The global transition to a zero-carbon economy presents investors with both an outsized opportunity and host of novel risks. For CalSTRS, the US state pension with $306 billion in assets, accessing those opportunities – and managing climate-related risks – are “fund-wide considerations”, said Nick Abel, portfolio manager, sustainable investments.
Abel is co-manager of CalSTRS’s sustainable investments portfolio, a “dual objective”, unconstrained allocation of up to 5 percent of the pension’s assets. As of end of February’s NAV figure, that equates to around $15 billion in capital to deploy.
That allocation splits into two separate portfolios. The first, the “scaling portfolio”, exists to “opportunistically improve the risk-adjusted return profile for CalSTRS at the fund level”, Abel told New Private Markets, in an interview in the run up to the New Private Markets Impact Investor Global Summit in London in May.
The scaling portfolio uses CalSTRS existing teams and relationships to deploy capital; the types of investment Abel describes for this portfolio – “environmental services consulting businesses” or SaaS and hardware tech businesses that support the transition to net zero – would already be familiar to the pension’s various asset class teams. As of the end of 2022, the team had deployed $96 million to “scaling” investments.
The second is the “opportunities portfolio”, which has a mandate to “source and secure investments that have a demonstrable contribution to a more sustainable global economy,” said Abel. Within this bucket, the team has more flexibility to “explore new investments”, he said.
“Over the past year or so we have been deploying across the risk spectrum, looking at low carbon solutions: everything from credit and infrastructure-like investment all the way through venture, growth and buyout,” said Abel.
So far, the investments have comprised a mix of fund commitments and direct co-investments totalling $490 million as of the end of 2022.
The aim is “to build a comprehensive flywheel that gives us a look through to the low carbon solutions value chain”, said Abel. “Low carbon investments vary widely; for us it’s a strategic focus to be able to invest across that sector and glean insights as we continue to learn and deploy capital in this space.”
There is no concession on the rate of return sought from this strategy; it has the same cost of capital as the overall pension fund.
Climate of risk
The case for developing those insights and new relationships is clear: as the transition unfolds and, hopefully, gathers pace, a new order of ‘winners’ – in both technology and operating companies – will generate returns for their backers. However, the combination of technology risk, regulatory risk and a limited pool of experienced managers in this space combine to create a high level of uncertainty. A research report by investment management business Partners Capital last year described the situation thus: “Few investors can see far enough down this path to invest prudently. While climate impact may be the largest investment opportunity of the decade, this is dangerous territory.”
Abel acknowledged the risk in climate investing, but notes that all investments involve risk. “At the end of the day, as a team, we are leveraging diligence practices across the fund to evaluate an underlying risk, and make sure we are being compensated for that risk. That applies generally, but also specifically to climate investments.”
“You think about what’s different, and you think about what’s similar,” he said, “You’re still evaluating people, culture, process, competitive advantage, transaction history, risk-return profile. All those things are the same.”
What is different, however, is the fact that there a very few established track records to scrutinise in climate investing. A handful of managers were early adopters of environmentally-themed private markets funds (for example Ambienta, Generation Investment Management or North Sky Capital) but the idea of climate as a recognisable investment strategy has only emerged in the last few years.
“A lot of these strategies are first time funds in some shape or form: either a first time firm or a first time team coming together,” said Abel. “So from our end, that requires extensive channel checking and reference calls, reviews of transaction history at prior firms, and making sure they have the appropriate skills or transferable skills to successfully execute the strategy. That applies to both GPs, but also the founders or operating partners.”
“I know it sounds quite simple,” he added, “but I cannot underscore enough just how much time we spend going deep into folks’ professional history.”
“As with any diligence exercise, sizing and control are the key levers we use to manage those risks,” he said.
Having a diverse set of backgrounds in the room is another lever Abel cites when it comes to de-risking climate investments: “What we see in the climate space is a mix-and-match of backgrounds: infrastructure or CapEx heavy backgrounds, along with venture or flexible capital solutions… and so we really want to make sure that we have this 360-degree review from different voices and opinions to challenge our investment hypothesis.”
Purpose and profit
“It’s an exciting time to invest in climate solutions,” said Abel. “You see that excitement across the allocators, the GPs, the founders, the business builders: investors at large.”
That excitement is drawing a lot of interest into the space. Climate-related strategies were the most commonly cited by LPs when asked by placement firm Rede Partners where they were focusing their impact allocations; 51 percent identified it as a core focus. This excitement is translating into capital formation: the largest impact funds to have closed – raised by Brookfield Asset Management and TPG Capital – are climate funds. Seasoned impact firm LeapFrog Investments – a long-time investor in financial inclusion and healthcare – launched a climate investing platform late last year. New Private Markets’ database contains over 100 funds in market with a climate action angle.
Abel believes this excitement is a net positive, but sounds a note of caution. “I think it’s important to call out the fact that there’s very few climate investors, founders and business builders that were part of the first clean tech cycle in 2004 onwards,” he noted.
The recent cycle has been dominated by generalists, with capital flowing towards wind and solar power generation. Abel doesn’t claim to know what will come next, but suspects “you’re going to see greater specialisation targeting climate solutions that decarbonise the real economy, versus generalist approaches.”
He also hopes that the geographic orientation of climate-focused capital shifts towards where it is most needed: emerging markets. “When you take a step back and look at climate finance flows – where they’re going in the world and where they’re needed globally – you quickly see that we’re under-investing in real world solutions at a global level,” he said.
The Impact Investor Global Summit runs on the 16th and 17th May 2023 in London. Abel will be speaking on day one on the topic of climate investing.