The Paris Climate Agreement: A starry-eyed approach to venture investment strategies or an opportunity in development?
Hello! We are in a climate crisis.
So, we’re in a climate crisis. That’s for sure. Whichever way we choose to cut it — 100 years, 10 years, or 3 years — we are already too late. In the words of Barack Obama, we are the first generation to feel the impact of climate change and the last that can do anything about it.
Despite all our promises, our emissions continue to rise. As of February 2020, the global concentration of CO₂ is 416 ppm. The globally agreed limit to avoid catastrophic climate change is 450 ppm (2°C) or 430 ppm (1.5°C). Ironically, since we set up the UNFCCC to make a concerted effort on climate change in 1992, we have managed to increase our emissions by almost half. Anyone who has the slightest grasp of compound returns is likely taking a sabbatical from work to dig a bunker.
Time is fast running out for action.
But, what does this mean for the investment community?
For a deeper look into the dynamics of climate finance, I recommend, the state of climate finance report here and some of the important indicators of why the finance world is shifting on multiple levels, here.
For now, and for the purpose of this deeply oversimplified explanation, let’s break this audience into two main groups: Group 1, The Influencers and Group 2, The Enablers. Note that some investors pitch a tent in both camps.
Group 2 will be the focus of this article.
The Influencers
Influencers are characterised by handling more mature investments and invariably are resilient enough that their future does not depend on a single or a small number of investors. They are usually asset owners or asset managers. Asset owners are either directly invested in a listed company or stock, or indirectly through a mutual fund managed by asset managers. Both, as demonstrated by independent actions like Blackrock, Norway and TCI Fund, and collective actions like CA100+, can influence their investees towards positive change.
One of the most promising moves in this community is the shift of investors not just towards divestment from the worst climate change contributors, but towards collectively aligning their portfolios with a 1.5°C or 2°C world. This takes some doing, especially given the cliff-face trajectories we increasingly know we have to face.
Meanwhile, some of the most long-standing and advanced investors, like Aviva, are publicly disclosing their slow progress. This, nevertheless, remains a strong market indicator for mature companies to take meaningful action on their decarbonisation strategies and others to capitalise upon it.
The Enablers
Enablers are characterised by earlier stage investments and have acatalytic role. In short, without them, a given change couldn’t happen. They manage funds and/or directly invest in companies or projects that could either serve the incumbents in their transition to a low carbon economy or disrupt them. They may be private equity or venture capital funds, corporate venture firms, climate investment funds, direct finance institutions, granting institutions, universities, green or transition bond investors and lenders.
There have been many positive developments in this field. Dedicated aquaculture or circular economy funds, blended finance to apply a more intelligent use of capital and, given time and proper stewarding, the development of a new class of transition bonds. However, while we can observe the bond investors aligning under the 1.5°C or 2°C portfolio goals, as invariably these actors play in both camps, the remainder of the community have yet to find their role in intervening in the system in the most effective way. Why is this?
Starry Eyed Investment Strategies?
Bond investors aside for a moment, when you speak to this Enabler community of investors about their strategies, they are, of course, protective over their specific methodologies, but overall they take a market evolution approach — assessing the growth opportunities in a sector that is aligned with a low-carbon economy and investing in technologies or solutions that can demonstrate an attractive growth rate and therefore return on investment. When questioned about how they see the role of Nationally Determined Contributions (the mechanism provided by the UNFCCC for each country to submit their commitments for carbon emissions reduction and adaptation over the coming years), perhaps rightfully so, they remain cynical. This top-down approach is largely considered “starry-eyed” compared to the unique methodologies and industry wisdom injected into, for example, a venture capital investment strategy found using a bottom-up approach.
This final point, however, is what I would like to throw into question. Why?
Climate Action is here to stay
While many doubt the efficacy of the Paris Agreement, this fundamental building block should not be undervalued for the knock-on effects it can have for the Enabler investment community. The cumulative effect of the Paris Agreement and the IPCC-driven consensus on science goes beyond early adopters, beyond critical mass. In the principles of regime change, it is the new regime.
In the coming years, we may start to see many of the dynamics of this agreement shift. We may see the ratcheting mechanism of the NDCs fall apart, a future COP fall to its knees, countries renege on their commitments or fudge on their reporting. On the flip side, we may also see stronger versions of the NDCs evolve from their weaker first editions, further stratification and game theory playing out through carbon markets of the highest ambition countries versus the lowest, or the positive rise of non-state actor influence and action in the face of political reticence. Whatever the weather (or should I say climate), this regime is here to stay. Here’s my top 5 reasons why:
- The impacts are already here: It’s currently burning down the size of England in Australia.
