The Impact Gap

Figure 1: The rate of deployment must hugely increase for a 1.5 degree pathway

_{Source: IEA⁷}

Investing in the right solutions, at the right time

Let’s consider what closing the impact gap means for investment in climate solutions.

While the exact path to achieving net zero is uncertain, various sources indicate that investment in relevant areas will rise to the tens of trillions over the next three decades. The IPCC suggests that supply-side investments must reach $1.6 to $3.8 trillion per year, on average, to 2050.⁸ The Energy Transitions Commission estimates $1.5 to $1.8 trillion of investment will be needed each year up to 2030 across power, hydrogen, industry and transport.⁹

These estimates don’t include the substantial investments required for other demand-side transformations, land use and agriculture, carbon capture and adapting to climate change, among many other things. McKinsey, for example, estimates it will take annual capital flows of $100 billion into nature-based solutions to realise these solutions’ full potential.¹⁰ The true total will therefore be far greater.

Figure 2: Key investment needs for net zero

Source: Energy Transitions Commission (2020)¹¹

Today, the volumes of capital flowing into net zero-aligned solutions fall well short of these levels. The Climate Policy Initiative estimates that investment into aligned solutions reached $632bn across public and private sources in 2019/2020.¹² BloombergNEF estimates that global investment in the energy sector (inclusive of carbon capture, hydrogen and electrified transport) reached around $500bn in 2020.¹³ Inflows into climate solutions must grow by three to eight times in order to meet global climate goals.¹⁴

As we noted above, investors are not allocating capital according to the greatest potential for impact.  Climate finance is currently focused in a few crucial areas, such as renewables, electric vehicles and LED lighting. These are crucially important, but we cannot get to a 1.5C pathway without a full-spectrum approach that spans hard-to-abate solution areas and geographies. Investment flows into climate solutions must go both deeper and broader.

We estimate that solutions with the potential to address 50% of global emissions receive around 10% of the capital flowing towards climate finance¹⁷ – a ballpark figure based on research for our investment roadmaps. Scaling up solutions in cement and steel (~7-8% of global emissions each), aviation and shipping (~4% of global emissions combined), and complementary nature-based solutions such as sustainable forestry and regenerative agriculture (with the potential to abate 20%+ of global emissions¹⁸) could, in aggregate, reduce approximately half of global emissions today. And yet, we estimate that these same hard-to-scale and hard-to-abate areas receive around $55bn annually – roughly 10% of the $632bn the Climate Policy Initiative estimates is flowing to climate solutions across asset classes and sectors. These are some of the areas with the highest potential climate impact –yet they attract the least capital.

Just as concerning is the distribution across geographies. Most solutions, from electric vehicles to clean hydrogen production, are being deployed in the developed world and in China. The OECD estimates that climate finance for developing countries was around $80bn in 2019.¹⁹ Some of the widest gaps persist in areas with the greatest and timeliest impact potential, such as parts of Africa, South and Southeast Asia and Eastern Europe, which continue to rely heavily on coal-powered generation, with its associated health impacts.

Of course, we also need to deliver clean technologies at the right time. Our Time Value of Carbon insights piece explains why cuts in greenhouse gas emissions today are worth more than cuts promised in the future, due to the escalating risks associated with the pace and extent of climate action.²⁰ In its latest Emissions Gap Report, the UN Environment Programme highlights the risk of waiting until 2030 before steep cuts begin.²¹

Source: Bloomberg Intelligence²⁴

We believe that the Impact Gap is caused by two sets of factors in particular. First, the understandable focus on the quantity of climate solutions has led us to downplay the importance of quality and integrity. Second, the systemic nature of the problem poses particular challenges that we are only now beginning to tackle.

Quality and integrity

Three interlinked quality issues are contributing to the Impact Gap. Together, these lessen the positive impact of the solutions being deployed, while simultaneously acting as barriers to any further scale-up.

First, as we noted above, the soaring interest in ESG funds and indexes is not yet driving a commensurate real-world impact on decarbonisation. This suggests that fundamental quality issues remain around capital allocation, despite the mainstreaming of sustainable finance in recent years. It’s as if the cogs are turning but the machine is not in gear. Capital flows are concentrated in a few technologies and geographies while other areas are starved of investment – something is clearly wrong in the capital allocation process.

