Tony Lent, MBA
Co-Managing Partner, Aldwych Environmental and Renewables Group
This past December, 196 governments signed on to a global climate agreement in Paris. One of the surprises of the conference was the strong turnout of major corporations and asset owners making public their commitment to address climate within their remits. The government plans that were agreed to, if fulfilled, would lead to 3.6°C warming by 2100, though the signatories also agreed we can barely afford 1.5–2°C warming (we are already at 0.8°C). These national commitments resulted in part from the belief that investing in mitigation will hurt economic growth. As the last six years have shown, the mainstreaming of renewable power to a profitable global industry demonstrated that low-carbon energy could provide a rapidly growing share of global energy, while contributing to economic growth and wealth creation.
This article reviews some of the finance innovation, savvy signaling, and luck that have helped to scale low-carbon energy since 2010 and points to where the next successes could appear. It then explores the rise of the impact investment and how its unusually proactive mindset can help address the finance challenges ahead.
Four major changes have occurred in scaling capital for renewables and climate mitigation since 2010; each represents a different facet of the change: (1) the rise of infrastructure investing since the crises, with renewables becoming a dominant infrastructure investment segment; (2) the invention of the residential solar financing model, supporting residential capacity growth of 30% per year; (3) the setting up of the green and climate bond markets laying the foundation for a low-carbon debt market positioned to power growth going forward; and (4) the successful signaling of fossil reserves liabilities leading to a public markets reassessment.
None of this would have occurred without a glide path of subsidy to support investment while costs were higher than fossil energy. And without manufacturers continually improving technology, the industry would have been unable to compete with shale gas after 2011. In just the last six years, equipment makers have driven down the cost of wind electricity by 60% and solar by 80%. Grid parity has been achieved for onshore wind. Utility-scale solar is at most 24 months behind. In many emerging market countries where electricity is unreliable, distributed solar is often less than half the cost of fossil.
The numbers provide a sense of scale. Investment in low-carbon energy is $324 billion per year and concentrated in the largest GHG emitters: China, the United States, and Europe. About two thirds of that investment is for project assets, mostly for wind and solar. Globally, zero carbon electric supply grows at 9% per year.
Project investment in renewables ($198 billion in 2015 per BNEF) has leveraged project finance tools developed for the independent power industry in the 1980s. These financing structures, well understood globally, allowed renewables to scale on a proven template. Post crises, renewables benefited from the rise of infrastructure as a subclass of alternative investment. Asset owners were drawn to infrastructure after the public markets reset because it provided predictable returns above their hurdle rates and came from long-term contracted revenue with investment grade counterparties. Renewables have taken market share because returns are equivalent to conventional power, but have no long-term fuel price exposure. In 2015 renewables became the largest infrastructure investment category, eclipsing fossil power, transport, and ports.
Growing at 30% per year, the residential solar finance industry is about self-invention. To address initial costs consumers could not comfortably afford, industry leaders including SolarCity, Sungevity, SunRun, and Vivint could only grow by becoming consumer finance companies. Instead of selling systems, they created a short-form residential power-purchase agreement to create payment streams that could be used to create third-party leases. With access to that long-term cash flow stream, bulge brackets provided warehouse lines enabling developers to scale their lease pools. After achieving tens of thousands of installations with default rates lower than mortgages, installers were well positioned to recapitalize. In September of 2013, SolarCity issued the first asset-backed securitization (ABS). Six more rated issuances followed, setting up a new ABS category. With the addressable rooftop market in excess of $100 billion and just 3% penetration, solar could scale to a significant consumer credit category in the United States and in many other developed markets.
If Ranked by the potential to enlarge the pool of available investment capital, the development of the green and climate bond market could become the most powerful environmental finance enabler of the decade. Pioneered by Scandinavian pensions, environmental finance NGOs, and bulge bracket banks, and incubated by the World Bank/IFC, green bonds are designed to enable climate mitigation investment to tap public debt capital markets, demarcating a new credit category. From 2008 to 2012, issuances slowly ramped from $2 billion to $5 billion per year. Those in 2013, 2014, and 2015 were $12 billion, $36 billion, and ~$46 billion respectively. After being dominated by DFI issuances, over the last three years green bonds have been issued by municipalities, power utilities, banks (for green lending), and corporations (for green product lines). Demand has been brisk; most green bonds have been oversubscribed. We could see the green bond category scale to hundreds of billions of issuances over the next five years.
