This article is sponsored by IFM Investors
The pipeline and scale of capital needed to drive the global energy transition is nothing short of incredible. The International Energy Agency estimates the annual investment required to achieve net-zero emissions by 2050 is around $2.8 trillion over the decade to 2030, split across energy sectors. To say that something of this size will create investment opportunities is an understatement on steroids, but this need for a huge injection of capital is occurring at the same time as investors, asset owners and asset managers operate against a backdrop of global volatility.
We know that for long-term investors, there are potentially projects we can fund and build that we expect to generate returns for years to come. But alongside these projects, long-term investors like pension funds should also be concerned about challenges at the system level as well – climate change and broader social factors, which if not addressed will impact returns in the decades ahead.
Factors that appear to be externalities in the short term, such as increasing carbon pollution or rising inequality, will not be able to be avoided or diversified away from over the long term and could impact investment outcomes.
Shorter-term challenges, such as threats to energy security, have in turn crystallised longer-term, systematic risks and an understanding that long-term investment returns are dependent on healthy environmental and social systems, now and in the future.
Australian superannuation and other global pension funds represent the largest pool of private capital in the world, managing a total of A$75 trillion ($48 trillion; €45 trillion). Pension assets are now equal to about two-thirds of the aggregate GDP of OECD countries, and over half of global GDP.
Increasingly, large pension funds can be seen as ‘universal owners’ – so large that they effectively own a slice of the entire economy. As long-term investors, pension funds are also increasingly aware that factors that appear to be externalities in the short term, such as increasing carbon pollution or declining trust in institutions, can’t be avoided over the long term and could impact the retirement outcomes of pension fund members.
The duties of care and impartiality are especially pertinent in the context of the systemic challenges facing our societies and economies, and mean that pension funds have particular perspectives and responsibilities relative to other actors in the system, including governments, regulators and corporates.
The Inflation Reduction Act is expected to push clean energy generation of US electricity above 80% by 2030
Put another way, there is growing awareness that the quality of investment returns in 10- and 20-years’ time depends on the quality of the system in 10- and 20-years’ time. That crystallises even further when you consider that someone starting their working life this year could still be relying on their retirement savings at the turn of the next century.
As pension funds become increasingly large and occupy a greater share of public attention, they are increasingly held accountable by members, governments, regulators, industrial parties and the broader public for how they invest and the role they are playing in financial systems, economies and communities. With their growing scale and prominence, pension funds cannot afford to not integrate these considerations and the risks that accompany them.
The size and growth of pension systems and their history of collaboration presents an opportunity for practical leadership and action. We have seen the formation of investor and industry initiatives such as the UN-backed Principles for Responsible Investment and Climate Action 100+ in recognition that working together can generate change more effectively than working apart. Pension funds have played a leading role in these, and similar, initiatives.
Addressing systemic risks and the transition
It is in this context that we need to consider the role of institutional investors and how they can collaborate to address systemic risks and the global transition to clean energy. That means that, alongside investing in the energy transition on an individual opportunity basis, long-term investors like pension funds should also be addressing challenges at the system level as well.
The size of pension funds today means they are now positioned as universal owners – they own a representative slice of the economy – so it becomes impossible for them to diversify away from systemic risks. You can’t stock pick your way out of climate change.
The size and growth of pension systems and their history of collaboration presents an opportunity for practical leadership and action. Importantly, they can work across investment markets and with governments to address these long-term risks.
As we increase collaboration, we should of course continue to invest to help make the energy transition a reality. At IFM Investors, we have committed to targeting net zero by 2050 across our asset classes and have made 2030 emission reduction commitments for our infrastructure portfolio.
Many other investors have also made net-zero commitments at the fund and asset class level. These commitments are important, but they are not the whole story.
There are two key investment imperatives that are driving the energy transition, the first being the need to invest in the new assets that our system needs to be healthy. To an extent, that is the easy part.
While it is a major task and requires a lot of capital, we know we need more renewable energy generation, battery storage, greener electricity grids and low-emission fuels, and investments are being directed in these areas.
The second investment imperative is just as important, but harder to execute on and that is to help transition existing infrastructure assets to the new clean economy as quickly as possible.
We cannot simply turn off essential assets that people rely on every day. If a district heating business runs out of power, it potentially puts millions of people at risk. That means we also need to drive capital into these assets. It means being willing to buy assets with significant emissions profiles and invest to support transition plans to get those emissions down.
This may mean the path to meeting our net-zero commitments is not so smooth, but the reality is that, while selling emission-heavy assets may help the emissions profile of individual portfolios, it won’t have a systemic impact.
The social impact of an inequitable transition
There is another systemic risk that we, as long-term investors, need to be aware of. Social factors – such as growing inequality – are increasingly important and something we should also be considering when we tackle the energy transition. Not managing the energy transition smoothly will have a social impact.
A district heating business without power may be an extreme example but consider what that would mean for the owner or the government that presides over it. Given the cost-of-living pressures in the world today, changes that spike the cost of energy or require a re-skilling of the workforce, such as required for the global energy transition, are also likely to generate a negative reaction. This is why it is imperative that governments, businesses and investors find a just and fair way to transition to a low-carbon economy, as failing to do so would likely stall progress on addressing climate risks themselves.
This greater collaboration and taking a system-wide approach to help deliver on the energy transition, one that delivers for all, will also necessarily involve governments.
The Inflation Reduction Act in the US is already driving material changes to the energy, transportation and manufacturing sectors along with innovation in clean technology. It is predicted that it could help increase clean energy generation to supply as much as 81 percent of US electricity by 2030.
While some might say the IRA is almost too successful in that it is pulling capital out of other countries into the US, other governments are not standing still. This is true in the EU, the UK and in countries like Australia, where IFM is headquartered.
This recognition from governments and investors of the scale of the challenge and risk that climate change poses to our society and our economy underscores the systematic nature of the challenge.
But the reality is, almost by definition, the impact of a single investor or investment manager on these systematic risks is tiny. We must therefore organise ourselves to collaborate much more strongly to influence systematic risks.
For the past decade or so, pension funds have collaborated and innovated to integrate sustainable investment considerations into their investment processes, helping enhance the performance of companies and assets. The next step is to boost collaboration and pursue deliberate impact at the system level in order to sustainably deliver risk-adjusted returns to their members and beneficiaries for the decades ahead.