As we enter the third year of the pandemic and witness the outbreak of another war, a consensus is growing that humanity is at a crossroads. If we do no more than recover and carry on as before, we can expect to be met with even more severe crises in the years to come. But if we instead take stock of the lessons learned and embrace change, we could now lay down the foundations of a more prosperous future.
Despite the unprecedented strain on individuals and massive toll on our health, COVID-19 has afforded us a unique moment in time where a singular event has indiscriminately disrupted our lives. Everyone on the planet is affected – obviously with different intensity – but no one is spared. Even in the most advanced economies, the standards of living have been dramatically impacted, either directly by the disease or indirectly by restrictions. The same holds for the devastations caused by the Ukrainian conflict, generating humanitarian and economic catastrophes across markets and countries. The pandemic and the war are therefore “great equalizers,” catalytic events laying bare the daunting challenges we share as a global community and the need to address them in earnest collectively.
The pandemic and the war are therefore “great equalizers,” catalytic events laying bare the daunting challenges we share as a global community
The financial community has swiftly responded to this call for action by flooding the market with new financial products with more ambitious objectives than purely financial returns. Broadly defined, responsible investing rose by nearly one third between 2016 and 2020 to reach $35 trillion, representing no less than 36% of total professionally managed assets. Mutual funds and exchange-traded funds (ETFs) that self-report as having Environmental, Social, Governance (ESG) or socially responsible investment (SRI) mandates have shown even faster growth. The assets managed by these funds have increased more than tenfold over the past five years and now stand at approximately $2 trillion. The Bank of International Settlements has recently pointed out that the explosion of sustainable finance incorporates features that look uncannily similar to earlier bouts of financial innovation that eventually led to the burst of a bubble. Indeed, limited transparency, poor product standardization, severe conflicts of interest, the culprits of the global financial crisis, are material to ESG finance as well.
We believe that untagged, rigorous academic research is key in overcoming the challenges that responsible investing is facing. In this direction, NYUAD has joined forces with our partners Mubadala and Al Maskari Holding to launch the Transition Investment Lab (TIL) as a powerful lens to analyze the current evolution. In this inaugural report, we present the first results of our initial research efforts, a balanced mix of articles containing original data, qualitative analyses laying down the foundation of our agenda, and relevant case studies from our target geographies and key themes.
The SWF paradox: while equipped to contribute materially to achieving the SDGs, SWF sustainable investment represents only 7% of total deal value…
One of TIL’s focus areas is the role of large institutional investors as universal owners of capital in playing out the required transition. Sovereign Wealth Funds (SWF) certainly belong to the upper echelon of this group and SWFs should be well-positioned and equipped to contribute materially to achieving the SDGs. Yet, SWFs are often referred to as “sustainability laggards”, on the claim that their participation in the responsible investing movement remains lackluster compared to other institutional investors and private-sector counterparts.
By examining two decades worth of data, Bortolotti, Loss, and van Zwieten set the record straight on the above mentioned “SWF paradox”, sorting through SWFs’ orientation (or lack thereof) towards sustainability by analyzing their overall investments over their recent history. Out of the total 3,565 transactions recorded in the database, the authors flag 564 transactions representing a total of USD 73.5 billion of aggregated transaction value as ‘sustainable (SDG) investments’. This represented 16% of the total number of transactions, and 7% of the total value of the SWF transactions.
The COVID-19 pandemic might play a key role in breaking the SWF paradox
For those who espouse the normative belief that SWFs should engage deeply in making sustainable investments, these are, in an absolute sense, not overly impressive numbers. Interestingly, the article shows an increasing appetite by SWFs making sustainable investments over time. After reaching a plateau in the 2012-2016 timeframe, total sustainable deal count accelerates in 2017 and peaks in the last sample year 2020. A similar trend is visible also in deal value. The sectoral distribution of sustainable investments shows an impressive concentration in healthcare, where deals worth USD 29 billion are reported. Indeed, SWFs played a major role in the medical response to the COVID-19 pandemic, with some of them backing the discovery of the most successful vaccines, such as BioNTech-Pfizer and Moderna. In their sustainable investments, SWFs allocate capital quite evenly among developed economies, while within emerging countries Southern Asia sticks out as the primary target due to the impressive activity of Singaporean funds. Sadly, Africa, the continent starving for this type of capital, is still under the SWFs’ radar.
