Innovative blends of private and public capital will be required to solve decarbonisation challenges in infrastructure and make the costs and benefits stack up for investors, said a panel of experts at Sustainability in Practice.

Government cooperation alongside private capital will be required to decarbonise some of the more challenging cases in infrastructure. For example, limited government grants could tip the scales in favour of lower-emissions measures making business sense, argues an infrastructure investment head.

John Ma, partner and head of North America infrastructure at Igneo Infrastructure Partners, the private infrastructure investing team within global asset manager First Sentier Investors, said the group had made significant investments into the renewable power generation sector in recent years, and there is “no shortage of capital within the renewable power space as it stands today.”

However, a “more challenging case” is achieving the emissions savings that can be made by increasing reliance on rail freight and reducing the use of trucks which have a much higher level of emissions per freight ton per mile.

“Looked at from a macro or policy perspective, if we as a society or government, can encourage more of a modal shift from trucking to rail, there will be huge savings in terms of carbon emissions,” Ma said.

On North America’s class-one railroads which carry freight trans-continentally on 100-car trains for thousands of miles, it is a relatively simple business case to replace fossil fuel-burning locomotives with electric locomotives.

The fuel savings alone can justify investing in electric locomotives, with some adopting a so-called “Prius” model where they will have a mix of diesel and electric locomotives driving a train to reduce overall emissions.

But it is harder to make the numbers work for short line freight railroad companies such as Patriot Rail, which Igneo has invested in. These companies connect shippers to the national network via short line routes scattered around the country without a central network, Ma said. Newer electric locomotives are around ten times more expensive than diesel-electric locomotives, and for a line that may be only 50 miles long, the fuel savings aren’t sufficient to justify this.

Other technologies are also in pilot phases, but so far none make business sense for this sector when looking at the bottom line.

This goes to the question of the role of private capital and what the government can do to decarbonise the sector, with both needing to act to make it work. Infrastructure grant programs could reduce the net cost of electric locomotives for railroad owners, and potentially drive down the cost of these units over time.

“You only need to go back to look at the renewable power sector and see what’s happened to solar cells and batteries and wind turbines,” Ma said. “With some catalyst, a bit of support from government, hopefully that cost equation comes down, and over time the cost-benefit will stand on its own.”

Igneo is still assisting with lowering transport emissions through its investment into Patriot by making modest investments in “transloading”. This refers to a factory that is, for example, 20 miles away from the railroad and loads its goods onto trucks because it is not next to the railroad. A modest investment can involve setting up a loading platform that would allow the goods to be taken 20 miles to the railroad, instead of all the way to to their ultimate destination by truck.

Max Messervy, head of sustainability, Americas, at Mercer, said Mercer’s manager research team has been integrating ESG ratings at the investment strategy level since 2010. Mercer uses a rating scale from one to four to rate how effectively and cohesively a particular strategy’s portfolio management team integrates ESG to drive value creation, compared to other peers in its asset class and universe.

This involves things like looking at how ESG data factors into new ideas; how ESG is integrated into portfolio construction and how it is implemented into engagement and proxy voting. It also considers how much support there is from the top down for these various activities, including investment in data software and analyst teams.

Out of 4700 strategies Mercer has rated, 171 are infrastructure-related and over 50 per cent have a rating of one or two, which are the top ratings, suggesting a systematic, consistent approach to ESG.

This significant level of ESG interest shows ESG considerations are essential to the infrastructure asset class, Messervy said.

“Massive construction projects affect communities; they produce environmental impacts that can be mitigated – or not. Ultimately this leans towards questions of social license to operate,” Messervy said.

With electricity, heat and power generation along with transport as the highest emitting sectors, there is a focus on decarbonising these sectors and on shifting energy consumption patterns, Messervy said. It is critical for asset owners to understand if their managers are taking decarbonisation policies into account, and thinking about how the macro-environment might shift if carbon prices are introduced.

The massive flow of capital needed to achieve net zero goals will require record levels of spending, he said.

He noted there will also need to be “massive flows of capital” into emerging markets to achieve the United Nation’s Sustainable Development Goals, and this will require alignment among investors. In private infrastructure and real assets in emerging and frontier markets, “the perception of risk frequently is overstated depending on jurisdiction,” Messervy said. Investors typically have a home country bias with limited allocation to emerging markets, he concluded.

