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

4. The current role of sovereign funds and SIFs in climate finance

The most direct way of assessing the level of climate alignment of sovereign funds and SIFs is by focusing on the climate impact of these funds’ portfolio assets. A sovereign fund or a SIF, like any other investment organisation, can reduce its carbon footprint by: i) investing in low-carbon assets and technological innovation, ii) excluding or divesting from inefficient high-carbon ones, and iii) by working with portfolio companies to reduce their emissions through the adoption of renewable energy, energy efficiency measures, or clean-energy technology.

Climate-aligned asset management is supported by climate-aligned investment processes. A second, complementary, option for assessing a sovereign fund’s or SIF’s climate alignment is therefore to focus on the investment process that underpins the evolution of its portfolio. Two frameworks are particularly relevant for sovereign funds and SIFs. The Task Force on Climate-Related Disclosures (TCFD) captures climate alignment of investment processes by the four concepts of governance, strategy, risk management, and metrics and targets. The One Planet Sovereign Wealth Fund Group (Box 1), refers to the climate-aligned investment process by the concepts of alignment, ownership and integration. Whereas the TCFD framework refers mainly to investor organisations’ internal processes, the One Planet framework focuses on the climate alignment of a sovereign fund’s mandate, interaction with portfolio companies, as well as process.

For externally managed assets, sovereign funds can seek to have their asset managers undertake low-carbon investment, emissions-related engagement with portfolio companies, as well as exclusion and divestment from inefficient high-carbon assets. Sophisticated sovereign funds, such as Norway’s Government Pension Fund Global (GPFG), engage directly with externally managed portfolio companies on climate issues, whereas many other sovereign funds leave portfolio company engagement to their asset managers. Such engagement may include support for energy efficiency measures, less carbon-intensive production and value-chains, and the adoption of low-emission energy sources. In recognition of the critical role of asset managers in implementing sovereign funds’ climate-related objectives, the One Planet Sovereign Wealth Fund Group recently established a corresponding One Planet Asset Manager Initiative (Box 1).

Box 1. One Planet Sovereign Wealth Fund Working Group

The One Planet Sovereign Wealth Fund Working Group (SWF Group) was established in 2017, following the 2015 Paris Agreement to mitigate the effects of climate change. The SWF group was one of several One Planet initiatives initiated by French President Emmanuel Macron. The SWF Group consists of six sovereign funds, which collectively hold more than USD 3 trillion worth of assets.

The One Planet SWF Group was established in recognition of sovereign funds’ role as influential, long-term investors, and their potential to promote long-term value creation and sustainable market outcomes. The Group was established “to accelerate efforts to integrate financial risks and opportunities related to climate change in the management of large, long-term asset pools.” The Group seeks to enhance sovereign funds’ capacity to address climate risk, and is not explicitly an instrument of climate policy.

In July 2018, the One Planet SWF Group published the One Planet SWF Framework. The objective of the Framework is to promote the integration of climate change analysis, and climate-related risk and opportunities, in the management of large, long-term and diversified asset pools. The Framework aims to “foster a shared understanding of key principles, methodologies, and indicators related to climate change; identify climate-related risk and opportunities; and enhance their investment decision-making frameworks to better inform their priorities as investors and participants in financial markets”.

The Framework is based on three principles:

• Principle 1: Alignment – Build climate change considerations, which are aligned with the Sovereign fund’s investment horizons, into decision making.

• Principle 2: Ownership – Encourage companies to address material climate change issues in their governance, business strategy and planning, risk management and public reporting to promote value creation.

• Principle 3: Integration – Integrate the consideration of climate change-related risks and opportunities into investment management, to improve the resilience of long-term investment portfolios.

Members of the One Planet SWF Group recognise that their climate-related efforts would need to be supported by their asset managers, and in July 2019 established the One Planet Asset Managers Initiative. The initiative includes eight global asset managers, with a combined USD 15 trillion of assets under management, who have committed to support the implementation of the Framework.

In July 2019, the One Planet SWF Group also announced the formation of the One Planet SWF Research Forum, in partnership with the Global Research Alliance for Sustainable Finance and Investment. The Research Forum aims to support the One Planet funds by “identifying and facilitating rigorous and impactful research projects relevant to the implementation of the One Planet SWF Framework, as well as providing training and capacity building for One Planet SWF Members”.

