access through traditional means. Private assets do, however, require careful consideration, as they tend to have high minimum investment levels and may be complex and illiquid.
Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
Environmental, social and governance (ESG) investment risk: The lack of common or harmonised definitions and labels integrating ESG and sustainability criteria at EU level may result in different approaches by managers when setting ESG objectives. This also means that it may be difficult to compare strategies integrating ESG and sustainability criteria to the extent that the selection and weightings applied to select investments may be based on metrics that may share the same name but have different underlying meanings. In evaluating a security based on the ESG and sustainability criteria, the Investment Manager may also use data sources provided by external ESG research providers. Given the evolving nature of ESG, these data sources may for the time being be incomplete, inaccurate or unavailable. Applying responsible business conduct standards in the investment process may lead to the exclusion of securities of certain issuers. Consequently, (the Sub-Fund's) performance may at times be better or worse than the performance of relatable funds that do not apply such standards.

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