Assessing the credibility of carbon transition targets is multi-dimensional and complex. Investors should be wary of pitfalls such as being “too ambitious on [carbon] metrics” in their portfolios to the detriment of helping to change the real world by engaging with high emitters, said Carsten Stendevad, the co-chief investment officer for sustainability at Bridgewater Associates.

“Too much focus on your own portfolio and not enough focus on the real world in terms of your goal setting is very dangerous,” said Stendevad, in a discussion about investors’ role in the transition to a low carbon economy at Conexus Financial’s Sustainability in Practice Forum at Harvard University.

Industries such as metals and mining are unsustainable in their current practices and critical to emissions reduction as they produce the zinc and copper that are needed in solar panels and electric vehicles, he said, in conversation with Amanda White, director of institutional content at Conexus Financial.

Investors need to look at the impact and potential future impact of the carbon transition on individual companies or countries, not just to figure out the potential risk to their portfolios but also with the aim of proactively deploying capital in a way that is financing the transition, Stendevad said.

“It’s critical to be able to understand at the security level, which company is, so to speak, a part of the solution and which companies are part of the problem.”

Stendevad presented statistics showing the most-carbon-intensive 30 per cent of global market capitalisation represents 90 per cent of corporate emissions and 60 per cent of all emissions. The 20 most emitting companies represent around 20 per cent of global corporate emissions, he said.

Pinpointing these pain points is relevant because these industries are susceptible to policy shocks and direct environmental shocks. They are also the companies that will need the most financing to change.

“They’re also the ones that need most of the financing, they’re the ones that need to change the most,” Stendevad said. “They really are at the centre of the transition story.”

Problematically, when looking at the science-based targets that companies have announced, total emissions aren’t moving much in his projections because most of the companies with ambitious targets tend to be in industries outside of those mentioned above.

“It’s wonderful if a pharma company reaches net zero…but it’s not the most critical thing for the world in terms of reaching net zero,” Stendevad said.

500 top emitters

Most critical, is action from the top 500 emitters, “who by-and-large don’t really have concrete plans,” Stendevad said.

Investors can look at three types of companies that are part of the solution, which he labelled broadly as leaders, enablers and improvers.

‘Leaders’ are not part of the problem, and may have either been “born emissions light” or have made a successful transition. ‘Enablers’ are companies that are critical for other companies making the transition, such as green technology companies and others providing solutions to aid in the transition.

But it is the ‘improvers’ that Bridgewater is particularly focussed on, as they are entities that currently are not sustainable. A key question is whether they are on a forward-looking path to becoming sustainable. Many of the companies in this category will not actually turn out to be improvers, he said.

“This group of companies is very tricky because…you can’t just sit back and assume that everyone is going to figure it out,” Stendevad said.

The challenge for asset owners is credibly identifying those that will turn out to be improvers. Investors also must deal with the potential impact to their own image and carbon metrics by getting involved with these companies which “don’t look good today.”

“So it requires you to lean in to companies that are unsustainable today,” Stendevad said. “It may even hurt your portfolio metrics, carbon metrics and others, but if you care about real-world outcomes, they’re the most important ones for the transition.”

This leads to the pitfall of “being almost too ambitious on metrics, like in my portfolio I want to have a perfect emissions metric by next year.”

An ongoing research effort by Bridgewater over the last five years has involved building a systemic sustainability assessment at the company level. It looks at where companies are now and where they will probably be in the future.

Assessing the credibility of improvement plans is critical. Is there a proven way that this company can reduce its emissions?

“If there is a proven technical way of doing it, but it just hasn’t been done yet, that of course makes a plan more credible,” Stendevad said. “If it’s effectively an unproven technology that we hope will come in 2040 and we will wait until it happens, that makes a plan less credible.”

Credibility

Other questions to ask when assessing credibility include looking at how economic is that abatement plan, and how specific are the targets.

It is also important to look at whether it is reflected in the corporate strategy. “When you actually hear CEOs talk to investors, is this front and centre of what the company is actually doing and talking to markets about?”

Additionally, is it reflected in how the companies are spending their money? Is it aligned with the company’s financial strategy?