The One Planet SWF Group founding members are Abu Dhabi Investment Authority, Kuwait Investment Authority, New Zealand Superannuation Fund, Norges Bank Investment Management, Public Investment Fund (Saudi Arabia), and Qatar Investment Authority.

Source: One Planet SWF Group website.

As illustrated in Figure 1, the level of climate alignment of a sovereign fund or a SIF can thus be assessed i) at the asset level; ii) at the intermediary or asset manager level; and/or iii) at the portfolio and process level. This section discusses the current role of sovereign funds and SIFs in climate finance, at these three different levels. The first part of the section considers sovereign funds, whereas the second part looks at SIFs.

Figure 1. Sovereign funds and SIFs’ climate alignment at different levels

The climate impact of a sovereign fund’s equity portfolio is the aggregate climate impact of the activities undertaken by the sovereign fund’s portfolio companies, weighted by the sovereign fund’s equity share in each of these companies. The most direct way of assessing the sovereign fund’s role as an equity investor is therefore to calculate the weighted aggregate portfolio impact according to a defined standard – such as the new EU Taxonomy (Box 4). The climate assessment of a sovereign fund’s fixed-income portfolios is facilitated by the ongoing consolidation of green bonds standards. This includes the EU’s new Green Bonds standard, which seeks to provide a common standard for EU countries.

According to (Bloomberg NEF, 2019[20])(2019) global clean-energy investment has reached USD 300 billion annually for the past five years. However, very little of this investment comes from sovereign funds. According to (Capape, 2017[4]), the total value of sovereign funds’ climate-aligned investment during the three-year period 2014-16 was USD 11 billion. This includes not only sovereign funds’ investments in clean energy, but also green debt funds and platforms, green infrastructure, green agriculture and green startups. The total value is equivalent to about 0.15% of sovereign funds’ total assets under management. Another estimate suggests that sovereign funds’ green investments grew from zero in 2006 to about 1% of the value of all reported deals in 2015 – with an uptick to 3.5% in 2016, driven by a small number of large deals (OECD, 2016[21]).

Sovereign funds’ low allocation to climate-aligned investments is reflective of these funds’ low allocation to infrastructure in general. In 2017, sovereign funds completed 28 direct investments in infrastructure, for a total value of USD 8 billion (International Forum of Sovereign Wealth Funds, 2019[22]), or about 0.1% of the value of total assets under management by sovereign funds. Sovereign funds’ small allocation to low-carbon assets also reflects common practice amongst institutional investors overall. The (Asset Owners Disclosure Project, 2018[23]) finds that large pension fund portfolios on average have only 1% allocation to low-carbon solutions, although there are exceptions with low-carbon allocations of up to 6%.

One significant exception to the rule of low sovereign fund investment in low-carbon assets is the United Arab Emirates’ Mubadala Investment Company, a sovereign fund that through its fully owned subsidiary Masdar has developed a high level of capacity to invest in clean-energy infrastructure (Box 2).

Box 2. Sovereign fund investment in new clean-energy infrastructure: The case of Masdar

The Mubadala Investment Company is among the very few sovereign funds that invest significantly in new, “greenfield”, clean-energy infrastructure. Mubadala undertakes this type of investment through Masdar, its fully owned subsidiary. Masdar is a private joint-stock company incorporated in Abu Dhabi. The company seeks to support the diversification of Abu Dhabi’s energy sources and economy, while delivering financial returns to its owner, Mubadala. Masdar was established to invest in commercially viable renewable-energy infrastructure projects in the MENA region and globally, and in sustainable urban development in Abu Dhabi. Given its comparatively small home market in the United Arab Emirates, Masdar has since the beginning pursued investments abroad. This has allowed it to acquire the necessary scale and competencies to operate at a global scale.

Masdar is both a developer and an operator of utility-scale renewable energy projects. It has the in-house capability to conduct end-to-end project development for greenfield infrastructure, but may also engage later in the project lifecycle. This could be at the time of financial close, when it would participate in the late-stage negotiations and construction management. Since it was established in 2006, Masdar has invested USD 4.5 billion in renewable energy projects, which have a combined value of USD 14.3 billion. The company participates in some of the world’s largest clean-energy infrastructure projects, including the London Array in the United Kingdom – which when built was the world’s largest offshore wind project.

