Profound forces are reshaping the fabric of the North American and global economies.  Near-shoring and friend-shoring are transforming global value chains. Shifting demographics are generating enormous new opportunities in some regions while leading to labour shortages and diminished economic potential in others.  And the advent of AI promises to accelerate the ongoing technological revolution.

To this list, we must add the growing impact of climate change and the accompanying race to decarbonization.

The scientific literature on climate change can make for depressing reading.  Despite considerable progress, emissions of greenhouse gases continue to rise and the likelihood of at least temporarily overshooting the 1.5 degree Celsius target of the Paris Agreement is becoming a near certainty.  Even remaining below the 2.0 degree Celsius target of warming appears increasingly unlikely.

This is not, however, the focus of this paper. Rather, the emphasis is on the unprecedented economic opportunities presented by the increasingly urgent race to decarbonize our economies.

At the international scale, 80% percent of global GDP is now subject to national net-zero targets.  Achieving these targets will require between USD $80 to $250 trillion of new investment by 2050 – a staggering sum roughly equivalent to 1.0 and 2.5 times the present size of the global economy.

Indeed, signs of this emerging transformation are everywhere. For example, of the USD $2.8 trillion projected to be invested in the energy sector worldwide in 2023, approximately USD $1.7 trillion, or just over 60%, will be allocated to clean energy. In the US, 23% percent of electricity is expected to be generated from renewable sources this year, an increase of over 10% from 10 years ago. In 2021, renewable electricity accounted for over 28% of global generation, up from less than 20% in 2010, while electric vehicles in 2022 made up 14% of all new cars sold, a tripling from 2020.

However, much more needs to be done.  Much of this enormous growth in the decarbonized economy has to date been concentrated in the energy and electric vehicle sectors. And the current ratio of dollars invested in decarbonized versus fossil-fuel based energy of 1.7:1, it would need to leap to 4:1 over the coming years to keep our global climate targets within reach.

Though initially something of a laggard compared with Europe and China in investing in the decarbonized economy, North America has forcefully upped its game from a policy perspective over the last 12 to 18 months.

In the US, the Inflation Reduction Act directs some US $369 billion towards climate and clean energy; however, as two-thirds of the baseline investment is channeled through uncapped provisions, the total amount of public spending could reach US $800 billion, which when leveraged with new private sector expenditures could spur over USD $1.7 trillion in new investments. In Canada, Budget 2023 included over CAD $80 billion in green economy investment tax credits. And Mexico earlier this year unveiled its new Sustainability Taxonomy which adopts an holistic approach in keeping with the spirit of the Sustainable Development Goals (SDGs) by fully integrating considerations of gender equality and access to basic services with traditional environmental concerns such as climate change mitigation and adaption and biodiversity loss.

All told the overall macroeconomic environment in North America has arguably become the world’s most supportive of the green economy. Combine this with its existing built-in advantages, including deep capital markets, an innovative and technologically sophisticated private sector, abundant natural resources, cutting edge R&D capacity, an educated workforce and favourable demographics, and it quickly becomes apparent that all the necessary ingredients exist for North America to seize the reins of the 21st century and establish itself as the pre-eminent green economy superpower.

Achieving the twin goals of building a decarbonized economic dynamo while contributing decisively towards climate change mitigation will, however, require more than an enabling policy environment. It will require investors to actively lean into the decarbonization and sustainability transition, and approach it not from a defensive or risk-mitigation perspective but rather as a once-in-a-generation economic opportunity to be seized through the purposeful deployment of their investable capital.

Institutional investors, such as pension funds, are particularly well suited to perform this catalytic role. First, concerning size, they steward the largest pools of assets under management – globally, some approximately $250 trillion USD, a figure that is expected to double by 2050, with North America being the largest region in the world at just under $50 trillion USD.

Second, the time duration of their liabilities runs essentially infinitely into the future, thereby encouraging a longer-term approach toward their investment decisions. Third, many are under growing pressure from their depositors to not only generate financial returns but also positively contribute to the societies in which they operate.

Focussing on the unique role that institutional investors can play, this paper argues for the adoption of a distinctively North American ethos or approach to the complex web of issues surrounding decarbonization and sustainability through a forward-leaning, offensively oriented approach that emphasizes value creation and active ownership – an ESG 2.0 – while embedding the traditional risk mitigation aspects of ESG 1.0 within a broader comprehensive non-financial risk management framework.

