Climate Investing 2.0 - Navigating an Increasingly Competitive Market
Climate finance is getting more competitive and complex. In the early years, investors could often generate returns just by being aware of a few big themes of the low-carbon transition, such as renewable energy, and betting on the companies that were helping drive them forward. The market has evolved since then, however. As the sustainable transformation of the global economy gathers pace, potential investments have proliferated along with the number of investors vying for the best opportunities. In addition, the market volatility in recent years, which dragged on many previously successful green investment strategies, has underscored that the transition will be a complex, long-term process. We believe success in this maturing market will require an approach that looks across asset classes to find promising investments aligned with investors’ key portfolio objectives, from managing risk to seizing opportunities.
We asked two of Goldman Sachs Asset Management’s most experienced sustainable investment experts to share their insights into this rapidly changing market. John Goldstein, Global Head of Sustainability and Impact Solutions in our Client Solutions Group, and Letitia Webster, who heads up Sustainability for Private Investing, advise clients globally on vital issues from portfolio strategy to implementation. In this article, they answer some of the questions they often hear from investors around the world.
How have investors’ approaches to climate finance changed over the past 15 years?
John Goldstein: In the early days, climate investment strategies tended to be more one-dimensional. They set targets and used data and metrics, but many of them were solving for a label, be it “green” or “ESG,” and weren’t necessarily aligned with the thesis of having real-world impact and a well-balanced portfolio. This approach also led to unintended exposures and concentrations, because in many cases investors piled into carbon-light sectors viewed as more positive for the environment and steered clear of hard-to-abate industries with higher emissions, such as fossil fuels. The result was that they underweighted the real economy rather than thinking about exposure broadly across markets and sectors.
What people have realized is that such an approach may not generate the right outcome from a climate perspective. If you want to decarbonize the real economy, that’s where capital needs to go. Another issue is that a lot of investors who thought they were taking a climate tilt were in fact tilting their portfolios toward growth stocks. Now they are seeing that this approach might not have made great sense financially, because taking sector and style bets inadvertently is generally not good practice. We’re getting to the 2.0 version of climate investing, which is more sophisticated in terms of thesis, has data and metrics that are really fit for purpose tied to that thesis, and has a wider variety of implementation tools.
Climate as an investing theme does not mean the rules of portfolio construction and risk management go out the window; they arguably become more important than ever. In our view, different parts of the portfolio are better suited to different elements of climate investing: some are easier to tailor for climate risk management; some are better suited to finding thematic growth opportunities; and for others this is just another economic lever—how can you manage risk, work on margins, be more efficient and effective. We believe it really starts with taking a multi-asset approach and choosing the right tool for the job.
How have the uses of data, metrics and analysis changed as climate investing has progressed?
Goldstein: The data journey is part of a very healthy evolution that I have seen in so many fields within sustainable investing. In a lot of cases, data approaches started out being more about labelling, which almost amounted to an outsourcing of analysis. Over time, we have seen investors begin to use the ever-improving data at their disposal to arrive at actionable investment insights, rather than solve for a label. This requires a more holistic approach that isn’t just backward-looking but has more real-time and forward-looking data. The problem with relying on backward-looking financial data to evaluate a company’s investment merits is that so much of a company’s value is in its growth prospects. Climate investing is no different, and that’s why we have worked hard to develop multifaceted ways of looking at data that cover past, present and future, allowing us to provide fuller information to our clients and to make better investment decisions.
A notable aspect of the rapid expansion of climate investing is the growing importance of private markets. What does this development look like on the private side?
Letitia Webster: Privately held companies tended to fly under the sustainability radar until four or five years ago, when they came under pressure from public corporations and the banking industry. Corporations are seeking greater climate-related transparency and tracking from their suppliers, most of which are still in private hands. Asset managers, which provide much of the capital for private companies, now have their own climate targets and reporting requirements to consider, so they are encouraging these companies to step up their climate ambitions.
This creates market-differentiating opportunities, in our view. When privately held companies that supply public corporations become more sustainable and provide the necessary data, transparency and impact needed to support corporate sustainability goals, we think they stand a better chance of becoming suppliers of choice. We see the younger generation in the workforce wanting to work at companies that are part of the solution. As a result, recruitment and retention of top talent becomes a competitive advantage. We also see younger consumers buying more sustainable products, so companies leaning in on sustainability can create momentum and value across their business.