Masdar’s business model seeks to commercialise novel technologies in solar power, wind energy, sustainable real estate, and waste-to-energy. Whereas Masdar initially prioritised markets that had government commitments to decarbonisation and renewable energy, the maturing of the renewable energy sector means that business fundamentals are now more important. This includes supply and demand, regulatory regimes, political stability, auxiliary infrastructure, and counterparty risk. Masdar’s target IRRs, based on the risk profile of each asset, are primarily driven by considerations that include:

• Geography – sovereign risk, political risk, rule of law

• Counterparty risk – level of guarantees on the offtake agreements

• Commercial arrangements – whether there is an offtake agreement or full merchant exposure

• Lifecycle of the asset – whether in development, under construction, or operational

Masdar is primarily an equity investor. When structuring deals, Masdar seeks to maximise the use of long-term debt – and for such debt to be non-recourse to Masdar’s balance sheet. In practical terms, this means that the lenders decide the amount of leverage, based on their criteria for coverage ratio.

The equity provided by Mubadala, its only shareholder, allows Masdar to act as a long-term investor. Nonetheless, the company avoids investing in assets that it may not be able to exit, and sometimes divests assets. Reasons for divestment may include tactical optimisation of returns; strategic portfolio re-alignment; selling down to a strategic partner to share risk; or returning cash to its shareholder. Masdar has the flexibility to pursue a full or partial exit in a private transaction, or a full or partial exit from an investment vehicle marketed to a private group of investors or to the public markets. Market liquidity and Masdar’s return expectations are the two potential constraints that affect its exit strategies.

Source: Mohamed Jameel Al Ramahi, Chief Executive Officer of Masdar, and Masdar website.

Some sovereign funds have a limited allocation to unlisted infrastructure. The debate around the recent adjustment to the mandate of Norway’s USD 1 trillion sovereign fund, the GPFG, provides an informative illustration of the issues facing sovereign funds that choose to diversify this way. As of 2020, the GFPG will be able to invest in unlisted renewable energy infrastructure. Initially, the Norwegian Parliament has allocated NOK 120 billion (Norwegian Krone) (USD 13 billion) for this purpose, or about 1.2% of the fund's capital. Ahead of the change, Norwegian and international climate-related NGOs were calling for a more significant role for the GPFG in climate finance. The government, on the other hand, emphasised the fund’s fiduciary duty to maximise risk-adjusted returns. When it became increasingly clear that unlisted clean-energy infrastructure investments could generate competitive risk-adjusted returns, Norges Bank Investment Management (NBIM), which manages the GPFG, endorsed the diversification into unlisted infrastructure, which was approved by Parliament in 2019.

The climate impact of the GPFG’s infrastructure investments, and that of other sovereign funds that diversify into infrastructure, will largely be determined by the extent to which sovereign funds decide to invest in new “greenfield” versus existing “brownfield” infrastructure. This is because the offer of greenfield infrastructure projects is inelastic. In other words, increased demand for existing “brownfield” infrastructure has limited effect on the supply of new projects. The reason for this is that most investors prefer de-risked brownfield infrastructure, which already generates revenue, rather than investing in the development and construction phases, which generally carry higher risk. In recent years, increased demand has therefore led to a significant rise in the prices of brownfield infrastructure, whereas the number of greenfield projects has remained steady (Plimmer, 2017[24]). To the extent that sovereign funds’ investments are directed at brownfield infrastructure, these investments will contribute to further price increases and will have limited climate-related impact.

Sovereign funds that seek to invest in greenfield infrastructure could examine the precedents set by large pension funds that undertake this kind of investment. With the price of brownfield infrastructure assets going up, pension funds have found it increasingly difficult to get a good return on such investments. Several Canadian and Danish pension funds therefore seek higher returns in greenfield, where there is less competition (Box 3). However, as discussed in Section 5, infrastructure investment is highly skills-intensive, and would require extensive capacity building for sovereign funds that have been set up to invest in listed securities. This is particularly true for greenfield investment, which requires sector-specific knowledge and experience in engineering as well as in finance.

