Sustainability is fundamentally reshaping investors’ approach to finance | Hotter on metals

A shift in spending from high- to low-carbon assets as part of the energy transition culture could create the biggest reallocation of capital in history – and is already fundamentally reshaping investors’ approach to financing

Banks, funds and private equity firms have raised the bar on capital allocation, meaning that the greener a company, project or technology is, the more likely it is to receive funding, and on improved fiscal terms. Companies that have immediate, credible strategies to reduce carbon emissions are being rewarded; those that do not, are losing out.

The financial criteria of organizations still matter, but lenders are rapidly ramping-up funding to projects that focus on advancing renewable energy, low-carbon buildings and transport, sustainable water and wastewater management, and the circular economy.

The trend is affecting all sectors but is perhaps especially being felt in what the United Nations describes as ‘hard to abate’ industries, for which the transition to a net-carbon-zero economy is more challenging.

These industries include aluminium, cement, chemicals, steel, aviation, road freight and shipping, which together are responsible for nearly one-third of global carbon dioxide (CO2) emissions – a percentage that is expected to double under business-as-usual scenarios. But the challenges of the transition apply across asset classes, including other sub-sectors of metals, agriculture and energy.

Anecdotal evidence from the heads of some of the world’s largest companies in commodities reveals that corporates now have to tick all the boxes to demonstrate that they are serious about sustainability before even making it into the room for a meeting with financiers.

The question is no longer whether environmental, social and governance (ESG) factors can affect access to capital – it is about how it will affect them.

The step-change comes with ESG principles being increasingly incorporated into business decisions and investment strategies, underlining corporates’ buy-in to the United Nations’ 17 sustainable development goals (SDGs), of which climate is one.

At its simplest, sustainable finance refers to the process of taking ESG considerations into account when making investment decisions in the financial sector, leading to more long-term investments in green economic activities and projects.

It includes a plethora of loans, debt mechanisms and investments, used in varying degrees to encourage the development of sustainable projects or minimize the effect on the climate of other ventures; sometimes, a combination of both.

The amount of money required for the energy transition is enormous. According to the Securities Industry Financial Markets Association, investment in the sustainable finance market needs to increase by between $3 trillion and $5 trillion per year to achieve the net-zero ambitions set out in the 2015 Paris Agreement.

Money is already piling in to keep this number on track. Analysts estimate that $4 trillion of sustainable debt was issued in 2021. The total number of new sustainable debt transactions is soaring, including green bonds, sustainability-linked export facilities and asset-backed security transactions, with repayment linked to achieving ESG metrics.

This is being seen across all commodities. Steelmakers US Steel and ArcelorMittal, iron ore producer Fortescue Metals, aluminium producers Norsk Hydro, UC Rusal and Novelis, copper producer Atlantic Copper and commodities merchant Trafigura are just some of the many companies in the metals and miningspace that are adopting sustainability-linked financial products.

Key agricultural commodities merchants ADM, Bunge and Louis Dreyfus have similarly secured loans to fund activities with environmental benefits, such as forest recovery and conservation, energy efficiency and renewable energy, sequestration and storage of greenhouse gas emissions, and conservation of water resources.

And even as oil majors such as BP, Royal Dutch-Shell, Statoil and Total continue to invest in fossil fuels, they are also making steps into renewables amid the knowledge that their green energy plans will represent a much bigger share of their investments in the future. Last year, Italy’s Eni was the first oil firm to launch a sustainability-linked bond.

That transition requires capital, something of which Saudi Arabia – the world’s largest oil-producing nation and home to the globe’s biggest listed company – is well aware. Consequently, the country has laid out plans to enter the market for green bonds.

Transition bonds

Lending to oil corporates and major producing nations may seem at odds with the goal of stimulating investment in developing new types of carbon-neutral, or low-carbon products, to replace high-carbon ones.

Energy watchers will recall May 2021, when the top two US oil companies, Exxon Mobil and Chevron, were rebuked for dragging their feet on fighting climate change, and a Dutch court ruled that Royal Dutch-Shell needs to accelerate cuts to greenhouse gas emissions.