To see how such an ESG 2.0 framework oriented towards value-creation could be implemented in practice, it is first necessary to ask the question of how institutional investors create value in the first place.

Fundamentally, the set of tools or actions available to institutional investors is relatively narrow.  They are:

1. Through investing or the deployment of their capital at the individual transaction level as well as in the construction of their portfolio as a whole;

2. Through engagement with their investees or recipients of their capital to have the value of their investment appreciate over time (or to protect against the depreciation or loss in value of their investment);

3. Through advocacy, market signaling, and thought leadership; a broad and diffuse set of activities that includes engaging with government officials and regulators, national and international standard setters and multilateral initiatives, and the publication of statements, position and research papers and other communication products with a view of influencing the regulatory and policy environment, prevailing market conditions and business practices.

Taking these as building blocks, what follows is a broad outline of the key elements of an ESG 2.0 framework as applied to the North American institutional investor context.

• Leadership from the top and integration into the firm’s overall business and growth strategy:

The first step entails setting the tone at the apex of a firm’s leadership and embedding a forward-leaning strategy within the company’s overall operational approach.

From there, a process of continuous dialogue between the executive leadership and the senior management of the various investment teams is needed to mainstream the strategy across the firm’s range of activities from defining the universe of potential investments through to the due diligence process and post-investment engagement with investees.

For those funds that principally deploy their capital through external asset managers, the integration of such a strategy is required to inform the process by which external asset managers are selected and in defining their investment mandates, their engagement practices with the firms in which they invest, and their reporting and accountability frameworks.

In parallel, engagement with the firm’s respective depositors is vital to secure their buy-in and support. Also, to communicate how such a strategy is anchored within and in support of the overarching goal of generating competitive risk-adjusted rates of return on their funds, while contributing to broader economic objectives.

The next North American Leaders Summit takes place from May 5 to 7, 2024 in Salt Lake City, Utah. What better time for the leaders of North America’s largest institutional investors to come together and announce their intent to jointly collaborate towards catalyzing the decarbonized economy and making North America the green economic engine of the world?

• Ensuring that investment teams have the requisite mandate, tools and incentives:

Whereas investments in renewable energy and the electric vehicle ecosystem are scaling rapidly in North America, investment flows towards other critical, often hard-to-abate sectors such as green cement or steel, sustainable aviation or maritime fuel, or carbon capture and storage, are lagging despite their enormous value creation potential.

There are several reasons for this, but principally they relate to the characteristics of the pool of potential investments in these sectors – such as the lack of economies of scale, the use of relatively immature new technology, and the start-up nature of many of the firms involved. In short, despite the enormous upside potential, investment teams of institutional investors are often impeded by their internal regulations which define the required risk-return eligibility requirements of a potential investment from deploying their capital in these sectors.

Overcoming such obstacles requires a specific set of tools. Though precise governance mechanisms and operational practices differ from institution to institution, and as such there is not a single one-size-fits-all solution, examples of the kinds of tools that could be considered include:

1. Creating a dedicated fund or funds within their organization with a specific mandate to invest in such emerging areas, whether thematic (targeting a specific sub-sector) or goal-oriented (such as contributing to decarbonization of the real economy);

2. Setting aside or carving out a specific percentage of existing portfolios for investments in such sectors, again whether thematic or goal-oriented;

3. Establishing a set of metrics or key performance indicators (KPIs), such as its growth or decarbonization potential, that, if met by a potential investment, can allow it to proceed within the existing mandated risk-return profile framework.

Beyond such specific investment tools, further measures can be taken to encourage and incentivize such investments, including:

1. Integrating decarbonization/transition sectoral experts or champions within existing investment teams to better identify potential opportunities and perform related due diligence;

2. Introducing positive decarbonization/transition elements within the remuneration structure of investment teams or external fund managers.   

The short-term aim of such tools is to engineer a small but significant positive shift in the institutional investor’s overall portfolio, thereby gaining increased exposure to this emerging multi-trillion dollar opportunity while contributing to the major societal objective of lowering greenhouse gas emissions.  The longer-term aim is to achieve these same societal objectives while positioning the institutional investor ahead of the curve and thereby able to achieve outsized future returns.

• Re-orienting company engagement towards a model of value additive active-ownership and cross-pollination   

  • The stewardship and engagement policies and practices of institutional investors towards their investee companies have attracted growing attention over the past several years. Much of the focus has been on voting practices on various shareholder resolutions during the annual general meetings of publicly traded companies on issues ranging from executive pay to equity, diversity and inclusion, to enhancing voluntary disclosures.

