COP26 and the Climate Finance Bubble

Robust debates about national commitments to emissions reductions will likely dominate the UN Climate Change Conference, known as COP26, in Glasgow, Scotland. But expect private capital to play a crucial supporting role.

Private capital plays a key role in “climate finance,” the broadly used term to describe funding for activities that help slow climate change. This means private investments have the opportunity to reduce key climate technologies’ production costs relative to their output, while also accelerating the technologies’ ability to scale.

COP26 will mark six years since the signing of the Paris Agreement, where nearly all the world's nations agreed to commit to cutting greenhouse gas emissions. But with every G20 country behind in honoring commitments and almost every other country following targets that are highly or critically insufficient to reversing current climate trends, private investment capital is becoming increasingly essential to accomplishing climate-related goals.

What’s Needed to Meet Global Emission Reduction Targets?

It is estimated that existing technologies combined with sufficient climate finance can reduce up to 65% of the emissions needed to reach the UN's net-zero target by 2050. The emissions reductions that need to occur before 2030 can largely be achieved by existing technologies such as solar, while the post-2030 emission reductions depend on innovative technologies, along the lines of improving energy efficiency, hydrogen fuels, and carbon technologies. A report from the World Economic Forum notes that to successfully expand and deploy these climate solutions in the 2030s, emerging climate technologies need to be validated at commercial scale in the 2020s.

However, the remaining 35% of emission reductions will require technological breakthroughs, according to a report from Boston Consulting Group. The report expects that this technology gap can be closed through climate tech innovations, which will require an estimated $100 trillion to $150 trillion over the next 30 years--equivalent to roughly $3 trillion to $5 trillion annually.

And even though climate tech venture capital has seen a tremendous influx in 2021--reaching $30.8 billion for the year to date, 30% more than the total in 2020--much more private capital needs to be invested through flexible and patient channels. For an overview of the burgeoning climate tech startup ecosystem, see PitchBook's recent Climate Tech Taxonomy here.

PitchBook data shows that venture capital comprises roughly 3%-5% of total climate finance. But, since it plays a key role in discovering, backing, and scaling companies that create innovative solutions to otherwise intractable problems, venture capital is critical to address the technology gap.

Venture-backed companies have a long history of driving breakthrough technologies, from semiconductors to vaccines. This time around, venture capital must accelerate the deployment of technologies that mitigate climate change by decarbonizing swaths of the global economy.

While COP21 proved groundbreaking, as it led to the adoption of the Paris Agreement, COP26 will likely reveal how much climate technology and climate finance are needed to attain those goals. In response to growing political and consumer pressure, along with corporate pledges to go carbon neutral, climate-based environmental, social, and governance, or ESG, investment reached a record $51.1 billion of net new money in 2020--more than double the year prior.

And despite their essentiality to achieving the Paris Agreement, climate tech venture capital and ESG funds remain nascent and somewhat nebulous. More structure in the climate investment landscape will help:

• ensure climate-focused private capital does what it should, and
• enable climate-focused investors to invest along the double bottom line more easily.

Streamlined ways to invest patient capital into climate technology and to define accountable ESG frameworks, along with transparent reporting mechanisms, will be key in determining the environmental impact of these well-intended investment strategies. Below, we map out a few key players in this effort.

1. Catalytic Capital Currently, most emerging climate technologies cannot compete with greenhouse-gas-emitting alternatives and are prone to market failure because of what the World Economic Forum called "an inability of businesses to secure financing for the initial commercial-scale deployment." As investments into climate tech are often high-risk and capital-intense, capital structures that blend different sources of public and private capital are necessary.

That's why catalytic capital, the combined climate finance from both public and private actors, is necessary. Catalytic capital reached $640 billion in 2020, according to a report from the Climate Policy Initiative, with indications that climate financing may exceed $1 trillion in 2021.

Still, experts suggest that these amounts need to be in the trillions of dollars to meet emission targets. Around 6 times more capital is needed annually to not exceed the 1.5-degree Celsius temperature increase.

Private equity and venture capital receive much attention, yet only account for a small slice of global climate finance. While private investors poured $40 billion into climate funds and $30 billion into startups in 2021 for the year to date, this amount of private capital is not nearly enough.

