The third trend is the topic of today’s conference. Sustainability can be thought of as externalities or impacts not yet captured by commercial prices. They present both significant threats as well as opportunities.
Using climate change as an example, we see the magnitude of its potential adverse economic impact. According to research by the Swiss Re Institute, we could lose up to 18% of global GDP if temperatures rise by 2.3 degrees Celsius by 2050.
As an investor, we see three challenges in the path towards net zero. First, it involves difficult trade-offs, including an inherent conflict of goals and time horizons, such as social versus climate goals, or the energy transition versus energy security. If you abandon fossil fuels, you might deny access to jobs for your local community. You might even create more gender inequality.
A useful angle here is to consider the additional costs involved and who is to pay for them. Of course, we always look towards governments to provide more subsidies or introduce carbon taxes and other mechanisms to price in the cost of carbon. Grants and other forms of financial support by philanthropists are also welcome – if only we had more of them. Consumers might also have to chip in, by paying a higher price for goods and services. In the best-case scenario, technology and economies of scale can reduce cost curves substantially. In some cases, innovative business models can address at least part of the additional costs, by building up scale. That’s the first challenge. How do we deal with these trade-offs and the costs which come with it?
The next is ESG data; improving the quality, availability, materiality and comparability of data for businesses and investors to be able to make more informed decisions. Fortunately, we are seeing progress made in the creation of more consistent standards for ESG reporting, especially with the launch of the International Sustainability Standards Board (ISSB) at COP26.
The third challenge relates to designing investment vehicles which can help crowd in private capital. This is very similar to the need – identified and recommended for many years by organisations such as the G20 or the OECD – to attract private capital to fund public infrastructure projects, especially in developing countries. Although trillions of dollars of capital are available to be invested in this space, attracting private capital has been met with limited success. Some of the barriers include potential political risks, lack of project pipelines or an enabling regulatory environment. Bankability and scalability are key factors for attracting large institutional investors.
As an example, about 15 months ago, GIC invested approximately US$2 billion in Duke Energy Indiana (DEI), a subsidiary of Duke Energy, one of the biggest energy holding companies in the US. DEI is the largest regulated electric utility in Indiana, serving around 850,000 customers.
While DEI traditionally depended on coal-fired power plants to generate most of its electricity, proceeds from the transaction will support its clean energy transition, including investments in renewables and the retirement of existing coal-fired units. The governance and legal frameworks in the State of Indiana provide a clear and proven mechanism for investing in new energy sources, which allow long-term investors such as GIC to both support the utility’s low-carbon transition and earn good risk-adjusted returns over the long term.
Such an enabling regulatory design would help attract more private capital into the sustainable infrastructure space, but we don’t unfortunately see many similar examples.
Importantly, however, besides these challenges, we see a tremendous amount of opportunities. In fact, we look at our investment universe as made up of three parts. The first is new sustainable tech solutions, including traditional renewables such as wind, solar or hydro which are becoming commercially viable with cost curves decreasing substantially in quite a lot of countries. Hydrogen, especially green hydrogen, is still in the R&D phase from a scale perspective, but holds a lot of promise, as do nuclear fusion or carbon capture, use and storage (CCUS). Technology might be able to come to the rescue again, just like in the case of Covid-19 vaccines. So that’s the first category in the investment universe, which is still relatively small. It might be worth billions in value, but in the context of the investment world, it only accounts for a small sleeve.
The second category refers to transition assets which form the bulk of investments, as every asset needs to eventually transition. In fact, companies must start to transition now, because it’s the ultimate solution to climate change. It requires a lot of resources, extensive bottom-up engagement and the repurposing of existing assets. A pipeline for natural gas could be repurposed to transport hydrogen, for instance.
Here, we can also use some out-of-the-box thinking. For example, to address water scarcity, which is a massive challenge and could in fact create conflicts between countries, we should consider reducing food waste – as food production and processing can be quite water-intensive –, and increasing energy efficiency as energy is useful for water production, amongst others. Solving the sustainability challenge could offer a lot of potential for innovation.
Finally, you are left with a set of investments that could end up becoming stranded assets such as thermal coal. In the short term, given the current geopolitical and macroeconomic climate, some countries might need to continue using coal. In the longer term, however, coal is not the solution and should be phased out.