Investing for impact in private debt to combat climate change

Impact investment strategies will have an important role to play if the green credentials of the world’s stock of real estate is to be transformed, argue Gregor Bamert and Stanley Kwong.

Investing for impact in private debt to combat climate change

After a year like no other, it would be easy to forget that at the start of 2020 it was climate change, and not the threat of a pandemic, that dominated newspaper front pages. That it should have been knocked off its perch by COVID-19 is hardly a surprise. After all, the virus has killed over two million people (as of January 20), infected almost 100 million, wreaked havoc on the global economy, and looks set to cast a shadow on the world for years to come.

However, even though the pandemic also caused what had been an inexorable rise in carbon dioxide (CO2) emissions to temporarily go into reverse, the existential threat of climate change has not gone away. As the pandemic is hopefully brought under control as vaccines are rolled out, there is every chance climate change will again rise to the top of the global political and corporate agenda.

Investors have attempted to align portfolios with the need to lower carbon emissions in three different ways

Until recently, investors have attempted to align portfolios with the need to lower carbon emissions in three different ways: certain types of investments, for example stakes in the fossil fuel sector, might be reduced; environmental factors could be incorporated into the analysis that underpins investment decisions; or portfolios could be positively tilted towards sustainable investments such as renewable energy producers.

While these approaches have their merits, they primarily focus on ESG through a risk-based lens. This fails to give asset owners an explicit inducement to operate in a more climate-friendly manner. Moreover, the impact on the environment of investing in this way is far from straightforward to measure.

Expanding investors’ ESG toolkit

This, together with the scale of the challenge that climate change presents, and the urgency with which actions to combat it must yield results, explains why there is growing interest in impact investing. It complements existing environmental, social and governance (ESG) strategies by ensuring portfolios not only consider the investment risk from an ESG perspective, but allow for the potential to make a positive impact on the environment.

It is especially suited to investments in private markets where investors have greater ability to influence the way in which projects or assets are managed. That is particularly relevant in the case of assets that tend to be illiquid.

There is no denying the unconstrained delivery of buildings and infrastructure has been a major contributor to the climate crisis

Real assets may be central to the way we live our lives, but there is no denying the unconstrained delivery of buildings and infrastructure has been a major contributor to the climate crisis. According to the World Green Building Council, 39 per cent of energy-related global carbon emissions come from buildings and construction. Operational emissions – mostly from heating, cooling and lighting buildings – account for about 28 per cent.1

Research suggests making buildings ‘greener’ will be essential to any plans to reduce greenhouse gas emissions. While it will be important to ensure new developments are as environmentally friendly as possible, arguably the priority is to improve the credentials of existing buildings given the amount of older stock still being used. It is estimated that in Europe, for example, 90 per cent of buildings were erected before 1990, meaning the majority of properties are poorly insulated and reliant on antiquated heating systems.

The problem for the owners of buildings that score poorly on environmental measures is that with tenants increasingly shunning them and upgrades expensive, banks are stepping away from lending amid fears such assets could become stranded. The good news is this is providing investors in private debt markets an opportunity to fill the void.

By lending to real-estate owners at the same time as offering them a financial incentive to make their building more environmentally friendly, it is possible to reduce a building’s detrimental impact on the environment and wider society at the same time as delivering attractive risk-adjusted returns for clients.

A potential win-win situation

Aside from the obvious benefits to the environment, from the asset owner’s perspective, impact investing can provide a means of funding upgrades to their building – thereby extending its life and reducing the risk of it becoming stranded – that will otherwise not be available. While loans can initially be expensive, the idea is that borrowing costs fall as the building is upgraded in line with pre-agreed objectives.

From the end investor’s perspective, this process ensures the return they can expect to receive is aligned with the amount of risk they are taking on. Initially, they receive a higher return for lending against a riskier asset. As the building is upgraded, and the danger of it falling foul of tougher environmental regulations drops, the risk of lending against it starts to decline and the return drops commensurately.

Investment opportunities that would previously have been rejected on environmental grounds come into consideration

Better still, risk-adjusted returns on a portfolio of assets can potentially be improved. Firstly, investment opportunities that would previously have been rejected on environmental grounds come into consideration.

Secondly, the impact of climate change is not always accurately reflected in real-estate values. Since markets understandably struggle to assess the likely impact of stricter climate regulations when making a long-term risk-return assessment, assets rather simplistically tend to be deemed ‘good’ and command a premium or ‘less good’ or ‘bad’ and come at a discount. Beyond this, there is little effort to determine how individual properties are likely to be impacted by new regulations. This can lead to pricing anomalies.

Aviva Investors’ real estate debt team has committed to allocate £1 billion to impact investment strategies by 20252 to meet growing expressions of interest from clients and demand from borrowers.

Definitions of impact investing vary across the industry. In some cases, buying assets in sectors that can positively impact society, such as social housing, may be considered an impact investment. However, it is important investors focus on the incremental ESG improvements expected, such as reduced carbon emissions.

Making a quantifiable impact on the environment

Viewing investments in private debt through this impact-investment lens is challenging as it is important to understand where your influence lies and where the most material ESG factors sit within a transaction. These will vary deal by deal, but investing in this way provides an opportunity to make a real and quantifiable impact on the environment.

We have developed a framework which offers several benefits to assist in the loan-origination process

To demonstrate our commitment to the transition towards a low-carbon economy and, more importantly, to try to ensure our investments have maximum environmental impact by engaging borrowers on ESG factors, we have developed a framework to assist in the loan-origination process.

Outlining six key performance indicators (KPIs) drawn from the UN’s Sustainable Development Goals (SDGs), the framework helps determine the targets attached to each loan. These KPIs range in importance from energy efficiency improvements, such as the installation of renewable heat and energy storage technologies and LED lighting, to creating electric vehicle charging points. The targets in turn guide the type of financial incentive mechanisms on each loan.

This framework offers several benefits. From our perspective, it ensures there is consistency in our approach to assessing the relative merits of different investment opportunities. When considering their impact on the environment, there are a wide range of buildings that require varying degrees of improvement. As an active lender, we need to identify and tailor the required actions if we are to best support borrowers as they look to upgrade buildings.

From the borrower’s perspective, it gives clarity as to the basis on which we are prepared to lend them money and the steps they need to take to improve the terms of that loan.

As for our clients, it offers transparency in terms of the environmental improvement their investment is helping bring about. Once we have agreed with the borrower the steps they need to take to qualify for the loan, the process is subjected to external verification by an independent opinion provider.

Similar to the function performed by a credit ratings agency, their task is to look at the materiality of the individual KPIs and the ambition of the targets as laid out in the terms of the loan, and ensure it is compliant with Loan Market Association principles.

As the COVID-19 pandemic begins to be brought under control, it seems inevitable politicians will once more view the need to tighten environmental regulations as a priority. It has never been more important for investors to focus on environment risks and opportunities arising from the low-carbon energy transition. If the world of finance is to play its part in helping combat climate change, impact investment strategies could form a vital part of investors’ toolkits.

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