The Day After Tomorrow: Private Credit and ESG – Chapter 1: Net Zero

Fight or flight?

A helicopter freezes in mid-air before a tsunami moves unrelentingly toward the eastern seaboard, eventually engulfing New York – fortunately, the dog makes it to shelter just in time. Phew. A new ice age begins.

Carrying on my theme of blockbuster movies in previous blogs, in The Day After Tomorrow the signs were there (Dennis Quaid had warned people!) but, as always, people were either too slow or too ignorant to action … worse, they wilfully ignored the signs. Hindsight is a wonderful thing – coulda, woulda, shoulda.

The journey to net zero is, seemingly quite straightforwardly, a good thing – both for the environment and, by extension, society and the economy. Ignoring the typical call-to-arms (“this is a crisis!”, “we need to act!”), which I take as a given, in this blog I focus rather on the role of private credit in financing the change – because it will be a (maybe the) driver of the debt that facilitates it.

A fight worth fighting

Supporting the transition to a net zero world seems like good risk management. Avoiding borrowers who do not maintain their social or environmental licence to operate, or avoiding assets which may become obsolete in a decarbonising world help us to minimise the long-term risks in our portfolios. Moreover, well-governed companies that manage all risks, particularly concerning the environment, we believe, have the potential to deliver more sustainable long-term returns. 

Private credit: financing the fight

So many numbers are quoted regarding financing the energy transition that it’s difficult to know who to believe; but one thing’s for sure, the energy transition financing need is exponentially large. According to the International Energy Agency (2021)[1], annual clean investment globally needs to more than triple by 2030 (to US$4 trillion) to hit 2050 targets. This will be pan-geographic, with investment sizes ranging from thousands to multiple billions of US dollars (equiv.).

Bank and public markets will continue to play a prominent role in promoting sustainable finance but, to my mind, it’s the private credit markets that will be the institutional clean energy financing force - whether retrofitting (buildings), facilitating the increased use of renewables (wind, solar), or electrifying (generation/transmission, transport) to name but a few applications.

The fact is, some markets have limitations when it comes to financing borrowers or projects that have a strong sustainability focus e.g., financing duration may be beyond natural bank appetite; or size (minimum benchmark size, ratings requirements) and/or structure (bespoke cashflows and/or project finance style structuring) might not typically lend itself to public bonds.

Private credit markets, on the other hand, can offer tailored financing solutions. A £50m 25-year amortising financing for a housing retrofit? A billion-dollar wind farm project?. It’s no surprise they have been the institutional heartland for sectors such as wind and solar over the past decade.

Practical investment opportunities

The net-zero opportunity set is substantial, with debt investment outweighing equity[2]. Looking through an infrastructure-focused lens, we see some opportunity types that, collectively, could make, in our view, a positive environmental impact.

Other opportunities, in our view, include carbon capture and sustainable agricultural infrastructure…and we haven’t even touched on corporate and real estate focused opportunities!

Prepare to fight

Positively, private credit markets now offer sustainable structures, including green bonds and sustainability-linked loans – allowing investors to explicitly support climate-related projects, with a quid pro quo of measuring positive outcomes, and, in some instances, offer performance incentivisation.

Alas, while ‘high quality’ investment grade (IG) and crossover credit (see our earlier blog) private investor demand for such assets is high, there remain barriers to investment – notably, credit positioning and related capital charges. So, if we can’t rely on Dennis Quaid or Jake Gyllenhaal, who or what can help support this transition?

It strikes me that the government, together with regulatory bodies, might be able to help stimulate things:

• Government
  • Subsidies or support mechanisms e.g., Feed-In-Tariffs or Contracts-for-Difference could be employed more regularly, as they were historically, to provide pricing comfort in emerging sub-sectors/ technologies. Similarly, tax or other rates relief for certain types of investment could be offered. By stimulating growth in sectors, we believe there will be reciprocal benefit in the future
  • Long-term policy making is critical to ensure appropriately priced financing
• Regulator
  • Reducing the capital charge ‘cliff’ from IG to the high-quality end of sub-investment grade (BB category, which can often be driven by the size of borrower or project)
  • Reduction of capital for construction of assets

These are but a few examples/ideas, but the point remains – by expanding sustainable finance through private credit, we believe we can create a more resilient, equitable, and environmentally conscious future for generations to come. We might just need some help delivering it.

[1] Source:  IEA (2021) “Net Zero by 2050: A Roadmap for the Global Energy Sector”

[2]  www.iea.org/articles/the-cost-of-capital-in-clean-energy-transitions

[3] BECCS is the acronym for bioenergy with carbon capture storage.