Sovereign funds differ widely in terms of their climate consciousness, and their climate-related transparency and disclosure practices. Sovereign funds’ engagement with climate change remains, with a few notable exceptions, aspirational. Currently, sovereign funds as a group play a very small role in green finance. This publication argues that sovereign funds could become essential contributors to the low-carbon transition, without necessarily compromising their role as commercial investors. The observation that a minority of climate-conscious pension funds allocate up to 6% of their capital to low-carbon solutions indicates that it is possible for institutional investors to engage with the low-carbon transition while remaining on commercial terms and respecting fiduciary duties to shareholders (Asset Owners Disclosure Project, 2018[23]). As the global green investment agenda gains further traction, and as pressure builds on investors to “green” their portfolios, transparent and climate-conscious funds such as these could help build initial momentum. Over time, traditionally less climate-conscious sovereign funds might find it in their interest to join them (OECD, 2016[36]).
Importantly, the climate alignment of portfolios and of investment organisations such as sovereign funds and SIFs is increasingly becoming good business. Several studies indicate that climate-aligned portfolios can provide competitive returns. Moreover, it is part of sovereign funds’ and SIFs’ fiduciary duty to their citizens and government to take full account of climate risk in their operations.
Sovereign funds and other institutional investors frequently cite a lack of low-carbon investment opportunities as a challenge when seeking to climate-align their portfolios. Portfolio climate alignment should be seen as a dynamic process, where reducing the emissions of carbon-inefficient portfolio companies may count as much toward emissions reduction objectives as buying shares of companies that are already carbon efficient. Furthermore, high-capacity sovereign funds could seek to build the capabilities required for developing new low-carbon assets, as Mubadala does through its subsidiary Masdar.
To achieve higher allocations to green, sovereign funds would need to undertake major investments in capacity building across several areas. This includes i) capacity to engage with portfolio companies on climate-related issues; ii) capacity to select and monitor asset managers based on their climate-related performance, as well as – for the stronger sovereign funds – iii) capacity to invest directly in low-carbon infrastructure.
SIFs can contribute to the low-carbon transition by providing equity and other forms of investment capital to sectors and stages of the investment process where the private sector does not invest by itself (OECD, 2016[21]). However, although SIFs are a promising type of instrument for climate finance, and are becoming increasingly common across the world, these funds would need far larger amounts of capital to contribute meaningfully to the low-carbon transition.
Sovereign funds and SIFs are complementary in several ways, and the synergies between them could be further exploited. Sovereign funds could benefit from collaborating more closely with SIFs that already have many of the skills required for a role in climate finance, and with pension funds that have built the capacity for direct infrastructure investment. For SIFs, collaboration with sovereign funds would provide an opportunity to scale their investments in low-carbon infrastructure and other climate-related assets.
For these transformations to happen, sovereign funds and SIFs would need the guidance and support of their governments. Governments that wish for their sovereign funds and SIFs to manage climate-related risk better, and take a more active role in the low-carbon transition, need to establish strategies for this transformation, with concrete plans for implementation. If not being provided with a clear direction by their government and private sector owners, sovereign funds and SIFs are unlikely to drive change on their own. Furthermore, governments should require their sovereign funds and SIFs to report according to the standards of the TCFD, and seek to adopt internationally recognised standards for green assets and financial products. Sovereign funds that are reluctant to report publicly on their investments could disclose aggregate numbers on low-carbon investments.