Climate change is a real, urgent and complex problem requiring innovative solutions. The global response from policymakers, private enterprise and individuals creates opportunities for investors.
Anticipating climate change’s many impacts and allocating capital to sectors and firms that are poised to benefit—while minimizing exposure to the greatest climate-related risks—will continue to be an essential component of active management in public markets. Investment firms that have demonstrated a commitment to understanding and mitigating their own climate impact are more likely to maintain the perspective and discipline necessary to apply this analysis within their portfolios.
But the world also needs dramatic improvement in resource efficiency in order to keep societies functioning and economies growing on a sustainable basis. We fully expect that a powerful combination of human ingenuity and investment capital will spur innovation that leads to solutions. Identifying specific technologies that are effective and scalable, and allocating capital early in their development through venture capital and growth equity, may offer the prospect of exceptional investment returns.
For asset allocators, this is not a political act; it does not require any sort of specific commitment to high level sustainability goals. Instead, it depends only on the recognition that policy and regulation are tilting in favor of more sustainable businesses, and that vast amounts of capital will be deployed in the service of adapting to the changing environment. Investing alongside these collective efforts may enable portfolios to generate better performance while sidestepping key risks.
The economics of climate change are becoming clearer
Economists acknowledge that the historical failure to measure the climate impacts of economic activity, and to assign costs to those responsible, has contributed to climate change. One consequence of this failure is that the historical market valuation of many financial assets has not reflected the sustainability of their particular business models.
This is changing. Policymakers are beginning to assign explicit costs to enterprises that contribute to global warming and are providing subsidies to those that can reduce it. Companies are adjusting their operations to avoid these costs and use resources more efficiently. Consumers’ preferences are shifting to favor more sustainable products and services. And investors are looking to allocate capital to firms that can navigate this changing environment to their advantage.
Firms that demonstrate these capabilities enjoy stronger equity returns, a greater flow of capital and a lower cost of capital—according to a McKinsey study, better environmental, social and governance (ESG) scores corresponded with a 10% lower cost of capital.1 Further, there appears to be widespread demand from consumers for products that are deemed to be sustainable (Exhibit 1A). Investors should welcome the evidence that more sustainable business models can be positive for financial performance (Exhibit 1B).
This data supports an argument that we made in a prior article: A positive feedback loop exists for public companies that invest in resource efficiency and sustainability. New technology offers meaningful improvement in operating costs and performance, investors reward these firms with lower costs of capital and higher valuations, and customers appear to be more interested in their products and services. Firms therefore already have clear incentives to implement more sustainable business models, and the additional impetus from public policy should serve to reinforce these incentives over time.
Current public and private sector commitments are substantial. The U.S. Inflation Reduction Act earmarks USD 369 billion for accelerating climate solutions, while the European Union’s REPowerEU plan provides EUR 210 billion in financing for clean energy, energy efficiency and energy diversification. About a third of the largest 2,000 publicly traded companies worldwide have committed to net-zero emissions.2
Financing innovation in climate technology may close the gap
Unfortunately, current incentives and public commitments to sustainability may not be sufficient to reach key global climate goals. An estimated USD 1.8 trillion in annual spending on resource efficiency and adaptation is needed across the four key sectors that drive over 80% of greenhouse gas (GHG) emissions: transportation, industrial production, agriculture and real estate. Current spending is far below this level and unlikely to reach it any time soon.
In contrast to potentially unrealistic spending targets, an alternative solution may arise in the form of climate-friendly technological innovation. The development of new technology that is both economically attractive and scalable will provide existing firms—which are already seeking to reach higher levels of sustainability—with new mechanisms for doing so. Early-stage investors in these technologies may stand to capture exceptional returns.
Within the already well-established venture capital and growth equity ecosystems, investors are nurturing early-stage firms as they develop their technology and seek to achieve scale. Some of these new firms will enjoy the benefits of building their business from scratch rather than retrofitting a legacy model and will compete directly with legacy firms in an evolving economy. Other new firms will prosper by delivering solutions to existing firms in the form of new technology, allowing legacy businesses to capture the benefits of sustainability for their shareholders.
Consider the examples of two private companies with very different technologies. Each offers powerful improvements in efficiency for industries that have played a key role in global GHG emissions.
A sensor technology and data analytics company allows for real-time evaluation of ore quality in the copper mining industry. Its core product is a physical sensor that sits inside industrial shovels and utilizes X-rays to measure the mineral content of each bucket of material as it is excavated. This technology enables the mine to direct high quality payloads into the energy-intensive refining process while discarding those that would otherwise waste resources. The result is a more efficient and more profitable mining operation.
A platform that connects community solar developers with consumers to facilitate easy access to clean energy while providing consumers with significant savings on their utility bills. This core service enables a comprehensive platform of consumer utility data which supports new clean energy product innovation such as electric vehicle charging analytics and smart home systems.
Public companies may be less likely to take a chance on unproven technology and will therefore seek to adopt sustainable practices in an incremental fashion. However, they do have the ability to make widespread use of technological advancements that have proven their effectiveness. In this way, emerging climate technologies have an opportunity to transition from the drawing board to the factory floor and make a positive impact in the battle to slow the pace of climate change. For those developing the next generation of climate tech, the market opportunity is vast.
Targeting climate technology via growth equity
The number of venture capital and growth funds targeting sustainability-focused investments has increased across the U.S., Europe and globally. Seed capital and early-stage investors tend to have less total capital per fund, but there are more of them. These focused funds have seen approximately USD 3.8 billion in capital invested since 2020. If one were to expand the analysis and include sustainability investments made by more diversified venture funds, the number would be significantly larger. This strong foundation will allow many early-stage firms to emerge and eventually seek later-stage growth equity capital in the next 12–24 months3 (Exhibit 2).
The population of managers in the middle ground of growth equity—between early-stage venture and late-stage private equity—is quite a bit smaller. This may reflect the relative newness of climate and sustainability as a domain of expertise within the private equity universe. But it appears that there is a need for skilled growth equity investors to step in.
Funds focused on later-stage growth equity and pre-IPO opportunities must make larger investments in more seasoned firms, where there is greater confidence in the technology’s efficacy and ability to scale across a suitably large addressable market. Such funds should have a broad network of venture capital firms from which to source opportunities, human and technological resources to filter and evaluate thousands of potential investments globally, and a track record of success in investment selection.
Additionally, managers that can extend broader benefits to portfolio companies—such as deep expertise in financing and capital structure, and access to a global network of potential end users—may secure the most attractive investments and ultimately deliver stronger performance. As mentioned earlier, a broad and demonstrated commitment to the process of sustainability across the manager and the parent firm is a powerful indicator of the degree to which a portfolio company can expect to benefit from these tailwinds.
The combined efforts of policymakers, companies, consumers and investors will be critical to meeting the challenge of climate change. In the public markets, active managers will play a key role by directing investments toward firms that are better able to navigate a dynamic economic and public policy environment. In the private markets, investing in emerging companies focused on impactful and scalable climate technology may deliver new solutions and higher returns. As the world works toward a more sustainable future, thoughtful allocation across both the public and private markets can benefit investors and the environment.