The Role of Sovereign and Strategic Investment Funds in the Low‑carbon Transition

2. The relevance of sovereign funds and SIFs to climate finance

The combination of increased climate risk and declining revenues from fossil fuels will significantly affect the sovereign funds of fossil fuel-exporting countries. At the same time, the sheer magnitude of sovereign funds’ capital, and their role as investors in companies across the globe, means that these investment funds are necessarily significant actors in the low-carbon transition (OECD, 2019[7]). Conversely, while the actions of sovereign funds have an impact on climate change, climate change also has an impact on sovereign funds through increased risk. Sovereign funds are diversified across a broad range of sectors and geographies. Climate risk, from which no sector is immune, is therefore likely to affect their portfolios significantly. Whether sovereign funds choose to take a leading role as climate-aligned investors, or remain passive, their actions will have crucial implications for the world’s ability to address climate change, and for the risk-adjusted value of their own portfolios.

Whereas the importance of sovereign funds to climate finance arises from their scale, SIFs are relevant due to their growing track record as commercial, yet policy-driven investors. Upwards of 30 SIFs have so far been established, most of them after the 2008 financial crisis. Several others are being planned or considered. Examples of SIFs include Bpifrance, the Ireland Strategic Investment Fund, Khazakhstan’s Baiterek, the Nigeria Infrastructure Fund (NIF), Senegal’s Fonds d’Investissement Stratégiques (FONSIS), and India’s National Investment and Infrastructure Fund (NIIF). The EU’s Marguerite Fund and the Africa Renewable Energy Fund are examples of SIFs that operate at the regional level.

Most SIFs are smaller than sovereign funds by orders of magnitude. The largest infrastructure-focused SIF, India’s NIIF, seeks a capitalisation of USD 6 billion, whereas the largest sovereign fund, Norway’s Government Pension Fund Global (GPFG) holds assets worth nearly USD 1 trillion, or about 170 times more than the NIIF. The exception to this rule is highly diversified sovereign funds with a strategic (SIF) component, which invest both abroad and at home. This includes Mubadala Investment Company (USD 369 billion in assets under management [AUM]), Malaysia’s Khazanah Nasional Berhad (USD 37 billion AUM), and Bahrain’s Mumtalakat (USD 15.5 billion AUM). These funds have portfolios that comprise foreign as well as domestic assets, but still invest with a “double bottom line” objective of contributing to the development of their national economies. For example, Gulf funds have played an important role in realising the ambition of building technology and aerospace sectors in their home countries. However, while SIFs are policy-driven investors, their focus on commercial returns enhances the integrity of the investment process, and reduces the potential for political interference in the investment process (OECD, 2019[8]) (Gelb, Tordo and Halland, 2014[9]) (Halland, Noel and Tordo, 2016[10]).

Institutional mandate

Whereas sovereign funds’ policy objectives are to save for future generations, with a possible fiscal stabilisation component, strategic investment funds (SIFs) are mandated to invest directly in priority sectors of national and regional economies. Many SIFs focus primarily on the development of national infrastructure, including clean-energy infrastructure, or on the financing of small and medium-sized enterprises (SMEs). Beyond their role as commercial investors, SIFs are also instruments of economic and financial policy. These state-sponsored funds invest mainly domestically, under a “double bottom line” mandate of commercial returns and economic, environmental, or social impact – or even a “triple bottom line” that also includes the mobilisation of private capital for investment in priority sectors of national economies. Several governments have set up SIFs with a mandate to catalyse private financing for new infrastructure projects, including clean-energy infrastructure (OECD, 2019[8]). However, SIFs hold only a tiny fraction of the capital that sovereign funds control, and their capacity to drive global change is therefore at present very limited.

Investment policy

Contrary to SIFs, sovereign funds do not have a “double bottom line”. As commercial investors, sovereign funds seek to maximise the risk-adjusted returns on their investments and do not invest domestically. Sovereign funds invest mainly abroad, in foreign-currency denominated financial assets.1 Sovereign funds are well placed to act as long-term investors. Whereas the share of capital that sovereign funds hold for fiscal stabilisation purposes is largely irrelevant to climate finance, since it needs to be held in liquid assets, capital that sovereign funds invest for the long term, can be used to seek risk-adjusted returns in low-carbon assets.

Since sovereign funds do not have short-term liabilities, and have a policy mandate to guard wealth for future generations, these funds are in a position to seek additional returns arising from long-term investment opportunities (Singh Bachher, Dixon and Monk, 2017[11]). Sovereign funds’ long-term investment horizon allows them to seek attractive commercial returns from investing in long-lived illiquid assets, including commercial clean-energy infrastructure. This differs from much of the global equity market, where many investors have shorter investment horizons and seek to avoid illiquid assets.

Sovereign funds’ climate-related policies need to be consistent not only with their financial objectives, but also with their fiduciary duties and macroeconomic functions. In fossil fuel-exporting countries, this typically includes mitigation of exchange rate appreciation (“Dutch disease”), fiscal stabilisation objectives, as well as long-term savings objectives. Reflecting this type of objectives, sovereign funds’ investment in low-carbon assets should take place abroad and on commercial terms. Another reason that these funds should not invest domestically is the risk of political influence on investment decisions.

Domestic investment should be reserved for SIFs, and for sovereign funds with a clear SIF function, where safeguards and capabilities appropriate to SIFs can be established. A number of SIFs have the capacity to undertake project development for new “greenfield” infrastructure. Recently, an increasing number of sovereign funds have acquired the capacity to undertake direct equity investment (Capape, 2017[4]). For now, this is with a view to generating profits in the technology sector, but it does demonstrate that, if given the right incentives, sovereign funds can build the skills to become direct equity investors.

Note

← 1.  For a definition of SIFs, see (Halland, Noel and Tordo, 2016[10]).