Our role in private markets is to support companies with tools, resources and expertise so they can enhance their sustainable practices to meet these market opportunities. In doing so, we believe it may lead to higher valuations at exit thanks to the increased demand for their products.
Asset managers can play an important role in analyzing markets, devising innovative tools and identifying opportunities that align with clients’ climate-investing goals. What aspects of this process, including the relationship with clients, are specific to private markets?
Webster: Engagement with portfolio companies in private markets can be much more hands-on than in public investing. Due diligence requires a commitment to learning about the nuanced environmental and climate challenges within a specific sector and the novel technologies to support a sustainable transition. This often requires months of deep work and engagement with the management team of companies we are considering for investment. We will also dive into understanding how the changing climate will impact the business through physical or transition risks. During the hold period, we aim to collaborate with the companies to work across their business model, operations and product to support them in building and growing a sustainable and resilient business that manages environmental and human capital resources responsibly. Where applicable we spend a significant amount of time understanding the functional benefits, market differentiation of the product and the impact it will have in supporting the transition to a lower-carbon economy.
We have a diverse global set of clients, many of whom are actively seeking to invest in these solutions to take advantage of the market tailwinds. Partnering with our clients to support their goals requires a high degree of experience in these markets to determine which technologies and management teams will be successful in the market and will be able to meet our return profiles.
What do investors need to keep in mind as they navigate the expanding and more competitive sustainable investment market? Where are they likely to find the biggest opportunities?
Goldstein: The market has developed to the point that everyone knows what the main themes are, so climate investing is no longer about awareness or interest, it’s about execution. You need to start with an understanding of where you are on the market maturity curve. Are you prepared for the risks involved in early-stage sectors, which tend to be capital intensive, take time to develop and have a potentially high failure rate? Are you committed to building up an emergent business to make it capable of originating assets that will become more appreciated and understood by the market, allowing you to potentially sell it at a profit down the line? Or are you looking for investments in mature companies, investing via fixed income and private credit?
A second point to consider is that the green leaders of today may be robustly valued, but if you can find or create the green leaders of tomorrow—the companies transitioning from gray to green—there may be real value uplift from a financial and a climate-impact perspective. A lot of these companies may be older-line industrial businesses in capital-intensive sectors, and that transition is where you’re really going to unlock potential value.
What other types of opportunities can investors find in the gray-to-green transition?
Webster: The solutions we invest in on the private side are typically developed by companies in unique market niches. They won’t necessarily become Fortune 500 companies, but they will be integrated into the supply chains of larger corporations, making them more sustainable and facilitating their transition. Corporations have set ambitious sustainability goals and need solutions to help achieve them. Understanding the levers to pull to achieve these sustainability goals across sectors offers up a wide array of solutions. One approach is to focus on broad solutions that can be integrated into a wide variety of products such as biopolymers, which are made from renewable sources and have a wide use case, including an eco-friendly alternative to traditional plastics in packaging to yoga pants.
We also look at carbon intensive sectors to understand their pain points in the transition to determine what solutions will be necessary for them to decarbonize and we then go deep into that theme. For example, we know the utility grid is challenged with transitioning to renewable power. Solutions that increase the grid’s overall output and reduce costs will be essential in the clean energy transition. We are investing in short- and long-duration energy storage platforms as well as in the inverters that are a critical component for battery, wind and solar storage projects by connecting and enabling the interaction between the power-producing asset and the power grid.
How has the situation changed for investment in early-stage companies?
Webster: Ten years ago, we saw only sporadic market demand signals for different types of solutions, such as organic cotton and electric vehicles. It was primarily only renewable energy—wind and solar—that had really matured. Investment in most solution developers was early-stage, which involved a considerable amount of seed capital and risk, with many companies never making it to the growth stage.
Now the companies and the market are maturing. As the technologies become more sophisticated and cost-effective, and there is more consistent and dependable demand that investors can predict and plan for, they become backable by larger institutional capital with larger investment commitments. Where we were previously considering investments in low double digit millions of dollars, we are now investing capital upward into triple digits, recognizing the growth potential of these companies with sustainable products.
Wrapping up, what would you say is the main question clients are asking about climate investing in 2023?
Goldstein: The common denominator for so many clients around the world is the broad realization that these themes are playing out in the market, so as an investor, what do I do? That question covers everything from implementing a multi-asset strategy to specific implementations in public or private markets. How do I think about this with real clarity grounded in a thesis about how this will affect markets and the economy in the years and decades to come? The answer to that question becomes the basis for action.