Assessing the auto sector, for example, is relatively easy as “it’s pretty clear what needs to get done.” Electric vehicles technology is already proven, and making this transition is realistic, he said.

Conversely, metals and mining is “a much more multi-dimensional and complex industry to assess,” because its products are critical for electric vehicles, solar panels and other technologies that are part of the solution, but its current practices are unsustainable.

An ongoing challenge includes dealing with the inherent ambiguity and imprecision of forward-looking assessments, he said.

Some companies may be doing all they can to transition and may not succeed, while others “will just legitimately say we just don’t know how we’re going to transition.”

“We feel we have enough [information] to start directing capital in this manner. We’re trying to be very humble but [we have] enough to make the relative assessments of who’s on a good track and who’s not.”

A “political solution” is the only way to supply energy needed to warm homes through Europe’s winter, according to an energy sector specialist with PGIM.

There is “no physical solution” to the energy shortage facing global markets in the near term, and there has to be “some kind of political solution,” according to an energy sector specialist with PGIM, the principal asset management business of Prudential Financial.

Today’s shortage of oil and gas has been years in the making, according to David Winans, principal and credit analyst for PGIM Fixed Income’s US investment grade credit research team.

Companies capital spending had been slowing ever since the 2014 oil glut that followed the “shale revolution” in the United States that started around 2006, but when the pandemic hit companies slashed capital to the bone and production finally rolled over.

The OPEC price war and ESG pressures also put pressure on investment and spending levels before oil and gas demand snapped back quickly after Covid-19. Then came the Russian invasion of Ukraine, and now Russia’s cutting off of gas supplies to Europe.

In a podcast discussion with Julia Newbould, managing editor of Conexus Financial, Winans said Europe’s gas shortage cannot be quickly resolved by US exports due to limits to liquefaction capacity. The US also faces its own supply issues due to the reluctance of oil and gas majors to invest heavily in the sector, and other issues such as ongoing legal challenges to pipelines (such as the Mountain Valley Pipeline), Winans said.

While Liquefied Natural Gas is a good alternative energy source, the greatest challenge is in getting it where it needs to be, Winans said. There is “plenty of gas in Canada at low prices,” and Canadian Prime Minister Justin Trudeau had expressed interest in the possibility of exporting gas to Europe, “which is very interesting, considering there’s no LNG export facilities in Canada,” Winans said.

You have to liquefy it, and these facilities take at least two years to build and they’re billions of dollars and it’s too late to do anything about it this winter,” Winans said. Gas pipelines from Africa could be part of the solution, “but once again these are long-term solutions and the crisis is now, so I don’t know what the answer is going to be, but there’s going to have to be a political solution to this,” Winans said.

Renewables will not satisfy aviation demand, trucking, shipping and other industrial uses, he said. They are also “not that great for heating your home,” and will not get Europe through winter.

Newbould asked his thoughts on balancing short term gains with the longer term transition to a lower carbon world.

The ongoing transition to green energy has put pressure on the supply side of the equation, but “oil demand and gas demand hasn’t moved at all,” Winans said, admitting he is not convinced markets have yet seen the peak in demand for fossil fuels.

For investors in the short term, “the money is there in oil and gas,” he said. Longer term, there are questions about the impact ESG considerations will have on supply.

“So, an oil price of $90 a barrel is telling you we need more supply investment now, but the funny thing is the ESG considerations have got many companies, like maybe some of these European oil majors, saying, “we don’t want to make those investments anymore.

“So there has to be some kind of supply response at some point, if you think the demand is going to be there,” Winans said. “And, despite this energy transition, I haven’t seen any clear evidence that demand is really rolling over anywhere, aside from European natural gas which is going to definitely get some demand destruction… globally, it’s still strong. People want this stuff…and we can’t replace all of it that easily.”

There is an overlap between mega-trend investment themes and the United Nations’ Sustainable Development Goals, according to Marc-Olivier Buffle, head of thematic research and client portfolio manager at Pictet Asset Management.

In a discussion about balancing active risk, tracking error and sustainability at Conexus Financial’s Sustainability in Practice Forum at Harvard University, Buffle said thematic investing involves identifying economic activities that are supported by multiple mega trends to identify companies that will grow faster for longer.