Box 3. Pension fund investment in a new clean-energy infrastructure

Very few pension funds invest directly in infrastructure, and even fewer undertake direct investment in new “greenfield” infrastructure. However, several large Canadian and Danish pension funds have developed the capacity for direct infrastructure investment, including clean energy and greenfield. These include for example the Ontario Teachers’ Pension Plan. OTPP is a USD 150 billion pension fund that has its own greenfield team, but also does greenfield investment through joint project development platforms with others. The Caisse de Depots et Placements de Quebec (CDPQ) USD 230 billion) and Denmark’s PKA (USD 48 billion) also make greenfield infrastructure investments. PKA, whose web page states “wind and sun provides good pensions”, has nearly 10%of its capital invested in climate-related projects, of which about half in offshore wind farms.

The experience of these Canadian and Danish pension funds, and of Mubadala and Masdar (Box 2), demonstrates that it is possible for large institutional investors such as sovereign funds to develop the capacity to invest in greenfield infrastructure, either directly, through a SIF, or through joint investment platforms where several investors bring complementary capabilities.

Source: CPPIB, CDPQ, PKA and OTPP websites.

Sovereign funds

Asset level: Exclusion and divestment from inefficient high-carbon assets

Divestment targets high emission sectors such as coal mining and thermal power generation. The impact of divestment is controversial, since the divested companies can seek capital elsewhere. Unless the divestment leads to the high-carbon asset being closed down upon divestment, or its emissions significantly reduced, these emissions will continue. Many investors argue that engaging with portfolio companies to reduce their carbon footprint is likely to have a higher impact. In general, sovereign funds could see divestment as a last resort option, in cases where emissions-related engagement with portfolio companies has not worked.

The total value of documented divestment by sovereign funds is USD 2.9 billion (Capape, 2017[4]), or about 0.04% of the total value of assets held by sovereign funds. Norway’s GPFG dominated these divestments; for a total value of USD 2.1 billion, followed by the New Zealand Superannuation Fund (NZSF) (USD 693 million).

The arguments for implementing these divestments were financial as much as political. For example, Norges Bank Investment Management (NBIM), which manages the GPFG, expects coal-based assets to continue losing value as countries step up efforts to address climate change. Therefore, NBIM has since 2016 excluded from its portfolio firms that derive more than 30% of their revenue from coal (Capape, 2017[4]). In the case of New Zealand, the divestments resulted from the implementation of its new global equity benchmark, which excludes carbon-intensive companies (Capapé and Santiváñez, 2017[2]). The NZSF aims to reduce the carbon emission intensity of its portfolio by at least 20% by 2020 and reduce the carbon reserves of the fund by at least 40%. To achieve this, it has sold stakes in almost 300 companies (Capape, 2017[4]).

Asset level: Engagement with portfolio companies

Like other investors, sovereign funds exercise their ownership role of portfolio companies through shareholder meetings and resolutions, and at board level in companies where they hold board seats. Investors that implement a climate-conscious ownership policy engage with portfolio companies on climate-related risks, emissions reductions and disclosure. Sovereign funds set up to track indexes are committed to allocating capital according to the index, and therefore do not have the option of investing in or divesting from companies according to their climate performance. For these sovereign funds, engagement is their only choice when seeking to implement climate-related objectives.

Sovereign funds differ in their capacity to exercise active ownership, and engaging directly with portfolio companies. Many sovereign funds do not have the capacity to exercise active ownership, and leave these responsibilities to their asset managers. One large sovereign fund, Norway’s GPFG, has upon Parliament’s request developed sophisticated policies for active ownership, which include not only economic, social, and governance matters, but also addresses climate-related risks of portfolio companies.

According to NBIM, the carbon footprint of NBIM’s listed equity portfolio in 2015 was 12% less than its reference portfolio. In 2016, this figure increased to 16%, implying an improvement of 4 percentage points that year (Capape, 2017[4]); (Norges Bank Investment Management, 2016[25]). There are no independent studies to confirm a positive impact of NBIM’s climate-related engagement with portfolio companies. However, recent research shows that NBIM’s engagement on governance-related matters has led to better corporate governance of portfolio companies (Aguilera, R., et al., 2019[26]).This finding confirms the impact of NBIM’s active ownership in general, and together with NBIM’s own assessment provides an indication that NBIM’s climate-related engagement with companies could also be impactful.

