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The Investment Case for Climate Opportunities

October 4, 2022

While asset managers are in the business of growing their clients’ wealth, they’re also increasingly being asked to support climate goals. On paper these two objectives may appear at odds with one another, but in practice there’s plenty of overlap between them.

Investing in climate opportunities can yield healthy financial returns and power the low-carbon transition, helping asset managers to fulfill both ambitions. These climate opportunities also usually come with lower non-financial risks, which have become more important to investors as environmental, social, and governance (ESG) concerns have climbed the agenda.

However, identifying the right climate opportunities to invest in is no walk in the park. Asset managers have to develop a holistic approach to climate investing if they want to capitalize on the most promising opportunities and avoid unwanted risks. As the market for climate-friendly investment balloons, they also need to be on the lookout for “greenwashing”: the practice of exaggerating how environmentally-friendly an asset is.

What is a climate opportunity?

Climate opportunities are investments that should yield positive returns as the world shifts toward a low-carbon economy and takes steps to adapt to global warming. As a new investment category, there’s debate over what assets and activities count as climate opportunities. However, the Task Force on Climate-related Financial Disclosures (TCFD), the world’s premier climate reporting framework, sets out a climate opportunities taxonomy that can serve as a guide.

The TCFD sorts climate opportunities into five major categories:

  1. Resource efficiency: Goods, services, and activities that promote lower energy usage. For example, improved building insulation and heating.
  2. Energy source: Investments in low-emissions power sources. For example, wind and solar generation.
  3. Products and services: Innovations that address climate transition and physical risks. For example, financial products that package and transfer companies’ extreme weather exposures to the capital markets.
  4. Markets: Opportunities linked to new markets and access to public sector incentives. For example, the growing carbon credits trade.
  5. Resilience: Efforts to enhance companies’, communities’, and countries’ abilities to withstand and recover from climate-related physical impacts and natural disasters. For example, investments in modern flood defenses.

These opportunity categories are not mutually exclusive, and a number overlap with one another. However, they are a useful lens through which to evaluate different climate-friendly investment options. 

The scale of climate opportunities is vast. In a 2021 analysis, the United Nations’ Race to Zero campaign estimated that USD$125trn of investment is needed to achieve a net-zero economy by 2050 and avoid the worst physical impacts of climate change. USD$32trn is needed up to 2030 alone, across six sectors: electricity, buildings, industry, transport, low-emission fuels, and agriculture, forestry and other land use. Race to Zero also identified 1,000 types of opportunities that cover different regions and technologies.

Choosing the right climate opportunities

The range of climate opportunities encompasses the entire risk-return spectrum. This means asset managers should be able to find climate opportunities that suit all investor types. These opportunities often track or exceed the returns available via conventional investments, all while furthering global climate goals. This should allow asset managers to recommend climate opportunities to clients that match their specific risk and return appetites. The key is first understanding what these appetites are.

Investors that want low-risk, low-return investments may be tempted by wind, solar, and nuclear opportunities. Plenty of large, established energy companies are scaling up their renewables businesses. Asset manager clients that want low credit risk and clean energy exposure could look at investing in green bonds issued by multinational corporations or private debt and equity deals linked to the renewables projects they sponsor. In jurisdictions where renewable energy benefits from supportive policy frameworks — like in the European Union or the US, following the passage of the Inflation Reduction Act — the risks of investing in these kinds of projects may be even lower.

On the other hand, clients with appetites for high-risk, high-reward investments may be more interested in experimental products and services opportunities. For example, carbon capture utilization and storage technologies play an important role when it comes to decarbonizing the atmosphere. However, these technologies are in the early stages of development and are untested at scale. The same goes for hydrogen-based technologies, as well as activities focused on decarbonizing industrial processes, like steelmaking. While these opportunities have enormous growth potential, many also come with a high risk of failure. 

Other factors — like an investor’s time horizon, liquidity preferences, and sectoral or regional biases — are also important to consider when matching a client to the right climate opportunity. The sheer size of the climate investing universe means there’s something for everyone. 

