Do institutional investors hold the key for a low-carbon future?

Institutional investors are important market actors that have been taking steps to divest from fossil fuels, but have so far channelled less effort towards the basic materials sectors. Whilst they may more readily move to low-carbon finance, their actions depend on other financial actors, which makes it especially important for the financial sector as a whole to rethink its relation to carbon.

Alongside the technical, social and political challenges that decarbonisation poses, in the past few years the significant issue of how a transition to a low-carbon future can be financed has come to take centre stage. As diverse public and private actors have sought to respond to this challenge, we have witnessed the growth of what we call carbon finance – including well-established markets for trading emissions rights and ecosystem services, investments in ‘natural capital’ for carbon storage, various banking activities that include green loans and mortgages and so on, alongside private investment that either explicitly commits capital to green projects or seeks to divest from assets associated with the fossil fuel economy. 

Institutional investors (which include e.g. insurance companies, pension funds, sovereign wealth funds)have been central to the growth of carbon finance. The Institutional Investors Group on Climate Change, a European body, counts 230 members in 16 countries with assets worth more than $30 trillion in its membership proactively seeking to invest in the low-carbon transition. Despite the significant numbers involved, the finances mobilised by institutional investors towards the low-carbon transition are still relatively small compared to ongoing public and private investments in the high-carbon economy. Rather than being because of the quantity of finance that institutional investors have brought to the table, their significance might instead be assessed in terms of how their role at the forefront of pioneering new ways of understanding the quality of investment in low-carbon terms [see Financing Net-Zero Report].

On the one hand, institutional investors have become important market actors in stabilising green bonds – a fixed-income debt instrument which funds investment in a specified project or a set of multiple projects undertaken by their issuer- by developing and using standards that create a shared understanding of what ‘green’ investments can and should involve. On the other hand, institutional investors – particularly faith-based groups, educational institutions and public sector organisations – have been important in establishing the qualities of assets that make them unattractive investments and in calling for and taking steps towards divesting from high-carbon companies. This has generated new ways of thinking about what the risks of investment are under conditions of climate change and has opened up the debate about what does and does not constitute a ‘good’ investment. 

To date however, these efforts have not been channelled towards the basic materials sectors. Equally, while the long-term nature of their investment strategies and public profile may suggest that they will seek to move away from high-carbon assets more readily than other investors – and indeed many are beginning to do so – we also see that they are dependent on the actions of other financial actors, especially stock exchanges which make up a large part of their investment portfolios, and on how risk and return are calculated [see Financing Net-Zero Report]. This suggests that unlocking the potential of institutional investors will depend on wider efforts to ‘green finance’ in which the financial sector as a whole comes to embed carbon as a critical issue around what counts as an asset and how both private and public returns on investment are calculated come to be rethought.