- Climate change just got personal: And politicians and corporations need people.
- Transparency and reporting are becoming mainstream: Think CDP, CDSB and TCFD and what they are doing for investment.
- Legal action is gathering speed: Powered by transparency and with thanks to James Thornton et al., action on climate change is fast becoming a globally enforceable human right.
- There is finally real market appetite: Albeit hamstrung by their clients, customers and investors, these audiences are finally showing signs of meaningful action.
Couple this with that fact that as a species, as laid out by the IPCC 1.5 °C report, we are banking the survival of humanity on a small number of technologies that have not been effectively tested at scale[1]. And one could wonder why investors in this Enabler community aren’t jumping for joy right now.
Translating political will into investable opportunities
While all the above may be so, for the Enabler community of investors who are focused on 5 or 10-year returns for their clients, these types of drivers remain abstract and unactionable. Political will or the mechanisms that facilitate it just aren’t enough. The ‘right market conditions’ and smart innovations focused on growth remain fundamentally important.
So, how can we translate the world’s biggest needs into the world’s biggest investment opportunity for the Enablers that can make it happen? How can we connect the dots from macro-level need down through to investment strategies on the ground?
Better still, how can we enable investors to work together with their peers towards common goals at the same time as protecting the unique and treasured methodologies that make them so attractive to their own investors?
Innovations already out there
Sometimes I sit and think, is it just me or is this really quite obvious stuff? And if so, why isn’t it everywhere already? Well, it turns out some other people are thinking along the same lines. And as usual, the great Climate KIC, spotted it and got behind it early.
The Climate Tech Compass was created to provide a roadmap of investments, energy capacity, and emissions —organized by sector, technology, and country — in order to achieve the 2°C target. The methodology recognizes that each sector has a specific transition pathway, or technology roadmap, for it to contribute to the Paris Agreement goals and creates a user-friendly way for investors to identify the alignment of a sector with their country’s 2°C carbon budget and assess the reductions that would need to be made.
While I salute this work, love the UX design and see such a tool as a huge step forward, for the Enablers community specifically, I feel that we need something additional, with a greater depth and sensitivity to market dynamics to get the coordination and momentum we need.
Here’s my humble theory for how we could build on this tool using the UK as a single example — as always, I welcome feedback.
High-level alignment
1. Assess the country-level NDC: [Europe] While at the point of writing this article we have officially left the European Union, up until December 2021 we will maintain all commitments. At the time, the EU’s first Paris target was a 40% reduction below 1990 levels by 2030.
2. Assess any country-level revisions: [Europe] On 13 December 2019, towards the end of the ill-fated COP25, the EU announced a new agreement by all member states (except Poland) to reach net-zero by 2050. This is scheduled to be enshrined into law by March 2020.
3. Assess any subsequent country-level legislation: On 27 June 2019, the UK became the first major economy to pass a law to ensure net-zero by 2050.
4. Assess the action gap: According to the Climate Change Committee (CCC), meeting future carbon budgets and the UK’s 2050 target to reduce emissions by at least 100% of 1990 levels will require reducing domestic emissions by at least 3% of 2018 emissions, that is 50% higher than under the UK’s previous 2050 target and 30% higher than achieved on average since 1990. This is an indication of how substantial the step-up in action must be to cut emissions in every sector.
5. Assess political climate action stability: With such a clear majority in the most recent general election, the Conservatives are largely considered to be in for two terms. That’s 10 years. Since assuming the role of Prime Minister, Boris Johnson has appointed himself Chair of the Climate Change Committee, and is appointing a Minister at the helm of COP. [2]
6. Assess power and stamina of public / political influence: As of July 2019, 71% of the UK population understands we are in a climate emergency and the problem is man-made. The trend is consistently on the rise, with less than half the population believing climate change was induced by human activity in 2007–8 rising to 41% of population believing it is a serious issue, to the 71% as of 2019. That’s more than critical mass, or a swing vote. That’s an all-party relevant voter majority.
7. Assess country-level performance record: According to the Climate Change Committee, the UK emissions were 44% below 1990 levels in 2018. The first (2008–12) and the second carbon budget (2013–17) have been met and the UK is on track to meet the third (2018–22) carbon budget but is not on track to meet the fourth, which covers the period 2023–27. Historical performance presents a decent risk forecast that this will continue.