Catalytic capital will need to be patient, risk tolerant, and readily available to support climate tech startups throughout high-cost research & development phases. Catalytic funding modalities can bridge geographic, institutional, and logistic gaps by, for example, accelerating commercialization and declining cost curves for key climate solutions. In addition, guaranteed offtake frameworks can derisk projects by guaranteeing customers for the product or service, and targeted project financing can help scale novel technologies.

2. Accountable ESG Reporting Environmental impact ratings (the E in ESG) are increasingly utilized to align investments with low-carbon solutions. They have the potential to provide essential information on corporate climate risks and opportunities. Accordingly, numerous financial products and practices have emerged to align capital with climate emission targets, such as indexes and portfolio products, along with third-party ratings.

Even though ESG and tech go well together, with the latter often perceived as having positive environmental impacts, research shows that technology innovations can have negative environmental impacts, and funds marketed as sustainable are frequently guilty of greenwashing.

A recent study from Util found that, of 77 funds with names containing the terms "green," "clean," "climate," or "sustainable," only four have a positive impact on environmental targets. The model analyzed peer-reviewed academic publications to extract positive and negative relationships between a company's products and the 169 U.N. Sustainable Development Goal targets. The aggregated impact of both--the total U.S. fund universe and the sustainable fund universe--scored negatively against the Climate Action Sustainable Development Goals (SDG 13), with negative 10.6% and negative 5.88%, respectively.

About $68 billion has gone into ESG exchange-traded funds in 2021 for the year to date, with $118 billion over the past 12 months, according to Bloomberg. With this rising trend, it is crucial that capital has the intended impact and contributes to meeting climate targets. Insufficient reporting mechanisms, weak frameworks, and confusing terminology explains why sustainable and total fund universes have a net negative impact on all five environmental goals.

However, these cannot serve as an excuse moving forward. Clear reporting standards, strict transparency mechanisms, and quantifiable metrics of actual impacts are essential to achieve the intended results of this capital. As sustainable fund performance shows a negative impact on all environmental SDGs, more accountable capital deployment is critical.

3. Impact Investment Frameworks While willingness to provide sustainable capital has grown since the Paris Agreement was signed, poor performance and a lack of consensus over terminology speaks to the need for clearer frameworks.

As the ESG arena is essentially unregulated, investors are left to navigate a broad and growing spectrum of possibilities on their own. By integrating metrics centered on environmental resilience, climate risk mitigation, and strategies toward renewable energy through ESG ratings, investors will be better able to align capital with climate targets. To meet the Paris Agreement emission reduction targets, it is necessary to provide investors with a clear path in ESG investing and ensure their investments have the intended impact.

Accordingly, both Morningstar and PitchBook are pursuing initiatives to improve investors' ability to approach the ESG landscape. Morningstar's Sustainable Investing Framework offers a straightforward method to understanding investor motivations; it also defines sustainable investing and provides pathways to success. (The framework's six approaches to sustainable investing are: applying exclusions, limiting environmental, social, and governance risk, seeking ESG opportunities, practicing active ownership, targeting sustainability themes, and assessing impact.) PitchBook is working to more clearly track impact fund formation, while its climate tech research is mapping the startup ecosystem.

Emerging Climate Tech Opportunities

As carbon has emerged as the leading culprit of climate change, nature-based solutions, or NBS, are, at present, the most feasible way to reduce atmospheric carbon. NBS represent an industry poised to generate $800 billion in annual revenue by 2050, according to a report from Vivid Economics.

Climate tech startups pursuing this opportunity apply several emerging technologies, including machine learning, geospatial mapping, and advanced reforestation. Concurrently, McKinsey Sustainability writes that the demand for carbon credits could increase more than 15 times by 2030 and up to 100 times by 2050, thus fueling the development of sophisticated global carbon trading markets. PitchBook's recently published market map identifies startups in the NBS category as part of 2,589 startups pursuing climate-related technology opportunities. Together, these companies have raised more than $50 billion in the past two years.

While important, technology cannot solve every climate problem. With successful reforestation projects often relying on land availability, COP26 will provide an opportunity to discuss inclusive climate solutions--as data from the U.N. indicates that many Indigenous territories prevent deforestation as well as or better than other protected areas.

It is clear that the unique problems presented by climate change require complex solutions. But perhaps the most challenging aspect of the issue will be creating pathways wherein public and private interests can merge and work cooperatively.