Why are asset owners opting for climate investments in private markets?

Capital allocations to climate solutions are on the rise. The California Public Employees' Retirement System (CalPERS), recently expanded its $100bn climate solutions investment strategies – one of the world’s largest of its kind - by an additional $9.7bn in committed capital. Across the Atlantic, the UK’s Border to Coast Pensions Partnership followed suit. Its latest climate change report, published last week, shows a £8bn allocation to climate solutions in listed equity and fixed income portfolios. 

Across the globe, asset owners have increased their exposure to the investment theme of climate solutions in recent years. This is true of Australian superannuation fund Aware Super, Singapore’s sovereign wealth fund GIC, Dutch pension fund ABP and another California-based asset owner – the California State Teachers' Retirement System (CalSTRS), to name a few.

A characteristic feature of these allocations is their embrace of private markets. CalPERS signed nine private market commitments for climate solutions investments worth $1.1bn in July. An additional $3.6bn of private market investments are under review.

"The combination of long-term investment horizons, high-growth potential, favourable risk-adjusted return characteristics, regulatory conditions and technological advancements make private markets an attractive destination for climate solutions allocations", a CalPERS spokesperson told Net Zero Investor.

Similarly, $1.3bn of CalSTRS’ climate solutions investment is in a private assets portfolio. This coincides with the rapid growth of private market assets, accelerated by a decade of tailwinds through record-low interest rates. As of 2023, private market assets exceeded $13trn, a near 20% increase since 2018, according to McKinsey's latest Global Private Markets Annual Review. Rising rates pose a new challenge for the asset class, with fundraising  dropping by 22% last year, according  to McKinsey. Nevertheless, asset owners seeking to invest in the energy transition continue to do so predominantly through un-listed assets. 

Why then, is this rapidly expanding pool of climate solutions capital gravitating towards private markets?

Scaling innovation

Climate solutions are somewhat of a broad investment theme. For the most part, when asset owners invest in climate solutions, they target companies, products and technologies that either reduce the emissions profile of current production methods – such as steel manufacturing using hydrogen or have a low emissions identity of their own – such as renewables.

A poll conducted by Singaporean asset owner GIC in 2023 highlighted the range of investments that the term “climate solution” could include – from energy storage and carbon capture to renewables and electric transport.

Some, such as EVs and renewables are in a relatively more mature phase of their commercial deployment. Others, such as hydrogen or sustainable aviation fuels, are in their early years – looking to scale up. Private markets are often the first port of call for climate solutions ready to climb up the financing ladder.

This is where asset owners believe their capital has a role to play. GIC refers to it as “industrialisation over innovation”.

Dutch asset owner ABP has a similar view. The pension fund’s climate policy 2022-2030 envisages a significant investment in climate solutions: €30bn by 2030. This includes private equity investments.

“We invest in private equity because we also want to invest in new companies in the early stages of development as they can play a key role in driving the transition”, the fund says in its climate policy document.

Speaking to Net Zero Investor earlier this year, Kirsty Jenkinson – CalSTRS’ investment director for sustainable investment and stewardship strategies cited similar reasons for the pension fund’s climate solutions-focused private market investments.

According to Jenkinson, the strategy is geared towards not only identifying innovation but also the opportunity to scale it.

Financial reward

For investors, the quest for scale is also financially rewarding. That demand for these climate solutions is high is a reasonable assumption to make. Particularly where solutions are targeting hard-to-abate sectors, companies that lead the charge are likely to yield high returns for their financiers, courtesy of a lucrative first-mover advantage.

When CalPERS announced an expansion of its climate solutions mandate, the pension fund’s managing investment director of the sustainable investments program Peter Cashion said, "we need a diverse set of investments and tools to generate the excess returns that are achievable during this historic transition to a low-carbon future”.

Cashion’s climate solutions investment thesis is set within a context of growing confidence in the expected returns from private markets. In March 2024, the CalPERS’ board of administration approved an increase in private markets allocation. The target allocation for private equity and private debt were raised to 17% and 8% of the fund respectively.

"Strong and on-going growth in private equity returns is behind this measured and appropriate increase," said trustee David Miller, chair of the CalPERS’ investment committee.

Portfolio emissions

In addition to the return expectations, asset owners themselves have set ambitious net zero targets that incentivize the search for climate solutions in private markets.

An asset owner’s targets relate to financed emissions i.e. the environmental footprint of their holdings. CalSTRS is aiming to achieve net zero portfolio emissions by 2050 or sooner. CalPERS has a similar goal as does the Border to Coast Pensions Partnership.

Investing in climate solutions is a means to that end. By the end of 2023, CalPERS had invested some $47bn in climate solutions – a number that the fund expects to increase to $100bn by the end of the decade. The reward at the end of the road is an expected reduction in portfolio emissions of 50%.

Some asset owners think this as a risky proposition. Increasing allocations to low emission private assets in order to reduce portfolio emissions – could be seen as taking one’s eye off the prize and concentrating the portfolio.

After all, the goal is to decarbonise not only the portfolio but also the wider economy within which it sits. Aware Super, for instance, has adopted a wider climate solutions investment mandate – one that includes investing in “high emitting companies that need significant financing to help them transition”.

The challenge however is that doing so would mean increasing portfolio emissions in in the short term. “To avoid this unintended consequence [of not financing transitions in hard-to-abate sectors] alternative approaches to investment may be required”, Aware Super says in its transition plan.

At a time when climate solutions have become a critical component of institutional investor portfolios, the financial footprint of private markets has simultaneously expanded. To some extent, these trends seem interconnected – they tell a common tale. One of asset owners investing in technologies looking to scale, encouraged by the possibility of financial reward and their own objective of constructing a portfolio that finances less emissions in the future than it did in the past.