“We’re talking about economics…and positive risk return, and then on the other hand, about having a positive impact in terms of society,” Buffle said. “Now, if you look at the growth rate of the companies in our thematic universes over 5, 10, 15, 20 years, you find that the growth rate of those companies is superior to the MSCI world.”

Pictet’s thematic focus on water aligns with SDG number six, focused on clean water and sanitation.

On the issue of data related to impact investing, he cautioned regulators against standardising data too quickly; getting too strict too quickly could stifle innovation.

“We are ready for transparency,” Buffle said. “We are ready to demonstrate how we do business and explain to people how we do it so that people can choose the right things. But let’s not standardise too quickly the kind of data that should be shown by the asset management industry because we are in the midst of an incredible amount of innovation and creativity.”

Also on the panel was Charles Hyde, head of asset allocation at New Zealand Super–a sovereign wealth fund created to help fund New Zealand’s national pension system.

Hyde said in 2016 the fund began a project to better understand climate change and its implications for the portfolio, having taken the view that carbon risk was not being properly priced in the market.

“An alternative way to think about this is that our carbon exposure in the portfolio amounted to an undue risk,” Hyde said. “The term undue risk has special relevance to us because it’s taken from the legislation that underpins our funding –  what we call our mandate.”

Reducing carbon intensity and fossil fuel reserves are the two main targets, focused particularly on the fund’s passive equity holdings. “We don’t have active equity managers, so that makes it a little bit easier to implement this strategy,” Hyde said.

Complexity

A customised solution implemented in association with MCSI complicated the portfolio substantially. It was implemented to the actual portfolio and also to the reference portfolio, the fund’s benchmark portfolio.

“One thing we regret a bit about that decision…was that the reference portfolio is supposed to be a simple and easy-to-implement portfolio [and] low-cost,” Hyde said. “I don’t think that satisfied the ‘simple’ at the end of that project because we had to, as I said, implement a fairly complex set of algorithms to lower our carbon exposure.”

Subsequent work was around climate scenarios, which was “quite difficult work.” Creating the scenarios was challenging enough, but applying those scenarios to specific assets was even harder.

More recently the fund has reconsidered both its purpose and its mandate which included the phrase ‘best practice portfolio management.’

“If you go back six years, we had a purely traditional interpretation of what that means, which is very much in the risk and return space,” Hyde said. “Now we think that addressing ESG considerations [and] sustainability more generally is very much part of what is required in terms of meeting that particular leg of our mandate.”

The fund also broadened its approach from initially taking defensive actions to protect the portfolio from the “external threats out there from the ESG complex,” to the more proactive stance that it was the fund’s responsibility “to be making investments which had a positive impact back on the environment.”

This has included realigning both the reference portfolio and actual portfolio with MSCI Climate Paris-Aligned Benchmark indexes.

Eric Farls, senior portfolio manager and ESG committee member at Maryland State Retirement and Pension System, said the System signed up to the United Nations’ Principles for Responsible Investment in 2008 and encourages the adoption of the UNPRI principles through its portfolio of external managers.

This has involved a range of practices and procedures that must take place before money can be awarded to a manager, including ESG-related questions, manager interviews and discussions of the findings during investment committee meetings.

The fund has more recently expanded its resources by hiring an ESG governance officer who will start next year.

When company leaders are presented with predictive maps showing the increased prevalence of drought, wildfire or flooding in their area due to climate change, one of the most common reactions is “Where did you get this information from?” according to Chris Goolgasian, director, climate research and portfolio manager at Wellington Management which has about US$1.4 trillion in assets under management.

While efforts to mitigate global warming are increasingly widespread, Goolgasian said communities and businesses around the world are under-informed and largely unprepared to adapt given a 1.5 degree Celsius increase in average temperatures is almost certain.

In a panel discussion at Conexus Financial’s Sustainability in Practice Forum at Harvard University, Goolgasian spoke with Zach Zobel, a scientist at the Woodwell Climate Research Center, about the ongoing partnership between Woodwell and Wellington. 

Societies face new vulnerabilities over less time than the duration of a typical mortgage, according to research by Woodwell. The discussion also highlighted the role the private sector can play in assessing and reducing the socio-economic risks associated with climate change.

 Translation between the worlds of science and finance is one the most important challenges in the partnership, said Goolgasian.

