The Shift Toward Transition Investing is Accelerating
Driven by the net-zero pledge towards green investments, institutional investors are finding themselves uncomfortably wedged between a rock and a hard place.
If they invest exclusively in green assets and earn lower returns than the broader stock market benchmark, as was the case in 2023 for environmental, social and governance funds, they’re criticized for underperforming. But if they invest a small portion of the portfolio in brown firms, investors face recrimination for greenwashing.
Also rubbing salt into the wound is the recent academic research that shows green investing may be counterproductive because it seems to push brown firms to become browner, while showing no significant improvement in making green firms go greener.
The exacting demands of sustainable investing will lead to disappointing outcomes and may ultimately result in an ESG backlash. It’s important for institutional investors to maintain and secure the goals of sustainable investment by taking a step back to rethink what it means to invest sustainably and what to expect in terms of risk, return and impact.
First and foremost, investors need to rethink the assumption that sustainable investing means investing primarily in green assets. Sustainable investments that will accelerate the green transition may include investing in brown firms. These may be brown firms that have committed to align with the 2015 Paris Agreement or firms that haven’t yet made the pledge but are equipped to engage with investors.
This alternative approach is called ‘transition investing’ and it has wholly different implications for the asset allocation and carbon footprint of an institutional investor’s portfolio. In the current state of sustainable investment, the green investor buys green with the goal of progressively reducing their portfolio’s carbon emissions to net zero. By contrast, the transition investor buys brown firms and then cleans them up by reducing their carbon footprint. Put differently, the transition investor engages in a green-positive “flipping” activity. Therefore, while the green investor’s carbon footprint goes down over time, that of the transition investor may remain elevated, even if the brown firms it invests in transition successfully into green firms.
Investors also need to be pragmatic about what to expect in the returns from sustainable investing. It makes sense that returns between a green investor and a transition investor will be different. Because demand for green investments is high, green firms have generally higher valuations than otherwise identical brown firms. The transition investor that buys less expensive brown firms ‘greens’ them and then sells them at a higher price should expect to earn higher returns. By contrast, the green investor that purchases the green firms at a high price should expect to earn lower returns on the investments.
Green investing and transition investing come with unique opportunities and challenges. Green funds benefit from owning firms that are clean, adapted to the zero-carbon economy and more resilient to climate shocks. The key challenge is to convince the funds’ members that their portfolio may have lower returns moving forward because the green firms are more expensive to purchase. The lower returns shouldn’t be evaluated as underperformance but as the price of purchasing assets that are greener and more resilient to climate change.
Transition funds gain from turning brown firms into green ones. The challenge is to convince the funds’ members that buying brown is part of a credible transition plan. It may also be difficult to transition a brown firm into a green one if the investor’s stake in the firm is small and the firm hasn’t established a transition plan. In addition, transition funds will need to develop key performance indicators that aren’t based on the total carbon footprint of their portfolio, which is typically done in the current net-zero evaluation system. Instead, they should be evaluated on the footprint reduction of the firms they’ve invested in that have been ‘greened’ and sold.
There are multiple approaches to sustainable investing, some of which involve investing in brown assets and some may come with lower average returns. For these approaches to be successful, it’s critical that sustainable investors are able to establish credible transition plans and clear performance benchmarks.
For this to happen, the adoption of a green and transition finance taxonomy — such as the one proposed by the Sustainable Finance Action Council — is necessary. The taxonomy provides a comprehensive and unified rule book that makes it possible for both firms and investors to clearly identify transition and green activities. In turn, it makes it possible for large investors such as pension funds, endowment funds, mutual funds and insurance providers to share with their thousands of members that their action plans are credible and verifiable.
This is an excellent comment from Sebastien Betermier, an Associate Professor of Finance at the Desautels Faculty of Management at McGill University and the Executive Director of the International Centre for Pension Management (ICPM).
Sebastien knows the Maple Eight very well and here he is highlighting the main differences between green investments and transition investments and why investors are damned if they do and damned if they don't invest in these assets.
In my last comment, I discussed why OTPP’s sustainable investing chief Anna Murray thinks the myopic focus around emissions intensity is "imperfect and backward looking' and why she feels it's more important to focus on investment opportunities to accelerate the shift to net zero, and that's across green and transition assets.
Every single large Canadian pension fund I cover is invested in renewable energy (green) assets across private and public markets and every single one of them is also shifting their attention to transition assets where there are opportunities to add value and transition an asset to net zero.
As Sebastien pointed out in his piece, green assets are very popular and their returns last year in public markets were nothing to write home about. In private markets, they were a bit better but the lag there will catch up to these assets.
As far as transition assets, there are opportunities for pension funds to earn great returns but it's a much longer process and requires a lot more work.
