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Craig Mackenzie: How investors can double their capital allocation to finance the climate transition

Climate-enhanced strategic asset allocation could increase the capital available

Avoiding climate change is an investment problem. According to the International Energy Agency (IEA), the world needs to invest around $2 trillion dollars a year in low carbon energy and transport, in order to achieve internationally agreed climate targets. More than half of this increase needs to happen in the fast-growing emerging markets.

We have been making progress, but so far, the world is investing less than half the capital it needs to each year.

Whether or not the world avoids dangerous climate change depends – among other things – on whether investors can, in less than a decade, double the rate of capital investment in renewable energy and other climate solutions.

Is the global investment community really doing as much as it could to allocate capital to climate solutions? Could investors allocate significantly more capital – within their fiduciary and regulatory constraints?

The key initial question is: what proportion of institutional investor portfolios is currently allocated to finance the low-carbon transition – i.e. financing climate solutions like renewable energy, electric vehicles, storage, energy efficiency, whether via listed equity, credit, infrastructure or other asset classes?

The answer turns out to depend a lot on the asset class exposure an investor has – some asset classes are much richer in climate solutions than others. A standard global equity index, for example, has about 4% allocated to climate solutions according to MSCI data. Credit portfolios are similar, though variable depending on which kind of credit you look it. For government bonds (which essentially finance fiscal deficit spending), climate transition finance tends to be a much lower proportion. I estimate a fraction of 1% for US Treasuries. A recent vintage infrastructure portfolio, on the other hand, might have 20% or more allocated to renewables.

If you take these percentages and multiply by a portfolio’s asset class weights, you can get a first approximation of the total amount of capital the investor is allocating to climate solutions.

We’ve looked at a number of portfolios and find that investors allocate wildly different proportions of their portfolios to finance the climate transition, even when they have similar investment objectives – from next to nothing in some cases to 15% or more in others.

What explains this wide variation? With a few exceptions, this is not active choice, but the unintended result of the portfolio optimisation process used by most investors for strategic asset allocation (SAA). SAA optimisation starts with assumptions about returns, risk and correlation for a range of asset classes and then seeks to identify the asset class combination on the ‘efficient frontier’ that best meets the investor’s objectives. Using this process, investors with similar objectives will often end up with significantly different asset class weights, depending on small changes in assumptions, views or optimisation methods.

This raises a fascinating possibility. If some investors are managing to allocate 15% of their portfolio to climate solutions, and other investors with the same investment objectives are allocating next to nothing, could the low-allocators catch up with the high achievers? Could their SAA process be enhanced so that it actively maximises the allocation to climate solutions, while holding risk adjusted returns constant?

Our SAA modelling suggests that this is possible, and it can result in large increases in capital allocation to climate solutions, both by identifying more climate-aligned mix of equity, credit, infrastructure or real estate, and by allocating to climate-enhanced versions of individual asset classes. This approach can double, triple or even quadruple capital allocations to the finance the low carbon transition.

Typically, the objection to allocating capital to positive climate impact has been that investors have fiduciary and regulatory obligations to prioritise the financial interests of their beneficiaries.This objection is sometimes misplaced – expected returns available from clean energy are currently very attractive relative to other asset classes, e.g. government bonds where returns are at all-time historic lows.

But, more importantly, from a fiduciary governance point of view, the climate-enhanced SAA process we’re describing selects only between portfolios with the same projected risk-adjusted returns. Financial interests are prioritised; climate impact is only a secondary objective used as a tie-break between financially similar portfolios. Climate allocations are increased to the extent, and only to the extent, that expected returns are not compromised.

“Can investors actually solve the climate crisis just by tweaking their SAA process?”

It therefore provides a robust operational governance framework for institutional investors to measure and increase the percentage of their capital that they allocate to climate solutions (or wider sustainability objectives), while ensuring their fiduciary duties are fulfilled.

If widely adopted, climate-enhanced SAA could significantly increase the capital available for climate solutions, perhaps taking us a substantial step towards the doubling the IEA says is required.

Is it really as simple as that? Can investors actually solve the climate crisis just by tweaking their SAA process?

Yes and no. If all global investors attempt to adopt climate-enhanced SAA tomorrow, the global clean energy sector would struggle to absorb the additional capital: investment opportunities would become over-crowded and prices would rise. Higher prices would likely mean lower expected returns for clean energy investments, and the SAA process described above would, as a result, scale back allocations – this correction mechanism is an important feature of the climate-enhanced SAA process.

To avoid the overcrowding problem, growth in investment opportunities must rise in parallel with growth in capital supply.

This is a lot easier today than it was a few years ago. Renewables are now cost competitive with new coal and gas in many locations, so the scale of growth is no longer limited by the availability of government subsidies. However, there are still barriers – grid connectivity, energy auction design, price uncertainty etc.; but these are the kind of bread and butter challenges that investors routinely deal with – and IIGCC and others already have public policy engagement programmes directed at removing them.

Interestingly, one of the largest barriers to clean energy is the cost of capital itself, particularly in emerging markets where the majority of capital is required to avoid exceeding 2°C. Renewable energy is capital intensive, and so cost of capital is a big factor in its competitiveness. More supply of low-cost capital from institutional investors could increase the ability of renewables to win auctions.

There are rumblings of concern that despite its massive popularity, ESG investing has a hard time demonstrating its positive impact. What better way to change this, than for investors to demonstrate that a significant and growing proportion of their capital is shifting to finance the climate transition and other forms of real world impact? A climate-enhanced SAA process provides an operational framework for investors to achieve this, while safeguarding their fiduciary risk-return objectives.

Craig Mackenzie is Head of Strategic Asset Allocation at Aberdeen Standard Investments. He’s available via email.