Our research suggests there is a disconnect between decarbonisation intentions and outcomes. The majority of asset owners (55%) who implement climate-related factor integration as an investment tool say it contributes more to portfolio decarbonisation than to reducing emissions in the real world (45%). A difference of 10%. Transition finance displays an inversion of this pattern – 34% say it makes a significant contribution to portfolio decarbonisation, compared to 52% who say it is lowering real-world emissions. A difference of 18%.
Transition finance is clearly recognised for its real-world credentials over and above meeting portfolio decarbonisation targets
The fact that developed countries have dominated the discourse on climate change may have contributed to this disconnect, explains Xolisa Dhlamini, Head of Sustainability Operations and Impact at Sanlam, a multinational financial services group headquartered in South Africa. There is a very narrow focus in the climate discourse because, quite often, the discourse is focused on solutions that speak to mitigation. Whereas [systemic] adaptation and transition are not yet getting enough financial support because of the skewed focus on mitigation opportunities,” he says. “It’s frustrating for us, as we’re operating in emerging markets, which are impacted significantly by climate change.”
Conflicting priorities
Surprisingly, the study shows that climate-related investment practices seem to have decreased, year-on-year, across the board. Despite asset owners viewing positive screening as the practice with the strongest impact in lowering real-world emissions, just 33% are using it in 2023, down from 44% in 2022. There are also fewer owners using active engagement (35%, down from 47%) and the adoption of climate-related themes (33%, down from 45%), both of which most asset owners say make a high contribution to lowering real-world emissions. Negative screening is the only practice on the rise (37%, up from 29%).
The decrease in certain practices is even more apparent in North America, where 2022’s top choices have plummeted: factor integration and positive screening, both cited by 52% in 2022, are now used by only 25% and 45%, respectively, while those adopting climate-related themes have decreased from 48% to 33%.
The US-based sustainability leader points to “the whole rhetoric playing out around ESG” in their country. “It’s hitting a lot of asset owners and more directly around pension funds. Certain states aren’t so fond of this concept of ESG, and there’s actually some impact that state legislators or attorneys general can have over how state funds are invested.”
Fewer report using climate-related themes, positive screening and active engagement
Climate targets are perceived to weigh on returns
The focus on emissions profiles, rather than real-world impact, may be related to the perception of a trade-off between climate-focused practice implementation and actual financial returns. Over half of asset owners (54%) are worried about achieving emissions-reduction targets while delivering the best possible returns. This is despite a reported appetite for high-risk/high-return investments: more than half (51%) state that their fund is seeking to invest in high emitters with innovative or ambitious decarbonisation plans.
“Asset owners need to maintain balanced and diversified portfolios, while managing risk, including climate-related risks,” Bioy explains. As the world transitions to a low-carbon economy, asset owners should know exactly how the companies they invest in plan to adapt their business models, their operations and their products and services. “Companies should have credible transition plans with science-based targets, and if they don’t, then asset owners need to engage and put pressure on them to disclose one. Transition plans are becoming mandatory in some countries, like in the UK,” she says.
Asset owners are looking to invest in high emitters with strong plans but appear worried about related returns
Research by Imperial College has found that return expectations for clean and renewable energy investments were on a par with or even better than traditional investment asset classes, including fossil fuels. “In many cases, the returns are more stable, which is a trait that many investors value. So, it’s not just the absolute return, but also the lack of volatility, which can actually be a huge benefit to asset owners,” Imperial College’s Wilkins says.
The transition finance opportunity
Although transition finance is the climate-related investment practice least cited by survey respondents, there is evidence to suggest that interest is high and the outlook for the investment strategy is strong.
Asset owners are aware of their role in helping companies in hard-to-abate sectors transition to sustainable business models and practices. More than half (51%) agree that financial institutions have a responsibility to help fund the decarbonisation of high emitters.
“When you look at the economic activity that has generated environmental damage, the private sector should clearly be contributing to addressing the risks brought by climate change,” says Xolisa Dhlamini. “Asset owners need to drive that through investments, whether it’s for mitigation, adaptation or transition — whatever the case may be, they have a part to play.”
Two in five respondents (40%) report that their fund currently owns or manages transition finance investments, with around one-third saying they will likely be making transition finance investments within the next 12 months (35%) and the next three years (30%). Only 3% state that they have no interest in transition finance investments. Existing transition finance allocations are mostly applied to actively managed private debt (38%).
Transition finance can be a strong instrument for investors looking to achieve real-world impact, according to the 52% who say the practice’s contribution to lowering emissions is high or very high. On top of this, 60% of consultants say they advise clients to make allocations to transition finance, even where this could increase portfolio carbon intensity.
The outlook for transition finance is especially strong in emerging markets and developing countries, which are expected to account for the bulk of emissions growth in the coming decades4. While private financing for emerging economies is currently limited because of risk aversion and disincentives to invest in hard-to-abate sectors (which make up a larger share of those economies), 57% of respondents agree that emerging-market transition finance will grow rapidly over the next three years.
In fact, half of respondents (51%) say that emerging-market transition finance is a major commercial opportunity for asset owners. However, concerns about future returns mirror those in developed markets. More than half (52%) also appear concerned about the risk/return profiles available in the universe of emerging-market transition finance assets.
Hortense Bioy says that there is a need for greater innovation to help developing countries access sustainable finance, such as blended finance: “In a public-private partnership, the government will take on the higher-risk tranches of an investment, and that will allow private investors such as asset owners to come in and thus scale the capital that is needed.”
Next chapter:
How can asset owners achieve real-world impact?
Asset owners are asking for greater standardisation and significantly more guidance regarding their approach to investing for an inclusive energy transition.
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