2024 Outlook ESG: Will High Rates Curb Infrastructure Investment?

Rates can easily be described as the hero (or villain) of the financial markets over the last two years. However, if we reflect on more long-term secular trends, the increased focus on sustainability and the climate transition is still the buzz of global economies. The implications of both of these themes have had wide-ranging and sometimes divergent impacts on many industries, but at this stage, it’s not yet evident who the winners and losers are and how they might change in the future. As we start a new year, we look to offer some of our early observations and long-term prognostications to help our readers gain insights and spark conversations.

How Much Will It Cost to Reach Net Zero By 2050? Estimates Differ

Source: Barclays Research, BNEF, IEA, IRENA, NGFS, BCG, McKinsey

Do Rate Indicators Flag a Pathway for Thoughtful Climate Transition Investment?

The U.S. government recently concluded its Fifth National Climate Assessment with a striking $150B annual price tag for extreme events and projected rising costs. These estimates are imprecise, uncertain, and typically based on extreme tail events. Still, various sources have put the annual capital investment needed to achieve net zero emissions globally at as high as $9.2 trillion a year. More conservative sources sources predict it will take a little more than half of this figure – a still shocking $4.9 trillion annually by 2030. We’re not scientists and are not always well-positioned to judge the spectrum between ambivalence and alarmism. However, as investors, we recognize a need and an opportunity to finance the climate transition in any form that moves it along, even if consensus on what perfect looks like is elusive. An investment gap remains between what is required to reach net zero and our current investment trajectory, even after re-directing brown assets–money funding assets that damage our planet and contribute to the climate challenge.

An Investment Gap Still Exists While the World Strives for Net Zero

Source: Barclays Research, IEA (2021), McKinsey (2022), NGFS (2022)

Unlike central government spending in areas such as defense, most funding allocation decisions in the climate debate involve many more participants searching for solutions from the corporate sector that meet their individual needs. This leads to many interested parties, spanning established businesses and entrepreneurial startups. Years of historically low rates and ambition that sometimes bordered on mania in the ‘green’ space have led to significant spending, ending in several bubbles, false promises, and bottlenecks. While this isn’t anything new, we think high rates spurred by inflation will be an essential crucible for determining the path forward.

Misguided government initiatives aren’t the only culprit; investors are also to blame. The government may offer broad incentives for companies to head in the right direction, but investors decide which companies are ultimately worth sustaining today and which will tread forward successfully. That said, the world will continue to learn about which technologies led by what incentives may generate actual outcomes. Flows often follow sustainability themes (sometimes dictated by government incentives), followed by some form of pushback and an eventual sharpening of the investment case. The future will not be marked solely by the amount of dollars pumped into climate adaptation and mitigation projects but by how quickly we can improve our knowledge and methods to discern and invest based on the efficacy of the capital deployed into that space. In other words, in a new era of cost of capital, investments in offsetting and adapting to climate change must have a substantially positive return on investment.

Given the massive demands on limited funds, investors must be more scrupulous about the companies and projects they finance. By that, we mean investors must more intently make investment decisions based on an assessment of a company’s understanding of customers, suppliers, regulators, and employees—all of whom play integral parts in delivering successful products and services to the places of greatest urgency and successfully making the investment case. We expect the future to favor projects and investments that realistically consider real-world outcomes early on and endure the scrutiny of regulators and investors. In other words, a rising tide will no longer lift all boats.

Indicator 1: Identifying the Places of Greatest Urgency

The reality of higher rates will be a tight squeeze on all government spending. The public is already noting the more significant impacts of climate change, and this strain will increase as dwindling discretionary government spending will make climate adaptation and prevention projects scarcer.

It’s tempting to think that new sources of innovation will solve most of these problems. While these blanket solutions may be comforting, they lack realistic expectations for the future. We believe the reality is much more boring, involving many more trucks moving dirt or pouring concrete, than expensive mega-projects or even carbon capture and storage, which is still working towards economic viability. We believe high-quality industrial and materials companies and utilities are indispensable to these endeavors, especially in jurisdictions with significant potential for stimulus and shrinking population centers.

Although high-value urban centers may be a part of the climate transition, most people live in areas where it’s hard to discern their vulnerability to the physical impacts of climate change. The costs most people feel won’t be as much about catastrophe as it is inconveniences that can have a significant cumulative negative effect over time—think clogged sewers, overheated electrical infrastructure, and commuter disruptions. Moreover, the underinvestment in the infrastructure of emerging economies amplifies the sheer scale of humans affected while making the high rates of future lending that much more problematic for rapid change. Governments may turn to local resources for those small patch-up jobs, but for large-scale infrastructure, there appears to be a shrinking pool of market participants who operate at scale and can field a large undertaking. The companies that realize and capitalize on this issue by optimizing to help the most people will come out on top.

Growth in CapEx Has Slowed over the Past 40 Years

Source: BoA Global Research

Indicator 2: Healthy Balance Sheets

As rates stay higher for longer, companies need to be ready, as high indebtedness constrains and limits a company’s ability to pivot. Those who want to be competitive bidders on contracts must have a reputation for management quality, a track record of delivering, and the ability to support bids with impressive research and development and human capital capabilities. Healthy balance sheets and disciplined debt management are required to exploit such business opportunities.

Indicator 3: Stealthy Technology

We are also interested in high-margin technology opportunities that will show resilience to lower capital availability and play a part in consulting-style services and pure computing capacity to support infrastructure design-build. Whether upgrading the power grid infrastructure or creating a more resilient physical landscape, most environmental projects require deep analysis of historical data and geospatial components before engaging expert scientific and engineering resources. Most localities don’t procure or staff the technology or expertise required to deliver on larger-scale projects in this area, exacerbating a need for consultants. We are beginning to see a shortage of sustainability consulting resources, showcasing the opportunity on the business side.

Indicator 4: A Crumbling Housing Environment in Need of Efficient Construction

Due to the high-rate environment, the construction industry has felt particular supply chain cost pressures. This industry has a significant investment deficit in the housing sector due to the shortage of new buildings as well as aging and quickly deteriorating existing stock, coupled with pressures to solve this quota problem without adding construction emissions. There will be significant demand for contracts that build the most units with the greatest efficiency, both in terms of embedded emissions of the construction process, cost savings, and how sustainable the new housing units themselves will be.

Conclusion

On the surface, it’s tempting to oversimplify the problem as one of investment, but this is also about fiscal choices and tradeoffs vis á vis entitlements and government programs, as well as managing issues of scarce industrial materials and skilled labor. That said, we would be remiss if we didn’t also acknowledge the many competing regulatory efforts coming into effect. Most of these rules are well-intentioned to incentivize the climate transition or improve the integrity of commercial solutions. While they also place significant compliance costs across all market participants, we prefer those rules to higher prices and the increasing risk of energy disruptions from climate change. We will see if efforts like the EU model of cumbersome climate regulation are the kind of front-loading of cost that positions companies for long-term success. Early indications, however, point to significant voter discontent with rapidly rising prices. Either way, companies that don’t monetize opportunities that can pay for those expenses will struggle, and as we see from the 77% or so unspent funds from recent government stimulus, swings in political leadership resulting from voter discontent may add even more planning risk.

A move towards vigorous evaluations of internal rates of return brings these indicators together and converges at opportunity. Whereas we view much of sustainability efforts today as R&D or simply performative measures, there’s an opportunity for it to take on a dimension of business rigor that allows us to meet the challenge of climate change with an eye towards financial opportunity. Simply put, the future of sustainability lies in strong (and realistic) economics.