What the green bond market should do next is tap directly into renewables projects, the largest pure-play low-carbon investment category. Since new projects are funded with 65%–80% debt from banks that will be constrained by ramping Basel III requirements, access to a liquid project bond market could help maintain and accelerate the build rate. And green project bonds may create two other network benefits: providing an equivalent or better yield than similarly rated corporates that have significant equity market beta. And by expanding low-carbon infrastructure returns to a wider investment audience, policy makers may feel more confident in advancing stronger policy commitments.
Turning to efforts to flag climate risk, we can see that accounting and communications have had an outsized effect. The Carbon Disclosure Project (CDP) and allied efforts were designed to signal climate risk to capital markets by using a financial risk-disclosure approach, and they have been exceedingly successful. Today more than 700 institutions task CDP to assess the carbon liabilities of public companies, and its assessments have been become widely read and recognized. As a tipping point, the 2012 Carbon Tracker Initiative report, “Unburnable Carbon,” and Bill McKibbon’s Rolling Stone article, describing a limited carbon budget, reframed the risk and the discussion. Without ever seeing a carbon price, these linked concepts changed investors’ and the public’s perception of the value of fossil fuels to a liability, circling all fossil reserves with a yellow or red pen. Informed by these concepts, what started as a limited divestment movement at university endowments upscaled to hundreds of financial institutions which—post crisis—looked at the issue through the lenses of value at risk and systemic (too big to fail) risk. Starting from 2013 and accelerating after Paris, dozens of asset owners have begun to identify investment opportunities in low-carbon energy and climate change mitigation as a response. Many of them are joining newly formed investor groups that are focused on proactive engagement and in which climate is now considered an issue intrinsic to long-term financial stewardship. As of December 2015, the combined equity market cap of the largest coal companies on U.S. exchanges was $10 billion, down from [~$200 billion] in 2012, this despite the industry having produced the same 900 million metric tons of coal and having the same reserves as in 2012.
The Mindset of Impact Investing
In the past 20 years, environmental finance developed tools and methods to value ecosystem services, to assess environmental and social risks, and to benchmark ESG performance. SRI funds embraced them, as did DFIs, the insurance industry, and some corporations, but most investors remained skeptical. This is partly due to two investor biases widely held since the 1980s: first, that the purpose of a corporation is to maximize shareholder wealth; and second, that any other objective, such as investment that considers environmental or social outcomes, must lead to inferior returns. This trade-off framing makes it easier for policymakers to conclude that investing to slow climate change must hurt economic growth. In the investment community, this viewpoint led to a prejudice against businesses that addressed sustainability challenges.
Prevailing mindsets guide us in business, policy making, and investment decisions. They can limit us. And they can enable us. Which is why the advent of impact investment and its proactive mindset is important.
From its seeds in 2008–2010, impact investing has evolved from a community of evangelists to the mainstream faster than environmental or sustainable finance efforts before it. Impact investors describe “impact” as investing to generate positive social and environmental outcomes while achieving competitive risk-adjusted returns. It rests on two enabling concepts that have a bearing on all environmental finance challenges: that prosperity and profit will result from solving the most pressing problems facing society and, as a corollary, that there need be no trade-offs. Impact investing has a broad remit, which is another of its strengths—it includes environment, financial inclusion, climate change, education, health, sustainable agriculture, forestry, and poverty alleviation. With that list, you could say impact is sustainability remarketed but with less academic language, better branding, and more of a “get it done already” attitude.