This is where it helps to work alongside an expert partner like Brookfield Asset Management which earlier this year announced the first closing of the second Brookfield Global Transition Fund:
BGTF II is co-headed by Mark Carney and Connor Teskey and focuses on investments to accelerate the global transition to a net zero economy while delivering strong risk-adjusted returns for investors. The Fund continues the predecessor fund strategy of investing in the expansion of clean energy, the acceleration of sustainable solutions, and the transformation of companies operating in carbon-intensive sectors to more sustainable business models. The Fund’s seed portfolio includes a UK onshore renewables developer and a solar development partnership in India, and the pipeline of further investment opportunities is robust. Brookfield is targeting a larger fundraise for BGTF II than its predecessor fund and continues to see a significant acceleration in transition opportunities globally.
The Fund is the successor of the inaugural Brookfield Global Transition Fund (“BGTF I”) which closed on a record $15 billion, inclusive of fund commitments and strategic capital from our investor base in June 2022, making it the largest such fund in the world. The capital in BGTF I is now substantially deployed or committed to a range of landmark investments across renewable power, business transformation, carbon capture and storage, renewable natural gas, and nuclear services opportunities. All investments are managed to science-based sector pathways for net zero and the total impact of BGTF I, measured in avoided emissions, is on track to exceed the combined annual emissions of New York City, London and Toronto.
Mark Carney, Brookfield Chair and Head of Transition Investing, said:
“We have demonstrated beyond doubt the breadth and scale of attractive investment opportunities in the transition to a net zero economy. By going where the emissions are, the Brookfield Global Transition Fund strategy is aiming to deliver strong risk-adjusted financial returns for investors and make meaningful environmental impacts for people and the planet.”
Connor Teskey, CEO of Brookfield Renewable Power & Transition, said:
“Corporate demand for decarbonization technologies is now the primary driver of transition investment, delivering significant economic value as well as meaningful environmental benefits. New trends are also emerging, such as supplying reliable, clean power to the surging data and technology sector, building entirely new industrial supply chains, and scaling technologies required for industrial decarbonization. The strong first close for the latest Brookfield Global Transition Fund demonstrates the growing appetite among leading global investors to capitalize on these trends.”
Fundraising for BGTF II is expected to conclude in Q3 of this year.
A lot of well-known pension funds like IMCO, OTPP and PSP Investments were part of Brookfield's inaugural Global Transition Fund and I wouldn't be surprised if they were part of the second one too.
Brookfield also put out a great white paper on why investors need to get their hands dirty in the fight against climate change.
You can read it here and see the main points below:
Brookfield gets it which is why it's a leader in transition finance.
As an example, read about their
Westinghouse serves as the core service provider for over 50% of the world’s 440 operating nuclear reactors. The company pioneered the commercial nuclear power industry and is the original equipment manufacturer for half of the world’s nuclear fleet.
Brookfield strongly believes nuclear energy must figure into the equation to attain net zero by 2050.
Back in 2022, they put out a white paper on a new dawn for nuclear energy which ended on this note:
New reactors should not have the vulnerabilities of the old. Today, more than 50 reactors are currently under construction. Going forward, we believe that the construction of large-scale reactors will be more cost-effective and punctual, given that the nuclear supply chain is now more established.
To win popular support for nuclear, a social license is arguably a prerequisite—in some countries, building a broad consensus might be required. This includes educating the public about developments in nuclear technology, such as passive safety systems (see sidebar on Westinghouse).
New nuclear construction will also require a mobilization of investment, and an assurance of a more streamlined and reliable development process. Recent news out of the European Parliament should help with this endeavor. In early July, European lawmakers approved a law designating natural gas and nuclear as sustainable energy sources in the EU’s financial labelling taxonomy. This taxonomy is a system designed, in part, to steer private capital toward investments that support climate change targets.
Nuclear reactors are an incredible investment for pension funds with long dated liabilities and they provide clean and safe energy for millions of households all over the world.
But to get this process going, you need political backing as well as to educate the public and why new nuclear reactors are nothing like the old ones.
I discussed this in my last comment and to be truthful, I'm seeing more change in Europe than in North America when it comes to nuclear power.
All I know is nuclear reactors are great long-term investments, just ask OMERS which owns Bruce Power.
Alright, let me wrap it up.
For me, it's clear, the big, scalable opportunities right now lie in transition investing but investors need to identify these opportunities and partner up with experts to undertake massive projects.
Green investing will obviously continue but returns there will suffer as an inordinate amount of capital chases these assets.
There too, you need to pick your spots carefully.
Below, Westinghouse is shaping the future of carbon-free energy by providing safe, innovative nuclear and other clean power technologies and services globally including AP300™ small modular reactor, a nearly identical, though smaller, version of the proven, licensed, and operating AP1000® reactor.
Westinghouse supplied the world’s first commercial pressurized water reactor in 1957 and the company’s technology is the basis for nearly one-half of the world's operating nuclear plants. Over 135 years of innovation make Westinghouse the preferred partner for advanced technologies covering the complete nuclear energy life cycle.
Also, Westinghouse is the largest provider of infrastructure services to the world’s nuclear power facilities, providing fuel, maintenance and repair services, plant components and parts, and sophisticated engineering services to two-thirds of the world’s nuclear generation plants.
You can only watch the second clip on Brookfield's website here, they didn't post it on their YouTube channel (everyone should post everything on YouTube or share an embed code on their site).
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