Private Credit: Funding the Climate Transition
Assets under management in both private markets and sustainability strategies have grown at a rapid pace in recent years. At the intersection of these two worlds lies an emerging and growing opportunity for private debt capital to play a critical role in the climate transition. It’s estimated $300 trillion of investment is needed through 2050 to meet Net Zero Goals.1 Private capital has a major role to play in the climate transition to net zero, with estimates suggesting up to 70% of total financing will come from the private markets. Furthermore, credit is expected to be the largest source of capital to fund decarbonization, making up an estimated 60% of the total investment required.2 Global contributors to climate change continue to be broad and diverse, extending beyond the traditional focus on the energy and power sectors, transport, and heavy industry. Private equity catalyzed this industry, but private debt is needed to scale it.
While the infrastructure debt markets have predominantly focused on financing established and largely de-risked clean energy assets, many other transactions in the broader energy transition space face significant funding gaps, creating the need for creative, solution-oriented financing instruments and, as a result, the opportunity for attractive risk-adjusted returns.
A supply-demand imbalance has been caused by a dearth of private debt capital being invested into sustainable themes while significant tailwinds are driving demand for climate transition capital. Though the sustainable investing industry has attracted significant capital over the last decade, only ~$50 billion has flowed into sustainability-focused private credit, compared to ~$650+ billion into sustainability-focused private equity. This is the inverse of what is needed to scale this industry going forward.
Source: Bloomberg New Energy Finance. Sustainable strategies include Pitchbook categories: Agriculture; Air; Biodiversity & Ecosystems; Climate; Energy; Infrastructure; Land; Oceans and Coastal Zones; Pollution; Waste; Water. Private equity funds include private equity, venture capital, and infrastructure. Growth metrics compare Capital Raised from 2015-2018 vs. 2019-2022. As of December 31, 2023. Please see additional information regarding sources at the end.
While climate transition sectors historically have been financed by banks, more lenders are entering the sustainability landscape today. The maturation of the climate transition industry has lowered the volatility of earnings streams, making the space more investable. At the same time, limited partners (LPs) are increasingly prioritizing sustainability goals, realizing the diversification benefits of this strategy and the attractive risk-adjusted reward opportunities within the sector. Borrowers within the space are looking for customized solutions to their growing and changing financing needs. Reflecting these trends, there has been an uptick in sustainability-oriented private credit products.
Private Debt Pivotal to Financing the Climate Transition
Macroeconomic tailwinds have increased the importance of private credit as a financing provider in the climate transition space. We observe a strong investment case for sustainable credit, supported by a number of macro tailwinds spurring the demand for capital, including:
- Maturation of Climate Industries
- Significant Policy and Regulatory Support, Catalyzing Capital Expenditures
- Need for Bespoke Financing Solutions
Tailwind 1: Maturation of climate industries
Innovation and scale are increasing the cost-effectiveness of many climate solutions, with many clean energy technologies having matured, making them less risky and more investable from a credit perspective. For example, renewable energy is now the cheapest form of energy production in most parts of the world, due to a dramatic reduction in costs over the last 10 years. On top of that, the cost of offshore wind has dropped 61%, solar power 89%, and batteries 83%, respectively.3 As climate industries have matured, companies within the space have grown in scale. These companies often have attractive cash-flow characteristics, including long-term contractual offtakes with customers that are often combined with a cash receivable related to a tax incentive. These factors create compelling investments from an underwriting perspective.
We have seen sustainable solutions emerge as a key thematic for many corporates due to their net zero commitments and increased focus on sustainability from customers, investors, and other stakeholders. Reflecting this, ~99% of the S&P 500 constituents publicly report sustainability metrics, and more than 75% of corporates list sustainability as the top agenda item. Furthermore, ~66% of Fortune Global 500 companies have set significant climate commitments, up from only 14% in 2018.4
Additionally, we have observed an acceleration of commercial opportunities across sustainability themes, where growth trajectories of sustainable business models are outpacing those of less sustainable, more traditional businesses. The opportunity is not just limited to renewable energy; as shown in the table below, we have observed this trend in waste and materials, sustainable food and agriculture, ecosystem services and water, clean energy, and sustainable transport.
Source: Goldman Sachs Asset Management. Please see additional information regarding sources at the end.
Tailwind 2: Significant policy and regulatory support, catalyzing capital expenditures
Today, governments are catalyzing investment through attractive incentives and policy support. Tailwinds from new legislation including the Inflation Reduction Act (“IRA”) in the US and recent regulations in Europe are increasing the universe of investable opportunities.
Within the US, the IRA is estimated to mobilize ~$2.9 trillion of total capital across the green capex supply chain by 2032.5 The most notable incentives include an extension of the 30% Investment Tax Credits (ITCs) for capex spent on renewable energy projects, an additional 10% ITC for using domestically produced content, and manufacturing credits (under Section 45X of the federal tax code) for domestically produced components for renewable energy systems. The 45X credit is available for a range of renewable energy and cleantech components, including products across the solar photo voltaic (PV) value chain, battery cells and modules, inverters, battery minerals, and wind energy products.6 Collectively, these policies are incentivizing the onshoring of renewable manufacturing and the buildout of additional locally based renewable projects. Some of these credits are only available through 2032, spurring some market urgency to build out manufacturing facilities to maximize the tax benefits and driving near-term demand for capital.
Europe is experiencing similar regulatory tailwinds, and European policies set out in recent green regulation are estimated to require over $1 trillion of investment through 2030.7 One notable piece of legislation, the EU Net Zero Industry Act, creates a regulatory framework to boost the competitiveness of EU industries and technologies crucial for decarbonization. As a result of the act, the European Investment Bank (EIB) announced that it will support the Green Deal Industrial Plan by increasing support for clean investments to €45 billion by 2027, a 50% increase above the EIB’s previously announced REPowerEU package. The EIB will make de-risking guarantees available for wind projects under the new EU Wind Power Package.