What about investment returns?

There will still be times when non-climate-related opportunities or even climate-harming opportunities, like new fossil fuel projects, appear to offer higher returns for the same risk as a similar climate-friendly investment.

However, asset managers and investors should understand that these promised returns may be illusory. Why? Because it’s unclear right now whether climate risks are properly factored into market prices. Investors and investees rely on well-established financial models and techniques to project the rate of return of a given asset. But these tools have traditionally neglected how climate transition and physical risks could impair an asset’s value over time, because the relevant data is rarely disclosed or is considered immaterial for investors’ decision-making.

This is starting to change as more companies put out high-quality climate disclosures. More than 3,400 entities support the TCFD, and a number of jurisdictions have already enforced, or are in the process of establishing, climate reporting requirements. 

Still, the piecemeal rollout of global climate reporting, coupled with the lack of standardization across sectors and countries, means markets are picking up more noise than signal from disclosures. As a result, certain assets — especially those highly exposed to climate risks — could be grossly mispriced. For example, an investment in a new oil and gas refinery may be worth far less than advertised once an investor factors in the implications of climate policies, the rapid uptake of electric vehicles, and the increased extreme weather risks that the facility faces.

It’s the duty of asset managers to tell their clients that there’s more to an investment than its headline return figure. They must also explain how they could take on more risk than anticipated if they don’t delve into how climate change could affect a given investment’s performance.

Watch out for non-financial risk

Investors that focus solely on financial metrics expose themselves to a universe of non-financial hazards linked to climate change. These include reputational, policy, and legal risks that may have little to do with an investment’s economics but have the potential to erode its value over time. Take the example of California-based utility company PG&E, which filed for bankruptcy in 2019 under the weight of more than USD$30bn in lawsuits which alleged the firm played a role in causing the Golden State’s wildfires.

Climate opportunities are typically less exposed to non-financial risks. A renewable energy company is not going to be sued for contributing to climate change because it doesn’t produce greenhouse gas emissions, whereas oil and gas companies are already battling dozens of climate-related lawsuits — some of which could prove costly. Similarly, an investor is unlikely to suffer reputational damage for investing in a zero-carbon steel mill, but it could take a hit for adding a methane-spewing chemical plant to its portfolio.

The growing demand for climate opportunities has given rise to another non-financial risk: greenwashing. To cash in on the popularity of climate-friendly products and strategies, asset managers are increasingly incentivized to brand their assets as green. In some cases, unscrupulous firms have relabeled old investment vehicles as climate-friendly or have added a “green” spin to conventional products’ or strategies’ marketing materials. These schemes could lead investors to unwittingly invest in non-climate opportunities or in investments that actively harm the environment.

Greenwashing elevates the importance of investor education and asset manager transparency. Without these two, clients and managers could suffer the reputational fallout of being publicly labeled as “greenwashers.” 

Educate, then execute

Asset managers have ample scope to boost their clients’ returns through climate opportunities. But investors may require guidance when it comes to navigating this evolving investment landscape. Companies can help by compiling climate-related information on their products and strategies and describing how this data could affect their risk-return profiles. Firms can also support initiatives like the TCFD, which seek to increase the prevalence of climate disclosures, allowing climate risks to be consistently priced into investments.

Asset managers may also want to reconsider their own messaging. Marketing climate opportunities as a chance to “do good” may attract some investors, but it’s unlikely to stir those who care most about portfolio performance. Making the case that climate opportunities offer better risk-adjusted returns than non-climate or climate-harming investments is key to convincing investors of their value and driving asset flows. It may also help asset managers refute the claims of those that oppose climate investing on ideological grounds. The response of the world’s largest asset manager, BlackRock, to US Republican state officials is an example of this approach in action.

How Manifest Climate can help

Asset managers and investors want clarity on how climate factors could affect investments. Manifest Climate’s leading Climate Risk Planning solution allows financial institutions to identify climate risks and opportunities, build internal climate competence, better align their disclosures with global reporting frameworks, and stay on top of market developments and peer actions. Request a demo to learn more.