Expert panel: How transition investments can help institutional investors reach net zero

Also rubbing salt into the wound is the recent academic research that shows green investing may be counterproductive because it seems to push brown firms to become browner, while showing no significant improvement in making green firms go greener.

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The exacting demands of sustainable investing will lead to disappointing outcomes and may ultimately result in an ESG backlash. It’s important for institutional investors to maintain and secure the goals of sustainable investment by taking a step back to rethink what it means to invest sustainably and what to expect in terms of risk, return and impact.

First and foremost, investors need to rethink the assumption that sustainable investing means investing primarily in green assets. Sustainable investments that will accelerate the green transition may include investing in brown firms. These may be brown firms that have committed to align with the 2015 Paris Agreement or firms that haven’t yet made the pledge but are equipped to engage with investors.

This alternative approach is called ‘transition investing’ and it has wholly different implications for the asset allocation and carbon footprint of an institutional investor’s portfolio. In the current state of sustainable investment, the green investor buys green with the goal of progressively reducing their portfolio’s carbon emissions to net zero. By contrast, the transition investor buys brown firms and then cleans them up by reducing their carbon footprint. Put differently, the transition investor engages in a green-positive “flipping” activity. Therefore, while the green investor’s carbon footprint goes down over time, that of the transition investor may remain elevated, even if the brown firms it invests in transition successfully into green firms.

Investors also need to be pragmatic about what to expect in the returns from sustainable investing. It makes sense that returns between a green investor and a transition investor will be different. Because demand for green investments is high, green firms have generally higher valuations than otherwise identical brown firms. The transition investor that buys less expensive brown firms ‘greens’ them and then sells them at a higher price should expect to earn higher returns. By contrast, the green investor that purchases the green firms at a high price should expect to earn lower returns on the investments.

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Green investing and transition investing come with unique opportunities and challenges. Green funds benefit from owning firms that are clean, adapted to the zero-carbon economy and more resilient to climate shocks. The key challenge is to convince the funds’ members that their portfolio may have lower returns moving forward because the green firms are more expensive to purchase. The lower returns shouldn’t be evaluated as underperformance but as the price of purchasing assets that are greener and more resilient to climate change.

Transition funds gain from turning brown firms into green ones. The challenge is to convince the funds’ members that buying brown is part of a credible transition plan. It may also be difficult to transition a brown firm into a green one if the investor’s stake in the firm is small and the firm hasn’t established a transition plan. In addition, transition funds will need to develop key performance indicators that aren’t based on the total carbon footprint of their portfolio, which is typically done in the current net-zero evaluation system. Instead, they should be evaluated on the footprint reduction of the firms they’ve invested in that have been ‘greened’ and sold.

There are multiple approaches to sustainable investing, some of which involve investing in brown assets and some may come with lower average returns. For these approaches to be successful, it’s critical that sustainable investors are able to establish credible transition plans and clear performance benchmarks.

For this to happen, the adoption of a green and transition finance taxonomy — such as the one proposed by the Sustainable Finance Action Council — is necessary. The taxonomy provides a comprehensive and unified rule book that makes it possible for both firms and investors to clearly identify transition and green activities. In turn, it makes it possible for large investors such as pension funds, endowment funds, mutual funds and insurance providers to share with their thousands of members that their action plans are credible and verifiable.

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