Impact Investing and Decarbonisation

Writer: Hauk Hofseth

Ever since Thomas Newcomen invented the first coal-powered steam engine in 1791, combustion of coal, oil and other fossil-based fuels has contributed to climate change. About 75% of total greenhouse CO₂emissions is a result of burning fossil fuels,[1] which in turn makes up about 80% of global energy consumption.[2] Moreover, these numbers are likely to look a lot worse over the coming decades- mainly due to increasing demand in the developing regions of the world. The aim of this article is not to detail the perils and propagators of the climate crisis however, but rather to point out some potential solutions. More specifically, I wish to explore the intersection of finance and environmental responsibility, with focus on the strategies most likely to make an impact.

ESG, or environmental and social governance, has been one of the foremost buzzwords of the decade in finance -with fierce competition form the likes of AI and blockchain- leaving some desensitised and skeptical of its merits. Some skepticism is healthy, as many firms exploit vague and weak standards and regulations with so called ‘greenwashing’. Nevertheless, stakeholder capitalism is gathering momentum in finance, and I will try to show that ESG considerations have not only environmental merits, but also that it should be a part of any profit-seeking strategy.

Few places have the share- to stake-holder transition been more apparent than in private equity. The swashbuckling corporate raider image of the 80s has largely been replaced by ideas of Corporate Social Responsibility and Green Growth. Nevertheless, the PE sector has seen a steep and steady ascent in size and value since the 80s.[3] Despite a favourable image being useful for fending off regulators and attracting talent, this growth is likely owed more to other factors than CSR. It does dispel a misguided myth though; High ethical standards and high profits need not be mutually exclusive. In fact, evidence is increasingly pointing to the contrary. An Oxford University paper confirmed that there is a conclusive correlation between sustainable business practices and economic profitability.[4] Nevertheless, sustainable investing is still underdeveloped and often misguided.

Source: Mastering Private Equity: Transformation via Venture Capital, Minority Investments and Buyouts, (2014), Zeisberger, C. et al.

The above illustration shows the gradient of private equity strategies and fund types in relation to social concerns. Despite the diverging line implying a trade-off between financial and social returns, it serves the purpose of differentiating between fund strategies. In the traditional shareholder model, corporate returns are paramount, come what may. The next step is negative screening, which refers to a popular approach revolving around a ‘do no harm’ concept originating from the Quakers refusing to invest in the alcohol and slave trade. Screening typically results in including reputational risk in due diligence and avoiding controversial investments, like tobacco, arms and oil. Proactive ESG managements improves on this by actively including ESG standards and programs in pre- and post-investment decision-making. Impact Investing takes this further by having social returns as a core goal in the business model, ensured and monitored by deep integration in firms’ Key Performance Indicators (KPI). As venture philanthropy, which seeks profits only for further philanthropy, is beyond the scope of what can be expected at scale from private actors, I will highlight impact investing as the ideal for PE.

In a 2015 report on impact investing McKinsey forecasted assets under management in the sector to grow to more than $300 billion by 2020, but even that would be a small fraction of the $2.9 trillion or so that will likely be managed by PE firms worldwide in 2020.[5] The same report concludes that impact investing can be both socially and financially profitable, returning a median internal rate of 10% on 48 investor exits in India between 2010 and 2025. At the same time, impact Investments touched the lives of 60-80 million people in India, one of the key targets for impact investments.[6] The perhaps most impactful investment opportunity of all is the clean energy sector. The climate crisis is global in scale, and costs to humanity are rising steeply. Renewable technologies like off-shore wind and photovoltaics are characterised by high up-front financial costs, but then low marginal costs, and would thus benefit from even more investment. Other promising technologies, like hydrogen-energy and smart grids, are being realised with the help of visionary impacts funds. Examples include Vital Capital Fund, working on infrastructure, education and renewables in Sub-Sharan Africa, and Energy Impact Partners, who at the vanguard of the ESG boom is investing their 1.2B$ in green technology ventures. In fact, the clean energy sector investments consistently made some of the highest returns in the McKinsey survey.

This has shaken even the Big Oil behemoths, who as a testament to ESG efficiency are increasingly pivoting towards renewables- as investors are divesting. The 1t$ Norwegian sovereign wealth fund and PE giant BlackRock are two examples. However, these efforts might be misguided. Bill Gates, the most generous philanthropist is history, has been at the forefront of oil divestment critique. The reality is that when a company is still profitable for the foreseeable future, someone out there will be willing to fund it, even if lower share-prices push capital costs upwards. Divestment from fossil-fuels and ‘sin-stocks’ in general, thus mainly serve to place these stocks at a discount. In fact funds and PE firms specialised on taking advantage of this perceived undervaluing is increasingly popping up, and a London Business School study confirms that sin-stock investments beats the market.[7] Hence, fossil fuel divestment rewards the immoral buyers, while not having any effect on the companies actual cash flow. INSEAD professor Theo Vermaelen suggests in a blog posts that the optimal strategy for society is to allow investors to invest in any securities, but have thorough CSR balance sheet reporting. Regulation could then require all profits from securities which does not meet standards to be invested in ventures with positive social impact. This would shift focus from damages in absolute terms to the harm reduction in relation to value creation, allowing maximisation of eco-efficiency.

Note that all this does not discredit ESG as an essential part of the modern business model, but rather highlights the inadequacy of negative screening as an ESG investing strategy, and the need to step up to impact investments. Ultimately, Big Oil will stay in business until demand falters. The last decades have been characterised by disruption and innovation, and yet the oil sector is relatively homogenous. While profits have been declining, larger forces are needed to complete the shift to renewable energies. The coronavirus demand shock coupled with the oil price war may damage firms’ profitability, but it also makes oil dirt cheap. Despite a very positive trend in the price of unsubsidised renewable energy, it is near impossible to compete with oil prices hovering around the 30$ mark.

Source: Lazard’s Levelized Cost of renewables Report 2017

The impact from investments in energy efficiency nascent clean energy technologies is likely the best bet when it comes to reducing fossil fuel demand. This point is not lost on Big Oil either, as we have seen increasing diversification away from fossil fuels among the oil majors. Not only rebranding, like British Petroleum becoming Beyond Petroleum or Statoil changing to Equinor, but also genuine action: both firms have pledged to reduce or offset total emissions to zero by 2050. The latter has also launched its own impact fund, Equinor Energy Ventures.

Amid the optimism, it is important to emphasise the gravity of the energy transition challenge. While the initial statistics in this article, like most current statistics on climate, provides a grim outlook, few are scarier than these numbers from the UN: reaching the Sustainable Development Goals in developing countries will cost about $3.9 trillion per year—and private and public sources are currently providing only $1.4 trillion.[8] This is a discrepancy that mega-institutions and undergraduates alike need to take in. The UK, as the world’s impact investment capital, is well positioned to do it’s part in helping the impact investment market mature, through incentives, regulation and it’s unique status as a hub for technology and finance- a view echoed in Nick Robins of LSE in his 2020 sustainable growth report[9]. Incubation is a word with increasingly negative connotations as of late, but I would like to implore you to leap back to memories of Silicon Valley idealism and the brazen optimism of the bull-run. Idealism and optimism are crucial ingredients in any plan aiming to realise the potential gains from impactful investing- environmental and financial gains alike.