James Tarry and Luke Layfield explore how the accelerating climate transition is creating risks and opportunities for real assets investors.
Read this article to understand:
- The impact of the energy crisis and new regulation on real assets
- Where opportunities can be found in real assets to support the climate transition
- The role of nature-based solutions in real assets portfolios
Record temperatures in Europe. Devastating floods in Pakistan. Crop-withering droughts in China and East Africa. Extreme weather swept the world in 2022, proving that global warming is not just a problem for future generations; it threatens lives and livelihoods in the here and now.
Meanwhile, Russia’s invasion of Ukraine has led to soaring gas prices, illustrating the need to expedite the shift towards renewables for energy security: this is the motivation behind the European Union’s wide-ranging REPowerEU plan. In the US, the Biden administration has passed the Inflation Reduction Act to promote employment in green industries and incentivise the development of climate-friendly technologies.
While such legislation represents progress, carbon emissions must be reduced much more quickly if the world is to meet the targets set out in the Paris Agreement. The need to accelerate the climate transition was high on the agenda at COP27 in Egypt and the G20 meetings in Indonesia.
Investors in real assets have an important role to play as the transition gathers momentum. Buildings and infrastructure emit significant quantities of carbon and are likely to face physical risks from climate change. New climate regulation may also render older, inefficient assets obsolete. But these trends will also create opportunities for forward-thinking investors to invest in greener assets aligned to the transition – and improve and upgrade those that are not.
In this Q&A, James Tarry (JT), who leads Aviva Investors’ multi-asset strategy for real assets, and Luke Layfield (LL), real assets portfolio manager, discuss how the climate transition is reshaping real assets and the key opportunities in 2023 and beyond.
We have seen global shocks over the last 12 months, from war in Ukraine to heatwaves across Europe, Africa and Asia. There has also been progress on key climate legislation. How are these developments affecting real assets?
JT: The war in Ukraine and the consequent energy price shock have shifted attention from longer-term net-zero targets to the pressing issue of energy security today. Clearly, this is a crisis that needs to be addressed. But in a sense, it only bolsters the case for renewables; transitioning away from fossil fuels will give us more security over energy supplies and reduce the need to import oil and gas from countries like Russia.
At the same time, regulation is coming that should accelerate the climate transition. We’re seeing evidence that the Inflation Reduction Act is already helping to make nascent green technologies commercially viable in the US, for example. But the extreme weather events we experienced in 2022 are a warning we need to move faster. The damaging impacts of a warming planet are already with us.
Our climate transition real assets approach1 targets opportunities to invest in real estate, infrastructure and nature-based solutions aligned to these longer-term themes, from electric vehicle (EV) charging networks to afforestation schemes. But the recent market disruption is also creating more immediate opportunities2 to acquire re-rated real estate assets that can be refurbished, upgraded and decarbonised, helping us meet both financial and climate objectives.
Are we seeing greater competition for green assets such as wind and solar power infrastructure? And if so, how is that affecting our strategies?
JT: Infrastructure, particularly renewable energy infrastructure, is one part of the market that has not quickly repriced during the recent market turmoil, partly because of the huge weight of demand for those assets.
Pension funds and other large institutional investors increasingly want to allocate capital to renewables, not only because this helps with reporting against their net-zero targets, but also because the sector is attractive on a financial basis. These assets have performed well from a cashflow point of view because many qualify for inflation-linked subsidies. Projects subject to merchant power prices have also benefitted from big revenue increases.
Renewable energy infrastructure is a big part of our climate transition approach
Renewable energy infrastructure is a big part of our climate transition approach – it helps us avoid emissions and achieve our environmental objectives. In addition to investing in operational or ready-to-build renewable assets, we also look to partner with developers to gain access to a pipeline of projects at different stages, from pre-planning right through to shovel-ready developments. Investing earlier in the process and retaining optionality around the pipeline can help us get ahead of the competition and drive better returns.