Globally, more than 140 countries, including China, the United States, India and the European Union, have set a net-zero target, covering about 88% of global emissions.8
Tailwind 3: The need for bespoke financing solutions
Given the tailwinds discussed above, companies are now, more than ever, in search of debt capital to meet their financing needs. Although traditional debt provided by banks has been a feature of renewable and project financing for years, borrowers are increasingly seeking bespoke financing solutions that are tailored to their needs and typically not available from traditional financing sources.
In particular, we are finding attractive risk/reward opportunities in some structured investment opportunities arising from new regulation. There are many borrowers seeking capital and only a limited number of general partners (GPs) have the expertise, experience, and geographic reach necessary to be able to provide this type of financing. Expertise in navigating complex regulations and tax considerations creates a competitive moat. Given the bespoke nature, we believe that many investments offer incremental yield versus other traditional corporate direct lending investments because they are more difficult to structure. Some examples of the bespoke financing solutions needed include:
Loans secured by the Company’s residual equity interests, often in a portfolio of long-term contracted clean energy assets.
Investments supporting development of clean energy or other climate-transition projects secured by project assets and cashflows. Some of these investments may also contain tax benefits.
Senior debt secured against facility / equipment, repaid via cash from clean tech equipment sales and Government receivables through “direct pay” tax credits (e.g., Inflation Reduction Act 45X Credit).
Potential Portfolio Construction Benefits
Investors are placing increased importance on climate transition, as there is growing recognition that sustainable investing does not have to be concessionary and can offer attractive risk-adjusted returns. Climate transition investing also offers an opportunity for investors to further diversify their credit exposure as the direct lending market continues to grow. We believe sustainable credit has low correlation with sustainable equity investments, similar to traditional equity and debt investments, offering an additional source of diversification in an investment portfolio.
We are also seeing increased sophistication from LPs in the way they seek to align their capital in this space—from integrating sustainability criteria like decarbonization initiatives or employee ownership, to aligning capital with specific impact objectives like carbon abatement or ecosystems preservation. We find investors are seeking to tailor their exposure around the specific areas of impact that present the most compelling opportunity and are also looking for new opportunities to diversify their sustainability investments across asset classes. Credit is likely an area of under-allocation for many investors in sustainability, as debt funds have accounted for only 6% of capital raised for sustainability strategies over the last 10 years, compared to 15% for private markets more broadly.9
We expect to see growing investor demand as sustainable investing continues to become mainstream and is incorporated into portfolios alongside traditional investing. The expected rise in investor demand will also come as a result of the Great Wealth Transfer from boomers to millennials; $84 trillion is being transferred to millennials, 90% of whom are interested in pursuing sustainable investing10 and this population is twice as likely to invest in funds that focus on environmental or social causes than the general population.11 Investors are increasingly creating their own sustainability goals and require solutions to achieve them.
Robust Pipeline of Opportunities
We see a robust pipeline of investment opportunities that support the global climate transition in a variety of end-markets. For example, a commercial and industrial (C&I) scale solar energy developer could use proceeds from a loan to acquire new assets and finance the continued growth of their portfolios. Also, financing is being sought by companies within the clean energy space, such as business-to-business engineering services for clients that operate in renewable energy, land development, public infrastructure, and power end markets. We also see this trend from providers of emissions control and acoustic solutions that reduce and eliminate pollutants and noise emitted by stationary reciprocating internal combustion engines.
Outside the world of clean energy, we see a broad array of interesting opportunities ranging from project finance solutions from sustainable aquaculture, production of biomass or bio-methane, to corporate finance situations such as financing energy transition-related software business or companies focused on emission-reduction technologies.
In the future we expect to see more diversity across environmental themes, sectors, and technologies, increasing the opportunity for investors to diversify their portfolio. Momentum within the sustainable investing universe will continue to accelerate over the next ten years and beyond. There is an urgency for capital to both scale companies and provide financing to sustainability projects. We expect to see the current supply demand imbalance corrected as increased investor flows continue to fund financing demands. In summary, we expect private credit to play a pivotal role in financing the climate transition.
Giving Credit Where It’s Due
While sustainable focused private credit has historically been less active than its equity counterpart, shifting market conditions are favoring this investment opportunity set. Global regulatory tailwinds are catalyzing investment and incentivizing managers and investors to invest in the climate transition. Demand for debt capital is rising as companies mature and increasingly seek bespoke financing solutions. There is a robust pipeline of private debt opportunities— including renewable portfolio financings, project finance, and supply chain financings—to meet the surge of investor demand for sustainable solutions. We believe that the intersection of private credit and the climate transition is an attractive investment opportunity and presents a chance for investors to further diversify both their sustainability and credit exposures as the market continues to grow.
1 McKinsey Global Institute, As of January 29, 2022.
2 United Nations Framework Convention on Climate Change “Net Zero Financing Roadmaps” As of November 2021.
3 Bloomberg New Energy Finance. As of December 2021.
4 Climate Impact Partners. Markers of Real Climate Action in the Fortune Global 500. September 2023.
5 Goldman Sachs Global Investment Research, GS Sustain. As of May 5,2023.
6 Internal Revenue Service. As of Dec. 14, 2023.
7 The European Commission. As of January 13, 2020.
8 United Nations. As of September 2024.
9 PitchBook. As of December 2023.
10 Nasdaq. As of September 23, 2022.
11 Visual Capitalist. As of August 11, 2017.