While such engagement is an important element, it is often high-level and with the sheer number of holdings of a given institutional investor, it can be somewhat generic and reliant on the recommendations of third-party advisors such as ISS and Glass Lewis. Such engagement tends to be very wide, often encompassing the width and breadth of the entire portfolio, but quite diluted.

A value-additive, active-ownership approach would supplement these existing efforts with a tailored approach focussed on a much smaller subset (perhaps no more than a handful initially) of the institution’s holdings.

The necessary first step would entail an internal mapping of a firm’s holdings to enable the identification of candidate firms who are well-positioned to contribute to the decarbonization of the economy or who face significant longer-term transition and regulatory risks.

The second step would be to engage in a comprehensive dialogue with the selected firms to better understand their strengths, challenges, and constraints. This would allow for the development of forward-looking strategies and business plans, bringing to bear the institutional investor’s existing expertise in each area as well as, when required, external consultants and relevant experts from other portfolio firms.

The final element of such a strategy would involve cross-pollination efforts. During this step, existing industry leaders within the institutional investor’s portfolio would be identified, as well as workshops or platforms where their solutions can be showcased. The solutions could be potentially matched with other portfolio companies that could benefit from them.   

Done well, such active ownership and cross-pollination efforts could position an institutional investor as a centre-of-excellence for their portfolio companies. This holistic approach could transform these investors into catalytic agents of growth potential for several of their investees, benefitting both the individual firms, as well as the value of the portfolio, and ultimately the bottom line of the institutional investor. Indeed, such an approach is at its heart ‘values-agnostic’ and principally focussed on seizing emerging business opportunities as they develop.

• Coordinated advocacy and engagement

The overall macroeconomic policy environment across North America, particularly concerning the green economy, has transformed over the past two years. Yet, considerable work remains to be done.

Across Canada, the US, and Mexico, for example, the electricity transmission grid remains woefully inadequate to support the growing electrification of the economy, representing a major obstacle for accelerated efforts for decarbonization. Just in the US, for example, the transmission grid must grow by 60% by 2030 and triple by 2050 to achieve carbon neutrality goals. However, policy measures to address this, including through permitting reform, often remain stuck with multiple bottlenecks at the federal, state or provincial, and municipal or local levels.

Advancing progress across this quiltwork of competing regulatory rules and frameworks, while ensuring that necessary environmental and social protections are maintained, is a monumental effort – but one that would benefit from the coordinated action of North America’s leading institutional investors.

On-going efforts, both nationally and internationally, to normalize and standardize sustainability-related taxonomies, as well as reporting and disclosure requirements represent another avenue ripe for enhanced collaborative engagement between North America’s largest institutional investors. Many North American institutional investors already enjoy a long history of close collaboration with each other, providing a solid foundation on which to expand such efforts and better confront future challenges.

• Integrate the traditional ESG 1.0 approach within a broader, comprehensive risk-management framework

The preceding elements, particularly the first three, taken together represent a considerable evolution in the way ESG and issues relating to sustainability have been traditionally approached by institutional investors.

Traditional ESG integration is principally a risk management tool. Firms such as institutional investors use it to identify potential drivers of risk that could hurt a given investment’s long-term returns or negatively impair the reputation of the firm. It is also used to help accurately assess the fair value of a given investment. Nonetheless, it is not generally used to actively create value, seize emerging opportunities, or help achieve particular environmental, social, or economic outcomes.

While numerous variations in methodology exist, the principal ways in which it is deployed is through negative screening or some kind of scoring system used to inform a recommendation (or veto) on whether a given investment should proceed. It can be used to adjust traditional valuation models and ratios or forecasted financials, upwards or downwards, helping to provide a more accurate assessment of the fair value of a given investment.

This ‘sober second thought’, a largely defensive function, is indeed virtually indistinguishable in form from those provided by other well-established risk assessments such as geopolitical, regulatory, or technological risk. That the three constituent components of ESG have been grouped is more the product of historical accident than any unique characteristics they share with this other material, but non-financial considerations.

There exist few if any practical reasons to continue to have the three components of ESG stand out on an island. More closely integrating them with other established sources of material non-risk would serve two goals. First, it would facilitate more holistic and comprehensive risk assessments covering all material non-financial drivers. And second, it would help remove the shroud of mystery that seems to hang over ESG practice in North America by more clearly embedding it in an over-arching risk-management framework.   