Coal has been canceled for some time, with more and more financial institutions calling on producers of the fossil fuel to adopt phase-out plans or to exit the sector entirely, like miners Anglo American and BHP did with thermal coal.

But, as Russia’s invasion of Ukraine and the subsequent energy crisis have highlighted, fuels such as liquefied natural gas, coal and oil are still required while the evolution to net-zero unfolds. This means that it is still necessary to incentivize investment in high-carbon assets, which have been facing a mass exodus of investor money, and it is here that transition bonds are starting to play a role.

These products fund a company’s transition toward a reduced environmental effect or lower carbon emissions. They are often issued in fields that would not normally qualify for green bonds, such as large carbon-emitting industries such as oil and gas, or iron and steel.

Naturally, this has raised concerns about greenwashing, particularly given the absence of international standards around transition bonds.

Challenges

While few can deny that sustainable finance has become all the rage, the devil is in the detail.

It is hard, for instance, to know if something is actually ‘green.’

Attention is typically focused on carbon emissions, with the result that high-carbon assets do not attract capital. Ironically, it is where emissions are the highest that the most investment – to reduce carbon – is needed.

Yet there is still no globally-accepted definition of low-carbon, and measurement standards that exist are poorly defined. This means there is no unified methodology for calculating the carbon emissions of a business or investment portfolio, something that is required for financial instruments to be truly green.

It is something that the aluminium industry, an early-mover in the push to decarbonize, has been debating for several years.

There is also a lack of data available, a problem that has led China - the world’s largest emitter of greenhouse gases - to delay the inclusion of non-ferrous metals and steel in its emissions trading scheme from this year until next.

Even when companies do report emissions, they often omit to include the entire supply chain. Some focus on Scope 1 (direct) and Scope 2 (indirect) emissions; others focus on Scope 3, which are all other indirect emissions that occur in a company’s value chain.

How a corporate reports carbon data does matter: there are a number of options, including total carbon, carbon intensity, and carbon intensity per unit of financing.

The bottom line is that financing the energy transition on a truly sustainable basis without concerns of data fudging is not going to happen without clear and consistent carbon-accounting frameworks.

The fragmented nature of sustainable finance does not help. Some disclosure requirements are voluntary, others are mandatory; some focus on climate, while others are related to taxonomy. Rules vary between jurisdictions too.

Then there is the question of offsets – the credits that can be purchased to decrease a carbon footprint. They are all well and good as a short-term way to reduce reported portfolio emissions and access capital, but they are in no way a replacement for a long-term strategy of investing in net-zero assets and corporations.

There are also some sectors, particularly agriculture, where zero-carbon options simply do not exist. It is here that carbon capture and sequestration will be required on a vast scale, which in turn translates to unprecedented investment in decarbonization technology.

The focus on carbon is potentially an issue too; while it is a key metric that sustainable financiers consider, there are numerous others that matter, including certification by an industry scheme, recycled content, and details of water or tailings management schemes. Social factors such as health, safety and community relations, as well as governance-related aspects around culture, board composition and transparency, are likely to play an increasingly important role in the future.

Tectonic shift

All this aside, the path forward is clear: sustainable finance is not going away.

Under pressure themselves to prove their own commitments to sustainability, banks have pledged to mobilize billions in financing to the sector in the coming years.

There is even an industry-led, United Nations-convened Net-Zero Banking Alliance bringing together banks, which are committed to aligning their lending and investment portfolios with net-zero emissions by 2050.

It currently has 110 members representing 38% of global banking assets and has pledged to mobilize €200 billion ($208 billion) in sustainable financing in the 2018-25 timeframe.

As the challenges of sustainable finance get ironed out over time, green financing will accelerate.

According to BlackRock, the world’s largest asset manager, investors have moved their money into sustainable investments at six times the growth rate of traditional investments, with assets globally now totaling $4 trillion across all ESG categories.

Describing the move as a “tectonic shift” in capital, BlackRock chief executive officer Larry Fink said in his annual letter to shareholders in January that this is just the beginning. Given the evidence so far, he is absolutely correct.

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