Asset manager level

There are currently no comprehensive studies of sovereign funds’ climate-related engagement with asset managers. A recent study of pension funds (Asset Owners Disclosure Project, 2018[27]) shows that less than 40% of pension funds have factored climate change into their selection, monitoring and evaluation of asset managers. According to the same study, a minority of asset owners nevertheless do take leading positions on climate finance. In an example from a Dutch asset owner, the pension fund ABP developed a carbon budget for all portfolio companies, jointly with its primary asset manager. The carbon budget supports the achievement of a target of 25% reduction of CO2 emission in their equity portfolio by 2020.

In its simplest form, sovereign funds’ guidance for asset managers can include sector– and company exclusion criteria. For example, NBIM has since 2016 had specific sector restrictions for its external managers in relation to environmental, social and governance risks.

Process level

At the process level, sovereign funds and SIFs can be assessed by the extent to which their internal structures and processes take account of the implementation of climate-related objectives. No broad comprehensive assessment exists of the level of climate alignment of sovereign funds’ structures and processes. However, sovereign funds’ level of commitment to international frameworks for climate-alignment of investment processes, and the reporting of these processes, provides an important indication. Table 1 provides an overview of sovereign funds that have officially adhered to climate-relevant international initiatives.

As shown in the table, sovereign funds have limited adherence to international investor protocols on climate finance. Only two sovereign funds, the New Zealand Superannuation Fund and Norway’s NBIM, are among the more than 1 000 supporters of the TCFD. The One Planet SWF Working Group has six sovereign funds as its founding members. The UN Principles for Responsible Investment has six sovereign funds and SIFs among its 2 500 members. No sovereign funds or SIF has yet joined the UN Portfolio Decarbonisation Coalition, although France’s CDC, now part of BPIfrance, was a member.

Table 1. Sovereign fund and SIF participation in climate-related investor initiatives

Name of fund	Country	Sovereign fund/SIF	TCFD	One Planet	PRI
Total # of signatories			1 0271	6	2 500
ADIA	Abu Dhabi	Sovereign fund		✓
BPIfrance	France	SIF			✓
InfraCredit	Nigeria	NSIA is founding shareholder			✓
ISIF	Ireland	SIF			✓
KIA	Kuwait	Sovereign fund		✓
NZSF	New Zealand	Sovereign fund		✓	✓
NBIM	Norway	Sovereign fund	✓	✓	✓
Khazanah	Malaysia	SIF			✓
Ithmar Capital	Morocco	SIF			✓
PIF	Saudi Arabia	SIF		✓
QIA	Qatar	Sovereign fund		✓

Note: As of February 2020.

Source: TCFD, PRI, and One Planet SWF websites.

Strategic investment funds

Asset level: Direct investment, private capital mobilisation and portfolio company engagement

Contrary to sovereign funds, SIFs are mainly direct investors, and target specific sectors. This includes renewable energy and other infrastructure sectors. SIFs are set up to mobilise additional private investment – investment that would not have taken place without the SIF’s involvement. SIFs do this by co-investing with private-sector partners, and by attracting private capital at the level of the SIF itself – at the fund level. Typical partners include project developers and private equity firms, with debt financing provided by banks and other debt providers. SIFs seek to supply financial products that are under-supplied by the market. For example, the equity markets of many developing countries are underdeveloped, and debt financing beyond 8-10 years maturity is frequently rare. SIFs can help fill these gaps. In other cases, it is the SIF’s knowledge of the local market that makes it an attractive partner for foreign investors. Furthermore, private investors may perceive SIFs’ connections to government as an implicit political risk guarantee, providing them with the necessary reassurance to invest.

A number of SIFs are investors in low-carbon infrastructure. Examples include the European Union’s Marguerite Fund, which has 13 investments in solar, wind, biomass and energy-from-waste infrastructure across the European Union; the Ireland Strategic Investment Fund, which has invested in energy storage and in several private equity funds is focused on wind and other renewables; and Senegal’s Fonds Stratégiques d’Investissements (FONSIS), which has invested in solar energy in Senegal. SIFs have been successful at mobilising private capital, including from institutional investors (Halland, Noel and Tordo, 2016[10]).