8. Assess country-level climate strategy: The BEIS Clean Growth Plan (2017/8) identifies 6 major industrial sectors based on emissions, business and industry efficiency, homes, transport, clean energy, natural resources, and the public sector (see chart below). The government then commissioned a Technical Report for ‘Net-Zero by 2050’ before enshrining in law, detailing power and hydrogen, buildings, industry, surface transport, aviation and shipping, agriculture, land use, waste, F-gas emissions, and GHG removals. We expect the government to update plans in line with the new law, soon.
Refining focus to the investable
Choosing a single industry area to illustrate the point, surface transport represented 24% of the UK’s carbon emissions. For the purpose of this explanation, I have drilled down to just one opportunity area within that emissions bracket. This process could be replicated across all transport types, before being built into a portfolio of needs where the appropriate finance can be sourced.
1. Assess industry level momentum: In the most recent Net Zero report to government, the CCC advised that bringing forward the date of transition from petrol and diesel cars from 2040 to 2030 is more cost-effective. On the 5th of February, Boris announced a ban from 2035. Furthermore, the CCC report advises that the heavy goods vehicle (HGV) transition should be achieved in the 2030s.
2. Assess Industry Opportunity: The current number of cars (2018) on the road are 18.5 million petrol cars and 12.4 million diesel cars. There are currently 11,000 charging points across the UK; it is estimated that we need 25 million. Remember this is a ban of ‘new’ cars, not the cars themselves. Therefore we also need solutions to help drive down the cost of electric vehicles (EVs) and improve the battery life and mileage potential for new buyers. This might involve establishing new incentive-based business models to enable the transition of petrol and diesel car owners towards EVs at the most environmentally responsible time. New EVs could be introduced within a service model to reduce resource needs through circularity and the sharing economy. In addition, significant step changes in infrastructure and performance are required to decarbonize HGVs. And where is all the energy going to come from? Hopefully clean sources, but let’s not leave that to luck, shall we. Scaling of regional and national renewable companies, as well as community energy projects, can become an opportunity.
3. Assess the Innovation Opportunity: What follows logically from here is a market analysis to find the best opportunities. This is where the unique skills and methodologies of leading VCs, corporate venture firms, lenders and private equity firms refined over decades will come into play. What will surface, if done right, is a portfolio of target companies with system-shifting potential. A needs-based investment strategy, if you will. Duplicate this across multiple sectors, or indeed across the emission reduction needs of the entire transport sector and we are onto some smart thinking.
The power of systems thinking for investment
Now, a single investor in the Enabler community could just do this for themselves. Find some gems, invest before the others and feel great in their role in helping make the world a better place. Fair play, I know many will do that. But for me, that is missing the point. We’ve moved past the age of eco-heroism and into an age where we know that we fundamentally cannot do this alone.
Let’s imagine for a second that we share the opportunities as detailed above, and instead chose to work together with our peers. Using the above example, this could be bond investors focusing on helping with the EV infrastructure development with perfectly placed corporates. Lenders could incentivise lending for EVs, or to businesses contributing to the transition. VCs could work together to scale new business models and solutions, co-investing and channelling their money into keystone players.
All this could be aggregated into a virtual meta-portfolio that could keep track of the entire system shift — not just individual portfolios. Imagine then, how much more satisfying impact reporting would become. Not only delivering on a real need for the country but aggregating the collective impact and reporting on that. This could be marketed to their own mission-aligned investors, and indeed packaged for the country to support the achievement of our NDCs.
The best thing about this type of cooperation, for me, is that it can still preserve the unique and treasured methodologies of each investor. It would just make the collective effort more market-making/shaping and impactful.
A collective of investors could start this today. Starting on an industry-by-industry, country-by-country basis. Tackling new regions as each reaches their political and public tipping point. Let this not be a tool just for the more mature economies either — it’s about marrying political will with market dynamics and that can happen wherever the market is ready.
To kick it off here in the UK, all we need is a couple of influential players and we can bring the market with us. It could, in effect, become the equivalent of the Institutional Investors Group on Climate Change for the Enabler community.
Would love to hear your thoughts, constructive criticisms and builds.
[1] For those that don’t know, three of the four scenarios (the one without it has fast become a pipe dream) laid out by the IPCC 1.5°C report requires dramatically increasing the use of carbon capture and storage technologies for our targets to be achieved. At the same time, the report took great pains to express its concerns that the required development of these technologies just isn’t being achieved despite the critical role it plays in staying within a 1.5°C or even a 2°C world.
[2] I will update this after the cabinet reshuffle on Thursday.