 He described the top floor of Woodwell, located in Falmouth, Massachusetts, where geo-spacial analysts create maps predicting the physical impacts of climate change. This helped him realise climate change research needed to be made visual for the finance world so the patterns and impacts could be clearly recognised.

 The partnership developed a mapping tool, the Climate Exposure Risk Application, or CERA, which incorporated company locations and data with the seven major climate risks of heat, drought, wildfires, hurricanes, floodwater, scarcity and sea level rise.

 Woodwell and Wellington partnered in 2018 to integrate climate science into asset management, using quantitative models to better understand how and where climate change may impact global capital markets.

 Their research has been used to rate 1600 stocks for their physical climate risk, with about 40 per cent receiving a 5 rating, which is the highest climate risk.

Semiconductor risk

 Semiconductor companies, for example, are highly water intensive. Using drought and water scarcity maps for the next 30 years, the research partners pinpointed the locations of semiconductor companies in regions with drought problems, notably Taiwan which has experienced significant droughts in recent years.

 Said Goolgasian: “We talk to the management team: What’s your backup plan for this? What’s your assumed cost of water? What are you going to do?” They can then talk about resiliency plans and the capital expenditure involved, along with freely sharing these maps with the companies to enable them to take action, he said.

Hydro power and agricultural crop yields are other areas set to be increasingly impacted by drought in the coming years, he said.

In another example, wildfire will become more prevalent in Europe, where in the past, few companies have had to consider this scenario or price it into their forecasts.

Companies have typically reacted positively when presented with this data, Goolgasian said. Moreover, the data has not yet been commoditised and often cannot be found using Google.

“I would say that reaction of ‘Where did you get this information from?’ is the norm,” Goolgasian said. “There’s very little denial that climate change is a real thing.”

Goolgasian described early conversations with Woodwell experts where he was told “adaptation” was the most under priced concept in the marketplace. As carbon levels are now beyond the point where mitigation is the sole fix, adaptation also needs to be factored in, he said.

 Zach Zobel said average global temperatures are going to rise 1.5 degrees Celsius “almost with absolute certainty,” and dealing with the impacts associated with this temperature rise is the focus of adaptation efforts, with mitigation efforts hopefully preventing an increase of 2 decrees Celsius.

 The increased occurrence of drought, and its impact on agriculture systems and available water, is “probably the one I’m most concerned about,” Zobel said.

 Areas that experience drought may, despite lower average rainfall, also experience more extreme precipitation events, he said. This was demonstrated starkly in Eastern Australia in recent years, with flooding this year in the same areas that experienced the 2019-20 bushfires.

“Our stormwater management system is out of date pretty much in every major city in the United States,” Zobel said.

Zobel described other projects Woodwell has in the works, one of which is with a company called Probable Futures which is taking the science and some of the data layers Woodwell produces and making them freely publicly available, along with education about how it should be interpreted.

Another project involves working with municipalities and town leaders around the world to help them understand the climate risks they face. This has included municipalities not just in the United States, but also in Brazil, Ethiopia, Nepal and India.

“The flood modelling we do is a big-ticket item for a lot of these municipalities but they’re very interested in climate risk across the board and how they need to start preparing and adapting,” Zobel said.

 The relative opacity of hedge funds and some private equity funds is proving a challenge for investors as they quantify their carbon footprints, particularly investors employing the mostly-outsourced “endowment style” of investing common in United States educational institutions.

 This and other challenges such as governance and talent were discussed in a panel discussion about implementing net zero emissions strategies, with experts from five different countries speaking at Conexus Financial’s Sustainability in Practice forum held at Harvard University.

 The Harvard Management Company, which uses the endowment style of investing to manage Harvard University’s endowment, has a different challenge to many other funds as the vast majority of its assets are managed by external, third-party managers, said Michael Cappucci, the company’s managing director, sustainability.

 Additionally, almost the entire portfolio is in alternative asset classes like hedge funds and private equity.

 Nonetheless, Harvard was the first among university endowments to commit to net zero emissions by 2050, and this challenged the fund to come up with a methodology for assessing its carbon footprint and working out a pathway to net zero. This proved particularly difficult for hedge funds, Cappucci said.

