22 February 2023
Author: David Merton
The investment required to reach net zero is vast. The global consultancy, McKinsey, estimates $275 trillion needs to be spent on physical assets to meet sustainability and water goals by 2050. That’s an average of $9.2tn a year with spending currently $3.5tn a year short of that1. A recent Economist article outlined just how far behind we are – the headline “the world is going to miss the totemic 1.5°C climate target” – doesn’t need any elaborating; although climate pledges (if achieved) would result in a 1.7°C temperature rise according to the Guardian2. At Fulcrum, we have made sustainability a core firm value and part of our purpose as a business, committing significant resource to become a leader in macroeconomic climate research. Signing up to the Net Zero Asset Managers Initiative (NZAMI) is part of that commitment, permeating much of what we do as a firm. We can create real change through our investments by funding the creation or improvement of sustainable assets and companies instead of just passively owning existing ones. We believe this is most impactful through our illiquid investments.
The ownership and maintenance of pre-constructed, existing assets like solar and hydropower facilities is, of course, crucial to meeting sustainability goals, and is where many ESG-focused funds concentrate. But it’s not enough. We need to build new renewable power generation facilities, new battery storage sites, install new home heating systems and improve the efficiency of our buildings at a much faster rate. These investments will, we believe, come with a substantial tailwind in terms of investment returns. Recent moves by the Biden administration via the Inflation Reduction Act as well as nineteen European countries announcing they are accelerating their decarbonisation targets following the Ukraine war3 are clear evidence of an ever-increasing momentum.
Listed Equity Markets
Many companies in the listed markets are contributing to the cause by building new assets to meet net zero. FTSE Rusell4 analysed 16,000 equities, 3,000 or so were found to have green products and services (or ~7% of 2021 market cap). This number has been growing at a CAGR of 24% from 2018-21, evidencing progress. That being said, the green economy is still only a small proportion of each sector with varying levels of saturation, e.g. only 5% of the Real Estate sector is ‘green’ versus 10% of the Technology sector. We co-lead the engagement with BP in conjunction with Climate Action 100 and they are a good example of change, having made, in our view, one of the most ambitious commitments to reduce emissions (and curb production) in the Oil & Gas sector. The company has pledged to “increase the proportion of its capital expenditure in transition growth businesses to more than 40% by 2025”5. We are pleased with the progress this engagement effort has made so far, while recognising they should go further and faster6.
Syndicated Debt and Private Debt
Primary debt issuance, both direct and syndicated via the banking sector, offers an opportunity to influence company management and direction. Banks are facing increasing pressure from shareholders and politicians to stop funding projects like new coal power plants. This is starting to yield results and should continue. Green/impact bonds are a welcome new development but remain a nascent asset class. Low rates haven’t helped – abundant capital has favoured debtors, weakening financial covenants and extending debt terms on lower and lower rates. Why would the average company want the hassle of adding green covenants too? The hawkish moves by central banks of late puts power back in the hands of the lender to design covenants that assist with the energy transition; for example, we are seeing some private debt managers look to incorporate carbon emission targets into all their loans. Infrastructure debt is often used to provide capital to sustainable projects at scale, although the yields are usually very low coupled with long bond durations. Therefore, these investments tend to only be suitable for liability hedging by insurance companies or defined benefit pension schemes.
Private Equity & Real Assets
That leads us to the rest of the private market, where we believe an investor can have the highest dollar-for-dollar impact. Given the heterogeneous nature of the universe, we walk through several important asset classes below:
Infrastructure and Real Estate
MSCI7 estimate ~90% of UK institutional investors that invest in real estate do so through ‘core’ mandates – this is akin to an investor holding a pre-existing asset mentioned at the start of the article. While core+ managers will make some improvements to their holdings (versus core investors who mostly maintain assets), they are small in nature, with the majority of returns still coming from asset operation. Moving up the return/risk spectrum to value-add, a smaller part of the market, involves the development of new assets or the large-scale improvement of existing ones. In the case of infrastructure, this is often done through buying land with planning permission and then funding construction, usually at a fixed price, reducing risk.
Within real estate, value can be added through improving energy efficiency or re-purposing a building, putting it to better use. This type of small-to-medium-sized development is vital to meeting net zero goals and is an area we allocate to within our illiquid portfolios. We don’t just need the largest offshore wind farms built by the likes of Orsted. We need solar panels on our local supermarkets and heat pumps replacing gas boilers in residential property. Net zero has to permeate our daily lives.
This asset class is somewhat less homogenious compared to infrastructure and real estate, often getting less attention by private market investors. Our chosen value-add focus here is on improving resource efficiency and driving toward a circular economy.
Forestry is a great example. Much of the world’s timber comes from smaller forests that are not run to the latest sustainability standards and lack efficiency, standing to benefit from better management. Buying small lot timber farms and improving them over time can have a host of potential advantages – higher carbon capture, yield, soil quality and increased biodiversity being some.
Precision agriculture and closed-environment farming are also budding areas for investment. Farming in its current form cannot continue – an ever-increasing requirement for farmland, the huge loss of topsoil via runoff and a growing use of pesticides and antibiotics are case in point. The institutionalisation of the greenhouse ‘closed environment farming’ sector is already underway, pioneered by the Norwegians. A greenhouse can be built on poor-quality soil and needs much less of it (output gains can be some 25x field farming), leaving space for renewable energy to be installed on any spare land to provide power to the greenhouse, or it can be rewilded. There are efficiency gains across the board, often only 10% of the water is required compared to field farming and pesticide use is dramatically lower too.
Private Equity and Venture Capital
The venture capital and lower-to-mid-size private equity markets are the bedrock of innovation and daily economic life. From a sustainability perspective, it is vital that we provide capital to those companies that are able to make the largest efficiency gains to their operations and to those creating goods or services that accelerate sustainability goals such as reaching net zero. We have a multi-sector approach and encourage clear sustainability plans.
Fulcrum invest across private and public markets and incorporates sustainability and ESG innovation across both areas. In the private markets, we believe that having a small-to-mid-market value-add investment programme gives us the best ‘bang for buck’, both in return per unit of risk and across sustainability metrics. Our hybrid-liquidity offerings provide highly diversified exposure to each of these areas to create a real-world impact for the generations to come without sacrificing return.