Once embedded in such a manner, there is no compelling reason to continue using the term ‘ESG’ and it can be gotten away with entirely. The five-step approach described above could simply be referred to as ‘sustainability investing’ or ‘smart investing’ or, even better, just as ‘investing’.   

The above presents a framework for an ESG 2.0 from the perspective of an institutional investor that seeks to shift the focus of ESG activity from a defensive, transaction-by-transaction approach centred on risk mitigation, towards a more active approach. This method recognizes the strategic imperative of investing in decarbonization, seeks to deploy capital, and exert effort through engagement and advocacy. This is to identify financial returns through a closer orientation with the historically unprecedented opportunities presented by the energy transition while promoting the vital social benefit of accelerated emissions mitigation.

It does so while presenting a vision of the future of the North American economy as the world’s pre-eminent centre for green economy innovation and production. A future where institutional investors, such as pension funds, are uniquely well placed to catalyze given their deep pool of capital and longer-term horizons.

The author hopes that we can seize this opportunity and together build the North America we want.

Annex – Contributing to Solutions at the Global Level

The discussion above focussed exclusively and purposely on the North American context and presented a framework for an institutional investor ESG 2.0 supportive of securing North America’s leading role in the global economy of the future.

But we know that climate change is a global challenge requiring a global effort, not one that can be solved at the national or even the continental level alone. And we also know despite the significant progress being made in most advanced economies, progress is stalled across much of the developing world.

Earlier this year, the Intergovernmental Panel on Climate Change (IPCC) released its sixth synthesis report. Among its headline findings was that the investment requirements for 2020 to 2030 that limit warming to either the 2 degrees or 1.5 degrees targets are a factor of three to six times greater than current levels. Or, stated slightly differently, mitigation efforts alone will require three to six times more investment than is currently taking place, with much of that having to be channeled toward emerging economies.

The report observes that sufficient global capital exists to close the investment gap but that there are barriers to redirecting capital towards climate action, especially in emerging economies. Overcoming these barriers will therefore be crucial if we are to succeed in mitigating the worst effects of climate change.

The obstacles referred to within the report of the IPCC are not trivial. But they are increasingly well-understood.

There are risks from investing in new and unfamiliar markets, from currency depreciation and default to breach of contract or expropriation. There are risks related to the construction and operation of new infrastructure. There is a lack of a pipeline of investment-grade projects in most emerging economies, a lack of credit and market data, and there are the cyclical challenges presented by prevailing high-interest rates in the advanced economies.

Finally, there is the challenge of reputation risk which extends to both the institutional and individual level – the reality is that the potential reputational costs of a failed investment in an emerging economy is perceived as much higher than a failed investment in a familiar, advanced economy.

Confronted with this myriad of risks and challenges, many institutional investors, even if motivated with a genuine desire to contribute towards global efforts to confront climate change, conclude that these challenges are simply too difficult to overcome.

Though understandable, we must not be satisfied with this conclusion. There is too much at stake and the potential role of institutional investors is simply too important. Though no silver bullet exists to solve the climate action financing gap in emerging economies, institutional investors hold the largest pool of investable capital globally and therefore represent a critical piece of the overall financing puzzle.

Fortunately, a small but growing number of institutional investors are beginning to recognize this, as are governments. This past June, for example, three leading institutional investors and members of the ILN or Investor Leadership Network (CDPQ, Natixis, and Ninety One) agreed to form a partnership with the US Treasury, supported by the Sustainable Markets Initiative (SMI) and The Rockefeller Foundation. The partnership seeks to develop solutions to the challenges referenced above with the ultimate aim of mobilizing private capital into emerging markets at a sufficient scale to significantly contribute to the realization of our global climate change objectives.

Building on the ever-growing body of technical literature on blended finance, focused efforts will be made to develop specific solutions to challenges such as foreign exchange risk or insufficient project pipelines. Further details are expected to be announced at the forthcoming CoP-28 summit in Dubai.

These nascent efforts can provide the institutional investors of North America with a historic opportunity to contribute decisively to the biggest global challenge of our time while building out new markets and opportunities and honouring the fiduciary obligations to their depositors.   

It also provides Canada, the US, and Mexico an opportunity to further advance our respective leadership internationally in the pursuit of a more sustainable future for all. I invite the institutional investors from across our region to join in this effort.