The scale of the climate challenge means that every part of the capital markets will have a vital role to play. Michael Ridley, Abdulla Zaid and Jakub Malich of MSCI discuss how private market investors are thinking about net zero.
Environmental Finance: MSCI now provides climate data and analysis to clients active both in the public and private markets. Why has MSCI broadened its offering into private markets?
Michael Ridley: Achieving net zero, which would mean cutting global emissions from around 50 gigatonnes per annum down to net zero by 2050, is estimated to cost between $100 trillion and $150 trillion, or about $4-6 trillion per annum. Given the magnitude of those sums, we believe that both public and private markets will have to be utilised in full.
Even for investors that are not involved in pushing the net-zero transition or delivering environmental impact, they will need to fund the decarbonisation of firms to reduce those firms' transition risk. In addition, because a significant degree of climate change is already baked into the system, we expect expenditures to rise to ensure the resilience of assets in the face of physical climate risks. Both private and public markets will need to be mobilised to respond to climate change.
EF: What are some key trends you are seeing in terms of climate investing in private markets?
Abdulla Zaid: Since 2020 and for the following three years, we have witnessed a 'green rush' in private markets. If we look at private funds with climate-related words in their names – such as renewable, sustainable, green, clean or climate – we find that over 75% of these, in terms of capitalisation, were launched between 2020 and 2023.
The cumulative capitalisation of these 189 funds is about $110 billion, as of Q4 2023, although – because we are only looking at 'named' climate funds – they represent a subset of the total private funds investing in the climate space. Of these, around 48% by capitalisation are infrastructure funds, mostly investing in renewable energy assets.
Venture capital (VC) funds make up the largest proportion by count at 29%, although, given their relatively smaller sizes, they only account for around 10% of the cumulative capitalisation of the climate-named funds. About 59% of those venture capital funds' assets (in terms of net asset value) are supporting early-stage companies and, of these companies, around 64% of them are in materials and industrials. This demonstrates that the climate space is not only booming for infrastructure funds, but for venture capital as well.
EF: What climate strategies do you see private capital funds adopting?
AZ: One climate strategy may not fit all investors. For a limited partner (LP) going into the market to invest in a climate fund, there are a number of different approaches to climate investing. One example might be a fund that aims to reduce the financed emissions at the portfolio level by avoiding carbon-intensive assets. This might be appropriate for an LP with emissions reduction targets.
Other strategies seek to provide LPs with the opportunity to gain exposure to financing the transition, by investing in clean energy and renewable solutions, for example.
When we compared public and private funds with climate-related names, we found that, although they had the same climate names, they pursued different strategies. On the public side, they've tended to focus on companies with low carbon emissions, so with more exposure to information technology. On the private side, we see more exposure to renewable energy, which made up over 40% of the underlying investment holdings valuation. This percentage demonstrates the role that private funds could play in financing the energy transition.
Figure 1: The green rush is underway
EF: Naturally, financial returns remain the primary consideration for investors when evaluating investments. Have private investments in renewables paid off, compared with equivalent investments in oil and gas?
AZ: There are several ways to gauge returns in private markets, but we'll use a simple and a direct approach: investment multiples, or the proceeds from exits made by the funds divided by the paid-in capital. Now, looking at the returns from the exited investments in renewables and oil and gas, we find that we're in front of two different markets – pre- and post-2016. Before getting into the details, there are a couple of wrinkles to iron out. We use 'renewables' to refer to companies in the renewable electricity Global Industry Classification Standard (GICS) sub-industry, while 'oil and gas' companies are those in the oil and gas drilling, exploration, production and integrated oil and gas sub-industries. It's important to also note that these returns are gross of fees.
As of Q4 2023, private capital exits from renewables have registered positive returns in all years since 2016, compared to only two years of positive returns between 2010 and 2015. Since 2016, the returns of the exited holdings in renewables outperformed those of oil and gas. This contrasts sharply with the period before 2016, when oil and gas outperformed renewables between 2010 and 2015.
