• Bridget Beals, Partner |

Non-financial reporting is coming into focus like never before. Why? Because it is widely accepted that risks, particularly those relating to climate and nature, are misunderstood and consequently mispriced. This, in turn, leads to the misallocation of capital towards traditional carbon-intensive projects where returns are perceived to remain enduringly high at the expense of developing markets.

So, will greater disclosure realign capital and fix the climate crisis? The simple answer: no. Greater alignment of capital towards a low carbon economy requires three additional attributes:

  1. Companies to view disclosure as an endpoint and start by realigning their business strategy to Net Zero;
  2. Capital providers to price risk appropriately for a Net Zero economy, utilizing disclosure and their strategic ambitions in making capital allocation and pricing decisions;
  3. More low carbon aligned projects and business models to be developed, enabling capital to be allocated according to commitments and demand.

1: A climate strategy should equal your business strategy

Over 1,300 companies across various industries and geographies have now committed to Science-Based Targets to limit global warming to well below 2 degrees Celsius and pursuing efforts to limit it to 1.5 degrees Celsius by 21001. At the time of committal, many of these companies may have considered this a gesture – an indication that they would, perhaps, manufacture with renewables, consider more closely their business travel and, as commercials allowed, change the company fleet to electric vehicles.

However, with regulation and understanding of climate change enhancing, the scrutiny over how your business strategy aligns with climate targets and financial statements is increasing. This trend is expected to increase as the International Sustainability Standards Board and Securities Exchange Commission's climate consultations mature into regulation.

Companies now need to consider carbon emissions as a core component of strategic business planning and make adjustments if the strategy doesn't meet short and medium-term carbon targets. Unlike historical thinking, this will mean reconfiguring the product mix for many organizations. This could be iterative change, like taking early write-downs on heavy carbon-emitting goods and services or accelerating the delivery of more resource-efficient products before they were initially intended. Alternatively, it could be large-scale change like up and downstream value chain acquisitions – disrupting your business models to seize opportunities before you're disrupted by climate change itself. Progressive!

Companies can make the right decisions with strategic, carbon and financial alignment and create clear, consistent disclosures around strategy, financial impacts, material assumptions, and critical risks.

2: Repricing of risk and opportunity

Financial institutions with US$130 trillion in assets under management are now committed to reaching a Net Zero state before 20502. So plentiful is this capital supply relative to the volume of lower-risk green projects that investors have begun to drive down returns for green projects to levels that may be perceived to price risk incorrectly.

For example, in recent UK offshore wind transactions, pension funds and other institutional investors have placed large amounts of capital ($500m+ ticket sizes) for a similar return on investment to onshore wind and even solar investments. Why? The oversupply of capital chasing green and the presence of solid operators makes for an attractive marketplace for organizations needing to meet climate commitments. With this backdrop, the reputational risk of underperformance on green and sustainable objectives outweighs the perceived risk of building further offshore and in deep waters.

This goes hand in hand with several UK universities' recently observed sustainable debt capital markets activity. Over £0.5bn has been raised at an implied discount of 5-10 basis points based on commitments to fund green capital projects and other sustainability initiatives with the issuance proceeds.

However, the tides are turning – following the implementation of the Climate Biennial Exploratory Scenarios (CBES), commercial banks recognize the need to realign their balance sheet to their financed emissions targets3. This means making tough, strategic choices between customers based on their Transition Plan performance and, over time, beginning to price the greater volume of capital to be held for adequacy purposes against high carbon assets or companies. In the medium term, the market is likely to see higher pricing for 'brown' assets, increasing the Weighted Average Cost of Capital and making 'brown' projects relatively less attractive. As greater awareness of climate and nature-related risks are built into crucial valuation assumptions, the business case may erode for primary or secondary investments in higher emissions or climate/nature exposed asset classes.

3: More opportunities

More low carbon opportunities should become attractive and viable propositions as the investment thesis shifts. But is it enough to match the supply of capital seeking low carbon opportunities?

The OECD estimates that around $6.3 trillion of infrastructure investment is needed each year to 2030 to meet the development goals and foster a 'just transition,' increasing to $6.9 trillion a year to align this investment with the Paris Agreement4. Rather than just starting over, the present use case needs to evolve and existing assets retrofitted to deliver a low carbon economy quickly. This brings two challenges: 1) the obsession with 'already green' and 2) new business models.

  1. By September 2021, the total volume of green bond issuances grew to $1.4 trillion, while the volume of transition bonds only stood at $9.9 billion5. Said transition bonds are focused on financing the decarbonization of emissions-intensive and hard-to-abate sectors rather than allocating capital to activities that already meet green standards, aka, green finance. The introduction of a taxonomy-based approach and/or clear, transparent Transition Plans – linking climate and business strategies to financial statements - will be critical to unblocking this hurdle and enabling the capital to flow most effectively across the market.
  2. Many opportunities, such as energy efficiency, exist in proven, cost-effective, and commercial technologies such as building management systems, artificial intelligence and LED lighting. The remaining challenge exists in packaging transactions into deals large enough to attract investors. Over time, we anticipate that product strategies akin to those deployed in rooftop solar will begin to emerge, unlocking vast swathes of capital across domestic and commercial sectors. Coupled with the commercialization of emerging asset classes such as hydrogen, carbon capture and storage, and electric arc furnaces, green and transition finance opportunities should begin to unlock at scale across the market.

All of this can't happen overnight, but iterative changes can. The circularity of strategy, risk and finance cannot be ignored. Disrupting the current cycle to drive strategy, price risk and realign capital is crucial to combatting the climate crisis and seizing opportunities.

Footnotes:

1. Science Based Targets, Companies taking action, April 2022
2. Glasgow Financial Alliance for Net Zero, Our progress and plan towards a net-zero global economy, November 2021
3. Bank of England, Guidance for participants of the 2021 Biennial Exploratory Scenario: Financial risks from climate change, June 2021
4. OECD, Financial markets and climate transition: Opportunities, challenges and policy implication, October 2021
5. Climate Bonds, Sustainable Debt Market Summary Q3 2021, November 2021
 

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