We are also looking beyond traditional wind- and solar-power generation assets into digital infrastructure that can make a difference to the climate transition, such as EV-charging stations and fibre broadband. Fibre is three times more energy efficient than copper and its speed enables more people to work remotely, mitigating transport-related emissions. Fibre networks should also benefit from other long-term trends such as the rise of smart cities and the internet of things, which are likely to increase overall data consumption.
Heatwaves in the summer focused minds on the need to adapt the built environment to extreme weather events. How do we ensure the assets we invest in are resilient to rising temperatures and other climate-related risks?
LL: We aim to obtain robust data on physical risk so we can account for it in our investment decisions. In addition to traditional environmental surveys, we conduct climate value-at-risk analysis, which allows us to determine the potential risk as a percentage of the asset value over a set period, based on different climate change models.
We aim to obtain robust data on physical risk so we can account for it in our investment decisions
This allows us to do two things. The first is to buy well, avoiding assets that face very high risks that are difficult to mitigate. The second is to understand the risks associated with existing holdings, and how we can reduce our exposure. When it comes to high temperatures, for example, buildings can be made more resilient at a relatively low capital cost. Landlords can improve the shading and shuttering of a building, reduce the glazing in the design and expose more concrete within the building to absorb heat.
As well as physical risk, our analysis sheds light on climate transition risks – the risks that new regulation and shifts in demand will make certain assets obsolete or commercially unviable. We aim to identify opportunities that will arise due to these shifts, such as ways to add value by future-proofing an asset via environmental improvements.
How do we assess the climate impact of refurbishing and upgrading less-efficient assets versus developing new assets built to higher sustainability standards?
LL: Investors need to start by considering the “whole-life” carbon of the asset. If they are building something new, they will have the opportunity to make it operationally efficient by using the latest materials and implementing modern design methods.
At the same time, the construction process will emit a lot of carbon, so the assessment needs to consider how long the completed building will remain operational in order for the carbon savings to compensate for the extra carbon “spent” up front.
From both a financial and environmental point of view, it is often better to invest in improving existing buildings than to build from scratch. According to the European Environment Agency, 85-95 per cent of all buildings today will still be standing in 2050.3 A lot of investment will be required to make that stock of assets fit for purpose during the transition. We see this as an opportunity to deliver on both our financial and climate objectives.
Do these refurbished assets tend to attract stronger occupier demand?
LL: Delivering environmental improvements often goes hand-in-hand with financial returns. We are seeing increasing appetite for energy-efficient office space among occupiers.
Delivering environmental improvements often goes hand-in-hand with financial returns
We recently acquired Curtain House, a historic warehouse building now used as an office located close to London’s “Silicon Roundabout” technology hub. We are extensively refurbishing and decarbonising the building, with new retrofitted insulation, roof-mounted solar panels, glazing upgrades and electrification of the heating. The building’s Energy Performance Certificate (EPC) rating will improve from an ‘E’ to an ‘A’ as a result.
We expect the asset to attract significant demand, as it will provide best-in-class office space close to an important industry cluster. This is a good example of a market where the equivalent building could not have been built from scratch, because land is in tight supply and much of the existing stock is listed. Curtain House will be cheap for occupiers to run because of the efficiency improvements and will also help them meet their own net-zero targets.
The climate transition approach also targets nature-based solutions, including afforestation schemes. What are the key benefits those assets provide?
JT: We recently invested in Glen Dye Moor, a 6,300-hectare site in Scotland, where we are planting five million trees and undertaking one of the largest ever restorations of degraded peatland. This will help remove carbon from the atmosphere while delivering a financial return.
Investing in natural capital can provide real assets portfolios with a diversification benefit
Investing in natural capital can provide portfolios with a diversification benefit as the assets are less correlated with other financial markets. Sustainable forestry generates long-term returns and also carbon credits that act as a hedge against rising carbon prices. By offsetting the emissions from elsewhere in the portfolio, these assets can contribute to the achievement of net-zero targets.
Through tree-planting and restoring peatland at Glen Dye Moor, we aim to improve biodiversity by bringing back habitats for rare animal species. The site will also include access trails and new public facilities and the project will generate employment for the local community. Through investing in real assets in a climate transition-aligned manner, we can provide these kinds of tangible environmental and social benefits.