The case for 'green transformation'

"For miracles you have to pray, for change you have to work," as Thomas Aquinas pointed out in the 13th century. If we are to solve the ecological challenges our planet faces, in particular (hu)man-made climate change, we can hope for miracles - or we get to work on transforming the way we act and think about transitioning our economy and society towards compatibility with planetary boundaries, says Tobias Huzarski, Head of Impact Investment, Commerz Real.

The required technological, financial and market ingredients as building blocks for transformation seem to be in place. Technological innovations, in particular around renewable energy and industrial production process innovations, have generated the possibility of decoupling continued economic growth from the destructive depletion of natural resources. Investor momentum coupled with regulatory pressure has led to an inflow of capital from institutional, retail and public investors into sustainable investment strategies.

From a market perspective, there is heightened awareness that "un-sustainable" assets which are not aligned with either climate or other social or development goals may increasingly become "stranded assets". 

Despite these buildings blocks being in place, facts point in the direction of further ecological depletion rather than improvement. Fossil fuel based primary energy supply growth is matching and outpacing renewable energy supply growth on a global basis - in other words, burning fossil fuels is a significantly accelerating and not a decreasing activity.

In the real estate space, whilst we have largely improved operational energy and emissions performance of buildings across the board, embodied greenhouse gas emissions for new-built assets have often not declined or in some sectors even increased over the past decades - with little if any improvement around the ecological footprint of developing and constructing real estate assets. So how come meaningful transformation is not taking place?

The (ir)rationality of capital flows

Transformation is sluggish partly due to how financial capital allocation and real world transformation are linked. The way we are allocating capital to solve an ecological crisis is part of the crisis itself, driven by two common misconceptions.

First, the idea that exclusion criteria are sufficient for investments to qualify as ‘sustainable'. Exclusion criteria tend to be so broadly defined that so far they have not stood in the way of fossil fuel expansion or other ecologically destructive activities.

Second, there is the misconception that investing in ‘green assets' by necessity has a real world positive effect. This confuses ‘asset impact' with ‘investor impact' - just because an asset in my portfolio is ‘green' does not necessarily mean that the capital I invested to purchase the asset (my ‘investor impact') did in fact contribute to the asset being green (the ‘asset impact'). To use a metaphor - buying an incredible painting does not make me an incredible painter.

And yes, whilst one can point to the indirect effect of ‘non-green' assets becoming increasingly illiquid, the reality is that in absolute terms there is sufficient ‘non-green' capital going around on a global basis which in turn makes any illiquidity discount rather remote. 

Underneath the distinction between (a) asset impact and (b) investor impact lies the way cash actually flows. It can either flow horizontally, from one investor to another, in lieu of shares, units or property rights in a certain fund or asset. The real world is untouched by this capital movement and the capital therefore has no direct ecological impact.

By way of example, a green methanol facility even with most incredible green credentials simply changing ownership has no real investor effect in terms of climate change mitigation - the facility was green prior to the transaction taking place.

Unfortunately, from an ecological perspective, most ‘sustainable' investment strategies, in particular ETF and public stock and bond based strategies, rely on horizontal capital flows if executed in secondary markets. By contrast, vertical capital flows are understood to be capital being allocated into a real world activity - such as the development of renewable energy facilities - taking the full life-cycle of ecological and social performance of the asset into account.

This is where real world transformation can take place and where asset and investor impact coincide. Vertical capital flow is also the backbone for transformation. 

The transformation solution

Investing capital with the agenda of ‘transforming into green' as opposed to ‘owning already green' assets is often perceived as challenging. Transformation can be more strenuous and involve greater operational risk. Furthermore, if the starting point is an ecologically harmful activity, such as concrete or steel manufacturing, any attempt to transform processes gives rise to the question as to how sustainable, in real terms, the underlying activity is or can be - this question often being coined in terms of ‘greenwashing'.

Finally, there can be regulatory disincentives to invest into transformation activities. The Sustainable Finance Disclosure Regulation in connection with the EU Taxonomy, for instance, defines and embraces green economic activities and assets rather than embracing transformation paths for non-green activities and assets to turn the corner. 

However, as Steven Pinker put it, changing one's mind can be a sign of rationality. And the key rationale for transformation is that it offers the greatest possible lever to make a real world difference. The 100 largest corporate emitters account for over two thirds of greenhouse gas emissions - using capital to transform these companies and their underlying activities has a far bigger effect than investing in already carbon neutral corporations.

The cement and concrete industry accounts for around 8% of global emissions - transforming production processes to minimize emissions has a more meaningful effect than investing in already green buildings, for instance. This ‘ecological leverage effect', in terms of emission savings per dollar invested, calls for increasing capital allocations into brown-to-green strategies.

And the above noted challenges can be overcome. First, risk in the form of complexity tends to correlate with expected returns, so there are blunt economic incentives driving transformation to be captured by astute investment managers.

Second, in terms of transparency, investors are increasingly focused on substance rather than form; a well-designed transformation strategy can attract significant capital and so it should. And third, in terms of regulation, transformation is well consistent with regulatory approaches and the idea that climate change mitigation is about emission reduction pathways. Plenty of reasons to get to work on allocating capital towards real transformation. 

By Tobias Huzarski, Head of Impact Investment, Commerz Real