In an interesting example of private capital mobilisation by a SIF, the Canadian Pension Plan Investment Board, and the Ontario Teachers’ Pension Plan, as well as AustralianSuper, an Australian pension fund, in 2019 invested a total of USD 650 million in India’s National Investment and Infrastructure Fund (NIIF) Master Fund, thereby bringing the Master Fund to its targeted size of USD 2.1 billion. Additionally, the three pension funds will have co-investment rights with the NIIF of a total of USD 1.95 billion. Whereas this investment is not meant for greenfield, and it is unclear how much of the capital will be allocated for low-carbon purposes, these investments do demonstrate the capacity of well-designed and well-run SIFs to mobilise capital from large institutional investors.

At least one SIF, Norway’s recently established Nysnø, has been set up for the specific purpose of investing in low-carbon technology – including solar technology and sensor technology to support energy efficiency. Nysnø defines itself as a sovereign climate investment company and operates under the authority of the Norwegian Ministry of Trade, Industry and Fisheries. Nysnø is yet incipient, and has a very small portfolio consisting of five companies and two technology seed funds.1 To be additional to private-sector financing, investments in low-carbon technology firms need to target financing gaps that are not covered by private-sector finance, including by acting as a venture financier for early-stage technology, where the private sector still perceives risk as being too high.

There is little information available on SIFs’ engagement with portfolio companies. As direct investors, SIFs can seek to influence portfolio companies’ climate-related activities without the need to go through intermediaries.

Intermediary level

Most SIFs do not make use of asset managers in the traditional sense, and there is little publicly available information on the climate-related engagement of SIFs with their intermediaries. Some SIFs, such as the EU Marguerite Fund, have established a dedicated management company that manages only the SIF’s portfolio. In at least one case, the Philippine Investment Alliance for Infrastructure (PINAI), a private asset manager manages the SIF – in this case Macquarie Infrastructure and Real Assets.

In some cases, SIFs invest in other funds, taking the role of fund-of-funds. In these cases, the SIF typically provides a capped proportion of the total capitalisation of the funds that it invests in. SIFs have used this strategy particularly to finance small and medium-sized enterprises (SMEs), and for small or medium-sized infrastructure projects. For example, the Global Energy Efficiency and Renewable Energy Fund (GEEREF) is a multinational fund-of-funds advised by the European Investment Bank. GEEREF invests in private equity funds that focus on renewable energy and energy efficiency in emerging markets. India’s NIIF has a fund-of-funds component that invests in Indian infrastructure-focused investment funds, which in turn invest in medium-sized infrastructure projects. Senegal’s FONSIS invested in Teranga Capital, which in turn provides financing for SMEs.

Process level

There is little publicly available information on the level of climate alignment of SIFs’ internal structures and processes. As of the time of writing, no SIFs are among the nearly 900 official supporters of the recommendations of the TCFD. Four SIFs are signatories to the PRI (Table 1).

Box 4. Low-carbon investment in the Silk Road Fund and Belt and Road initiative

The USD 40 billion Silk Road Fund (SRF), a “long-term development and investment fund” was established in 2014 by the Chinese government. The SRF was established to invest in the Beijing-led Belt and Road initiative, together with other public and private Chinese and international financial institutions. Given the SRF’s important role in the financing of projects in the Belt and Road initiative, the climate-related policies and practices of the SRF could have an important impact on the emissions profile of these projects.

A recent study by Tsinghua University and Vivid Economies finds that the joint GHG emissions of the 126 Belt and Road countries could rise from 28% of the global total today, to 66% in 2050. According to the Study, "If B&RCs (Belt and Road countries) follow historical carbon-intense growth patterns... it may be enough to result in a 2.7 degree path, even if the rest of the world adheres to 2 degree levels of emissions.” The Study calls for the decarbonisation of more than USD 12 trillion of planned infrastructure investments, and for safeguards to ensure the implementation of low-carbon technologies and practices.

The SRF is one of the 29 global institutions that are initial signatories to the Green Investment Principles for the Belt and Road (GIP), established in November 2018. The GIP are a set of voluntary principles jointly launched by the Green Finance Committee of the China Society for Finance and Banking, and the City of London. The initiative seeks the commitment of financial institutions and corporations that invest and operate in the Belt and Road region, to align their projects with environmental sustainability requirements and the Paris Agreement.

Source: (Ma Jun, 2019[28]), (OECD, 2018[29]) (Tsinghua University, Vivid Economics, 2019[30]).

Note

← 1.  As of May 2020.