There are two main takeaways from the recent outlined shift in returns. First, understanding renewable investment trends and returns may be increasingly relevant to a wide range of energy investors, not only climate-focused investors. Second, bridging renewables' climate impacts with the financial returns may provide the industry with much-needed capital to finance the net-zero transition. This bridging is especially important to tap into additional pools of capital that may not have climate mandates but are focused on financial returns.
Figure 2: Sunny side up: Renewables have overtaken oil and gas since 2016
EF: Given that performance, how do you see the flow of capital into private markets for renewable energy and for oil and gas?
AZ: As Michael said, it's going to take trillions of dollars to reach net zero. This financing gap highlights the importance of bridging renewable investments' climate impact with the financial returns to increase private capital allocation from a broad range of investors, regardless of their climate focus.
The more positive returns outlook for renewables since 2016 has been reflected in cash flow trends. So, if we look at the net investment flow, which is basically inflow minus outflow, we see that oil and gas maintained a positive net inflow until 2019. Since that year, it turned negative, meaning that there have been more exits than new deals, and more proceeds than new investments, as of Q4 2023.
Now, when you see what's happening in net investments in renewables over the same period, it was the exact opposite. The net deal count and net investments have both surged after 2019, demonstrating a rush toward renewable assets.
Figure 3a: A rush toward renewables amid net exits in oil and gas
Figure 3b: A rush toward renewables amid net exits in oil and gas
EF: How about the situation in the public markets compared to the private? What are the similarities and differences?
Jakub Malich: The obvious difference is that there is more data, and more transparency, in the public markets. So, not only are we able to see financial flows and issuance, we can look at sustainable finance transactions and see if a sector is directing capital to green projects, say, and if they're linking these transactions to their sustainability goals.
One immediate insight is that, in the sustainable finance markets, we're seeing a clear discrepancy between utilities and the energy sector. Utilities issue almost 20% of all labelled bonds, while less than 2% come from energy. This data suggests that the former is deploying more debt capital in decarbonisation and green projects than the latter.
Not only is there more data in the public markets, but it is also increasingly well-defined and comparable. There are national and international disclosure requirements, standards for sustainable finance transactions, as well as different taxonomies. These allow us to orientate better – and we can not only track flows, but we can also look at the companies issuing these instruments and see how they are doing in terms of their climate performance. We published research last year that found that issuers of labelled bonds performed better on their climate targets than their sectoral and country peers. This is a big advantage when it comes to public markets.
EF: What lessons from public markets are most relevant to the growing provision of sustainable financing in private markets?
JM: At MSCI, part of our mission is to bring transparency to markets, both public and private. So, we can take sustainability data from public companies and use this data to navigate private markets, to approximate where private companies from the same industries might be, where we don't have granular data and disclosure.
The second step is to apply lessons from sustainable finance to address data gaps in private markets. As we see more sustainable finance transactions and labelling in the private space, we can draw conclusions from the public markets on what it may mean for companies engaging in them.
EF: What about the sustainable loans market? How do you see that evolving?
MR: One observation is that sustainability-linked loan (SLL) issuance is now much larger than green loan supply. In 2024, so far, SLL issuance is about three times that of green loan issuance. In the labelled bond markets, green issuance is still significantly larger than for sustainability-linked bonds.
The other thing we would note is that SLLs tend to come from a more diverse set of sectors than green loans. In SLLs, energy, real estate and miscellaneous make up 37% of issuance. In green loans, those sectors account for 64%.
EF: What other markets do we need to think about in terms of achieving a successful transition?
MR: We believe that, among other things, infrastructure is likely to be key to the transition – and we need to interpret infrastructure broadly. It's not only energy, but also metro systems, green buildings, guided buses. We also need to think about green infrastructure, such as using mangroves to protect against sea inundation. Infrastructure is made of long-lived assets, so it has to have a small impact on climate change during construction and operation, but also be resilient to a changing climate.
Michael Ridley is head of fixed income ESG and climate research, Abdulla Zaid is a vice president, private capital research, and Jakub Malich is a vice president,ESG & climate at MSCI in London, Boston and Hong Kong, respectively.
For more information, see: Sustainable Investing – MSCI and Private Capital – MSCI