 “Hedge funds are notoriously quite secretive and quite reluctant to…provide access to their holdings and position information,” he said. While private equity funds do provide more information about their investments, it is harder to get the information necessary to understand their greenhouse gas emissions profile.

 While limited as a non-profit to engage in public policy debates, the Harvard Management Company has twice submitted comment letters to the US Securities and Exchange Commission in favour of its climate disclosure rule proposal.

Imperfect data

Funds with greater levels of in-house management face different challenges on the same journey towards net zero, particularly working with imperfect data.

 Canadian pension fund CDPQ manages about C$392 billion which is invested largely in-house. The fund has been working on sustainable investment for more than 25 years, and started looking at targets related to climate change immediately after the Paris Agreement, according to the fund’s head of sustainability, Bertrand Millot.

 Setting the tone on sustainability from the top is important, along with some degree of tolerance to imprecise data, Millot said. While lack of data is sometimes given as a reason for inaction on climate, “you will never have enough data to make decisions,” he said. “You just need to get going; get started.”

 In 2017 CDPQ announced [net zero] targets for all of its asset classes, and linked them to remuneration.

 “That focussed the mind,” Millot said. “Within the organisation, of course, there was resistance, but it was, I think generally…understood that this was the thing to do.”

 At Australian superannuation fund State Super, chief investment officer Charles Wu said it took the fund about six months just to collect the information required to understand its carbon footprint, with private equity and hedge fund investments proving particularly difficult.

 While admitting State Super was “late to the party when it comes to net zero,” Wu said the fund wanted to make sure there was a resilient and actionable plan before making the commitment.

These are long-term plans, that are subject to a lot of variables and use numbers where “what you see may not be what you get,” Wu said. “So the actionable plan needs to be very robust and very resilient to all kinds of different market conditions, and that’s why the formulation of that plan was challenging.”

 Building tools and expertise was the most important element in the strategy for Edinburgh-based asset manager Abrdn. Fionna Ross, head of sustainability institute, Americas, for Abrdn, said the global asset manager has focussed on having the governance structures, and bringing in the expertise, to drive its strategy and commitments.

 Last year, Abrdn appointed a head of climate change strategy, and has been developing the tools necessary to collect the data to measure and benchmark progress.

 All investment teams have been equipped with a carbon footprint tool to position portfolios against a carbon footprint benchmark, she said. This allows teams to dig deeper and understand what is driving their carbon footprints.

 “Often…it does seem to be a few companies that are actually driving that carbon footprint,” Ross said. “Increasingly, asset owners, the people that we’re working with, they want to be able to have visibility on that as well.”

 Abrdn has also introduced a climate scenario analysis tool which assists in engaging with higher emitters that are implementing plans to decarbonise. “It’s obviously important to understand how your portfolio is currently positioned, but in order to drive progress, in order to reach the net zero 2050 future, we need to be thinking about the further trajectory of those companies that we’re holding.”

GIC 

GIC, the sovereign wealth fund in Singapore, is playing an active role in engaging with emitters to reduce the emissions of the Asian electric utility sector.

 GIC invests across a wide range of asset classes with many actively managed in-house. Sustainability is integral to the fund’s mandate to deliver long-term returns, and to enhance and preserve the purchasing power of assets under management, according to Rachel Teo, GIC’s head of total portfolio sustainable investing and head of sustainability.

 GIC has committed to supporting the global transition to net zero emissions through its investments and operations, Teo said. Reducing the operational footprint via cutting travel has been the easy part; elsewhere some of the reduction has to be achieved through offset.

 On the investment side, GIC invests in green solutions that will help accelerate decarbonisation in the broader economy and engages with portfolio companies. “We are prepared to fund our portfolio companies in their adoption of low-carbon technologies to bring their carbon emissions down,” Teo said.

GIC is part of the Asia Investor Group on Climate Change, in the Asian Utilities Engagement Program, as the Asian electric utility sector contributes to approximately 23 per cent of global carbon dioxide emissions.

 “One of the companies, CLP [Power] in Hong Kong, committed to phase out its coal-fired plants by 2040,” Teo said. “Tenaga Nasional Berhad in Malaysia, and PLN [State Electricity Company] in Indonesia – both of them set quite aspirational net zero targets.”