Second, most claims about climate impact involve a forward-looking dimension. This includes setting targets for net zero and allocating capital to low-carbon goods, services and infrastructure which promise to deliver future carbon reductions. Investors must therefore consider not only a company’s long-term goal, but the credibility of its plan to meet it.

Focusing more on the future is a welcome development, but it brings new challenges. For instance, the issues around setting net zero targets are discussed in our Insights paper on the topic.²⁵ It is critical that consistent, high-quality approaches to setting and disclosing net zero goals for both corporates and investors are agreed. In particular, we must be able to evaluate whether near-term action is setting organisations on a credible path to net zero.²⁶

The third ‘quality’ issue is the credibility of claims made about carbon sources and sinks. These have both temporal and spatial dimensions. For nature-based solutions, for instance, it takes time for carbon dioxide to be absorbed into trees and other vegetation. A landscape being reforested might sequester carbon at a rate of around 10 to 20tCO2 per hectare per year over the first 20 years.²⁷ Problems arise when claims are made about carbon removals from nature that will take years to achieve and then used to offset current activity. Put simply, planting a tree today that will absorb carbon over decades is not a fair ‘offset’ for your company’s flights last year.

An even harder question is whether that carbon removal would have happened in the absence of the investment. Challenges in assessing ‘additionality’ have been well-documented, while the permanence of carbon storage in vegetation and soils is also hard to assess. Equally, the impact of nature-based solutions on biodiversity, water and human livelihoods must be considered alongside carbon considerations. The assumptions used to evaluate the impact of climate solutions in these areas are important and contentious, especially when organisations plan to claim them as ‘removals’ in their net zero plans.

Carbon sinks and sources do not only arise in the context of nature-based solutions. The new 2050 net zero plan for the cement and concrete sector, for instance, includes a chunk of carbon removal, because concrete slowly absorbs some carbon from the atmosphere.²⁸ The use of geological carbon storage also raises questions about permanence and governance.

Systemic factors

Several systemic and structural factors contribute to the Impact Gap, many of which are mutually reinforcing.

First, there is an information barrier: many investors and emitters have limited knowledge of how to achieve net zero in their companies or portfolios. Transition plans require technical or regulatory expertise that institutions often do not have in-house. Indeed, plans for certain areas simply may not yet exist – the playbook for hard-to-abate areas such as cement, steel and some other industries is still to be defined. This information barrier drives both the quantity and quality aspects of the Impact Gap. Even capital allocators that seek to get involved struggle to do so, due to insufficient data or a lack of experience in delivering the highest-quality investments in these spaces.

Furthermore, achieving net zero in many sectors is a systems challenge, requiring progress to be made at multiple levels for net zero-aligned business models to make sense. There are many interdependencies between solutions, such as where several technologies need to come down the cost curve in parallel, or the co-evolution of applications and use cases is beyond a single company’s control. Scaling green hydrogen is a case in point: the supply-side economics will depend on continuing cost declines in renewables and electrolysers over the next decade, which need to continue to scale at a double-digit rate. On the demand-side, while hydrogen has many potential applications across industry, mobility and power, many use cases have yet to mature, and sources of long-term offtake for hydrogen projects remain challenging to secure. All of these factors create further friction in decarbonising hydrogen production in general, and demand even greater commitment and creative persistence on the part of participants.

There is also a systematic mismatch between the capabilities of today’s capital markets and what is required for a 1.5 degree pathway. We need to expand what capital markets value by incorporating impact within a traditional risk and return framework. Investors will otherwise remain hesitant to invest due to the complexity of decarbonisation solutions and the unknown regulatory outlook. Investing in net zero-aligned solutions requires an assessment of climate impact as a value driver.

Impactful climate opportunities often have high-risk elements, resulting from commercialisation uncertainty, market dynamics, regulatory uncertainty or exposure to carbon markets – all of which may cause these companies and projects to fall outside of investors’ existing mandates.

As a result of all these factors, there are few funds with meaningful track records in the areas that most require further investment, and there remains a collective lack of expertise in how to take these unconventional risks.