Impact is a big tent and it is attracting a diverse and powerful crowd: from venture capital, private equity, emerging markets finance, corporate strategic investment, DFIs, foundations, and ultra-high-net-worth investors. It is drawing in some of the most energetic billionaires and best entrepreneurs of the generation who are competing with each other to see who can most successfully address big problems. It is attracting millennials who seek purpose at work, the wealthy who seek to align investment portfolios with their values, and financial institutions that sense a shift in the market. In the last five years, Credit Suisse, UBS, HSBC, JP Morgan, Black Rock, Morgan Stanley, and Goldman Sachs have all begun building out impact investment groups.
Impact assets under management lie mainly within private equity and are growing at about the same pace as green bonds: $46 billion in 2014 to $60 billion in 2015, according to the GIIN and JP Morgan study Eyes on the Horizon.
2015 was a headline year. In April, San Francisco-based DBL saw its third venture fund oversubscribed ($400 million) in part due to impact positioning. June saw Goldman Sachs acquire Imprint Capital, a leading impact advisory, with a plan to apply Imprint’s expertise across all of Goldman’s asset management businesses. In October, Bamboo Finance, in partnership with commodity specialist Louis Dreyfus, launched a sustainable agriculture fund for Africa. LeapFrog, an emerging markets financial inclusion fund, won investment from TIAA-CREF and, in December, an additional $200 million from OPIC, making it one of the few impact platforms to cross $1billion in assets under management. Behind that list are many more small and mid-sized funds that have been well subscribed and a handful of cross over funds that combine broad new themes and impact overtones, such as the one launched by S2G with a focus on the nutrition and organics verticals, along with transparency and authenticity in the food brands it funds.
As an emerging field, the impact investment community does have its internal divisions. Making the field confusing to outsiders looking in, some impact investors are stridently “profits first” and dismissive of the DFIs and philanthropists that helped to found the space. Some are impact, first and foremost, and either deeply ambivalent about high returns or unconcerned about returns. These tensions and some odd combinations have led to investing strengths. Whereas sustainable finance focused on environment, and cleantech on technology solutions, impact investing is more nuanced, catalyzing collaboration between investors with different risk profiles, interests, and domain expertise. Examples of this collaboration range from USAID’s providing a first-loss tranche to Althelia’s ecosystem conservation–finance private equity fund, to M-Pesa, the African mobile payments pioneer, incubating and calving off M-Kopa, now the fastest growing village solar company on the continent, to Planet Labs funded by elite venture capital funds and most recently, the IFC. Planet Labs drastically lowered the costs of satellites, launching in three years a global network of more than 80 satellites that monitor climate conditions, crops, and weather, globally, in real time.
Climate and ecosystem science are saying we have about 30 years before things accelerate from a disconcertingly bad situation to one where we have caused irreparable and widespread harm. In the global energy system, renewables have scaled from a financial backwater to a rising global industry. Low-carbon energy has positive momentum; that said, getting to near-zero carbon in 30 years is going to take far bolder investment going forward. Addressing the next set of environmental finance challenges will benefit from a more muscular investment mindset with a bias toward solving big problems. The impact investment community has that mindset. It is dynamic and parts of it are intrepid. While the impact bus is still unproven, it is leaving the station, charting course to the problems that matter and attracting outstanding talent and resources along its course. Environmental investing can benefit from hopping on board.
Mr. Lent has 20 years of private equity investment and financial advisory experience focused on low-carbon energy, resource efficiency, and sustainable real assets. He was previously a managing director of Wolfensohn Fund Management, where he had oversight for clean energy and served on the Investment Committee for the fund. From 2003 to 2009, he was a cofounder and managing director of US Renewables Group, an $800 million private equity fund focused on proven renewable energy and scaling promising energy technologies. He led or participated in fourteen investments, spanning solar, wind, geothermal, biomass, first- and second-generation biofuels, energy storage, and wind. From 1994 to 2002, he cofounded and was a managing director of EA Capital, a financial advisor focused on cleantech commercialization and the development of funds in renewables, carbon, sustainable forestry, and biodiversity. From 2005 to 2010, Mr. Lent served on the Investment Committee of the Sea Change Fund, an impact venture fund focused on sustainable fisheries-linked investments. Mr. Lent received an MBA focused on technology management from UC Berkeley, and a BS in biology from Tufts University.