Private credit assets as catalysts for climate impact

January 18, 2022 06:00
Photo: Reuters

“The window is still open, scientifically, to act,” according to Professor Johan Rockström, architect of the nine planetary boundaries – environmental thresholds for humanity recently popularised by the Netflix documentary, “Breaking Boundaries”.

During the Zero-Hour Sessions, an event convened by Lombard Odier during the COP26 climate summit, Rockström stressed that our planet – “a complex, adaptive, self-regulating biophysical system” – has tipping points which, if triggered, cause “self-enforced drift in the wrong direction”.

While the stability of our planet, and the economic activity it supports, depends on humanity keeping within these science-based thresholds and avoiding the “no-go zones” beyond them, we have already broken through four limits: toxic waste, air pollution, freshwater overuse and agrochemical pollution – and are on course for transgressing a critical fifth boundary: keeping global warming within 1.5°C above pre-industrial levels.

According to the IEA, COP26 commitments reduced the forecast global temperature rise from 2.7°C to 1.8°C. While further policy impetus is essential in directing real decarbonisation throughout the economy, private sector resources must be marshalled to realise the required emissions reductions. The financing gap to put the world on a path to net zero is estimated to be USD $32 trillion in the next decade.

New arenas of risk and opportunity
As illustrated below, economy-wide decarbonisation presents new variables to consider in evaluating risk-adjusted returns as transitional, physical and liability risks increasingly factor into corporate profitability and valuations:

• Transitional risk includes shifts in demand among climate-aware consumers, companies’ ability to reduce emissions and the impact of higher carbon costs and regulation

• Physical risk includes the damage caused by more frequent extreme weather events and the associated degradation of agricultural yields and less-productive labour forces

• Liability risk includes historical responsibility for climate change among companies and sovereigns, as well as mitigation and adaptation costs

Forward-looking investors may identify public and private businesses that are mitigating climate risk and acting on the opportunities generated by the transition. Lombard Odier believes there are significant opportunities available to advance the transition to Net Zero (“NZ”) through not just traditional public equity and debt markets, but also through private markets. While private equity capital has been well-deployed towards sustainable finance, we believe the broad versatility of solutions-oriented private credit is positioned to play an important role in accelerating the transition into a low-carbon carbon-resilient economy.

Financing impactful firms

The broader consensus move to NZ creates investment opportunities in select sectors targeted as priorities by large asset owners and corporations. While many large companies are creating meaningful in-house contributions to the climate transition, some of the most impactful solutions are coming from entrepreneurs within fragmented, underfinanced markets working directly with corporate partners. Such corporate consumers of sustainable goods and services often find it more accretive to purchase and scale an externally sourced product or service than to allocate such development to balance sheet.

While equity is a necessary component of business development, particularly in funding earlier stage technological and business development activities, properly structured private credit capital can help catalyse growth. Drawing on structured, specialty and infrastructure finance methodologies, private lenders can provide well-covenanted tailored liquidity to borrowers not typically available in public markets. As enterprises seek to scale disruptive climate solutions, access to low-cost capital will remain a key driver of a virtuous cycle of asset creation.

Sustainable private asset managers have an obligation to be more than simply capital providers to their partners; they can help create mutual value through influencing corporate behaviours and actions. Managers can provide guidance and technical support to growing enterprises seeking to overcome various challenges, including United Nations Sustainable Development Goals (“SDG”) alignment; regulatory frameworks compliance; key performance indicator (“KPI”) transparency and Environmental, Social & Governance (“ESG”) risk management.

Climate commitment

The forces driving the NZ transition are clear. COP26 provided further evidence of policy and social tipping points for recommitting to the Paris Agreement’s 1.5°C threshold. The private sector is delivering novel solutions today to profitably adapt and reduce carbon emissions, while improving resilience. Frameworks such as Rockström’s planetary boundaries provide a guide for investors who seek businesses that are adapting their business models to be profitable in a sustainable future.

“There is no question about the direction of travel anymore,” Rockström said. “The question is: can we act fast enough in order to land in a safe operating space for humanity?”

Much of the answer lies in action within the real economy, where private credit is essential to catalysing and scaling additional impact.

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Sustainability Analyst, Lombard Odier Investment Managers