The European Union is leading the way. It has committed to becoming climate neutral by 2050 and intends to mobilise investments totalling 1 trillion euros during the current decade for its Green Deal. China, today the biggest emitter of CO2, will have to invest similar amounts to achieve its objective of climate neutrality by 2060. If President-elect Joe Biden keeps his word and rejoins the Paris Climate Agreement, the US too will be a massive spender on green investment.
Climate change is already making itself felt. We are noticing in our daily lives how temperatures are on the up. Forest fires and other extreme weather events have become more frequent, with resultant economic damage. At the same time the Covid-19 pandemic has plunged the world economy into crisis. Countries that act countercyclically can provide stimulus by investing in green growth.
Governments need to push ahead with investment in green growth, but they should not bear the burden alone. By building the right technological base (e.g. propagating the use of hydrogen fuels) and creating incentives, the public sector can animate citizens and businesses and thereby multiply the effects achieved. At the same time, environmentally harmful subsidies and other ungreen incentives must be discarded.
Governments’ legislative muscle enables them to set other incentives as well. Particularly important in this context is the regulation of the financial services industry, especially in Europe. The majority of European companies still raise finance by bank loans rather than in the bond market. If the capital ratio requirement for loans to finance ecologically positive measures were relaxed, greener companies would benefit from lower financing costs. Central banks could create similar incentives in their bond purchase programmes by taking account of companies’ climate impact or the purpose for which bonds were issued.
Thus the job of the public sector is less concerned with raising capital directly than with providing the right incentives. This includes creating a suitable framework for a market in which prospective green solutions compete for investors’ money. One thing is clear: the transition from fossil fuels to climate neutrality and a more environmentally friendly use of resources requires a fundamentally revamped economic model. This will necessitate an enormous input of private capital.
But will the private sector be willing to cough up? Central banks’ policy of low and negative interest rates has produced a “yield famine”, which particularly affects pension funds and other institutional investors that have only limited scope for switching to higher-yielding but more volatile asset classes. Such investors will therefore be very interested in investments that offer attractive and stable cash flow. Raising sufficient finance is therefore first and foremost a question of attractive investment returns. In a low interest rate environment this should not be too much of a challenge.
Investors can’t afford to ignore this as the challenges will also offer opportunities. The shaping of a greener economy will require new technologies, and that means pumping money into research and innovation. Many of the companies that cater to the public or private sector in these fields are not (yet) equity market heavyweights. In order to tap this potential, investors should put at least a part of their equity allocation into theme-based investments.
Besides these direct economic impacts, equity and bond prices will also be affected by the restructuring of investment portfolios in the years ahead. Investors are adjusting their allocations to give greater weight to sustainability. Enormous sums are flowing into sustainability-oriented investments. Governments, companies and private individuals are all pulling in the same direction. This increases the chances that climate neutrality will be achieved and that an investment exposure to the greening of the economy will pay off.
Note: This is an abridged article published in the latest edition of our investment magazine Telescope.
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