The added value of looking beyond the ‘E’ in ESG

The focus on environmental, social and governance (ESG) aspects of investments by institutional investors has increased significantly in the past decade • Current government and investor agendas tend to be ‘E’ skewed • Infrastructure investments can offer much more than just environmental benefits • Recent rise of UN Sustainable Development Goals (SDGs) have raised greater ‘S’ and ‘G’ awareness

Over the last few years, public awareness of climate change, resource scarcity, global population growth and rising wealth disparities triggered governments and policy makers to respond to these challenges by setting up new regulations that promote more responsible business practices. In addition governments, as well as companies, undertake actions to meet the goals of the Paris Agreement on climate change whilst bolstering their commitments to deliver on the Sustainable Development Goals (SDGs, see figure 1 below).

Investors no longer focus on financial returns only

The 17 Sustainable Development Goals (SDGs), and the 169 underlying targets set by United Nations in 2015, represent an internationally agreed list of the most material and pressing environmental, social and governance considerations, which if realised by 2030 could end all forms of poverty, fight inequalities and tackle climate change, while ensuring that no one is left behind*.

As these issues are increasingly important, institutional investors and other stakeholders started to look for investment opportunities that bring a positive impact and improve their ESG performance without reducing financial returns. Many financial institutions, including ourselves, have welcomed and support the SDGs as a framework that can facilitate social and business value, and more recently engaged in other voluntary climate change combatting initiatives (a.o. Climate Action 100+ and the recommendations of Taskforce Climate­related Financial Disclosures (TCFD)) in support of the Paris Climate Agreement.

As a result, many institutional investors have modified their investment policies and are now placing a greater focus on active ownership and monitoring of ESG aspects of the assets in their existing portfolios.

Figure 1: UN Sustainable Development Goals

Source: UN Sustainable Development Golas 2018

Furthermore, investments in strategies that offer measurable and beneficial social and environmental impact without giving up financial return are viewed as being particularly attractive. At the same time, many institutional investors have been increasing their investment allocations to alternative asset classes, such as infrastructure, during the last few years. This has been mainly driven by enhanced returns generated by switching a portion of their public market assets to less liquid private markets.

Infrastructure projects offer both enhanced yields and environmental & social benefits

In this context, infrastructure investments are particularly attractive, enhancing risk adjusted returns for investors while at the same time delivering essential public assets and services that provide significant social, environmental and economic benefits. Of the various infrastructure sectors, renewable energy is the most obvious investor choice. Such “green” investments help both governments and investors to achieve carbon reduction targets, which are essential in the transition to a low carbon economy. In Europe alone, the need for investments in clean energy to meet the 2 degrees global warming target (as defined in the Paris Agreement) is estimated to be EUR 180bn per year for the next 20 years according to the European Commission report.

While the ‘E’ of ‘ESG’ that renewable energy projects mainly address is undoubtedly important and relatively straightforward to measure and monitor in terms of the Greenhouse Gas Emissions avoided or the Gigawatts of clean energy generated, the other social and governance benefits might be overlooked. Furthermore, an exclusive focus on renewable energy sector alone can lead to concentration risks appearing within portfolios, in particular as a result of potential future changes of law or regulations, which subsequently may have a negative impact on portfolio returns.

Infrastructure as an asset class offers a much broader range of opportunities for investors who want to invest responsibly across many sectors that provide both social and environmental benefits and address several of the challenges of UN SDG’s. In figure 2, we listed a number of sectors that we believe provide E, S and G benefits and are positively linked to a selection of the SDGs. Investments can be made, next to energy and utility assets, in:

  • projects in transportation sector (rail, light rail, public transit terminals, EV charging infrastructure) expand the availability of low carbon mass transit in urban and rural areas;
  • digital infrastructure, such as fiber optic (‘Fiber to the Home’), promotes an inclusive growth in internet communications and improves delivery of essential services like online banking and education through increased coverage of rural areas;
  • social infrastructure, such as healthcare and education facilities, provides access to basic services in socially disadvantage areas.

Figure 2: SGDs & infrastructure sectors

Source: UN Sustainable Development Goals, NN IP, October 2018

What about the G?

The private nature of infrastructure investments implies that both debt and equity investors are able to influence the ESG performances.  It is common for infrastructure equity to have board representatives to directly implement and manage ESG aspects. For debt investors, ESG considerations are a key part of the due diligence process and negotiations of the finance documentation. Most infrastructure debt investors require the inclusion of specific information and monitoring covenants, encouraging transparency and early disclosure to allow for appropriate monitoring of ESG aspects and measurement thereof. As a result, infrastructure debt investors can also influence the management of ESG matters throughout the project lifecycle.

Investing in infrastructure to support multiple SDGs

There is no doubt that the growth of institutional investment in the renewable energy sector is a welcome development, and one that is crucial in the transition to low carbon and climate change resilient economy, while at the same time offering these investors an attractive alternative to traditional instruments.

However, in order to deliver long­term, sustainable and inclusive growth, we believe that ESG benefits across a wider range of sustainable infrastructure sectors are well worth considering. This broadens the range of investment opportunities beyond renewable energy, offering both better diversification as well as the ability to support a larger number of SDGs at the same time.

* UN Sustainable Development Goals, 2018

Magdalena Kowalska, Portfolio Manager, Project Finance NN Investment Partners

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