The authors observe that the COVID-19 pandemic might well play a key role in breaking the SWF paradox, even though it is too early to tell in light of the pandemic’s disruptive effects on risk management and deal-making practices. However, as overarching themes such as sustainability, ESG, climate change mitigation and adaptation, SGDs and SGD-aligned investing become more and more prevalent in the investment world, one might reasonably expect the SWFs come into the fold, relaxing the strict adherence to the fiduciary duty that characterized their investment strategy so far.
A second, key feature of TIL research is its focus on a vast, but specific target region comprising the Middle East, Africa, and Southern Asia, that we label MEASA. The reason for this geographical restriction is simple: MEASA is the area with the highest growth potential, but also the one facing the most dramatic environmental and social challenges. Fostering sustainable growth in this region is therefore key to hasten the sought for transition.
MEASA is the area with the highest growth potential, but also the one facing the most dramatic environmental and social challenges.
Peter Lejre’s article highlights the unique MEASA macroeconomic characteristics. The region is home to about 50 per cent of the global population, exhaustible resources, and arable land, but it accounts only for 15 percent of global GDP. This asymmetry is responsible for the “MEASA underweight” observed in financial markets, as global institutional investors allocate less than 4 percent of their listed assets to the region, with a share shrinking to less than 1 percent in private markets. Interestingly, investors are turning their back to a region that has the stronger demography and a significant growth potential. Indeed, the entire world population growth projected for this century will originate from MEASA, and over the last decade its GDP per capita has almost doubled in real terms, outpacing the growth of the rest of the world. One of the biggest hurdles to unlock future economic growth in the region is to close the investment gap observed in capital of all stripes: human, social, and physical.
MEASA accounts for 53 percent of the global population, but only 15 percent of world GDP
This lack of capital has certainly a great bearing in the poor records achieved in sustainable development. Indeed, 83 percent of MEASA countries report UN SDGs scores values below the world mean. But how can this huge gap be closed? National governments, international financial institutions, and private donors will join in this journey, but without capital commitment to MEASA by global long-term financial institutions no significant, durable change will be achieved.
83 percent of MEASA countries report UN SDGs scores values below the world mean
Lejre concludes by listing the major obstacles preventing large-scale institutional capital in the region, and providing some useful recommendations. Firstly, additional insights and awareness of the region and regional opportunities need to be developed and shared with the international investor community. Secondly, to overcome the lack of investment opportunities of institutional quality, products such as scaled access strategies (providing investors with broadly diversified investment products, e.g., systematic equity products, fund-of-funds) as well as project investment collaboration between local and global institutional investors should be prioritized in order to gain international investor attraction. Thirdly, as the region still struggles from previous (and current) issues causing reputational risk concerns, focus should be directed towards investments with a strong sustainability profile combined with a clear and measurable impact on the SDGs. Finally, comfort must be built around some of the typical emerging markets risk, including governance and legal issues that can be partly mitigated by leveraging solid regulatory environments as investment gateways (e.g., Abu Dhabi, Singapore).
Tackling the MEASA underweight…
The articles summarized so far have provided us a broad view about the challenges faced by SWF in sustainable investment and the key features of MEASA as TIL’s region of choice. Ghosh’s contribution focuses on social inclusion as an investment theme, touching upon another focus area of TIL, namely the role of grass-roots level investment in private markets to drive rapid impact.
Social inclusion as an investment theme
Social inclusion can be defined as the process of improving the term of participation in society, particularly for the people who are disadvantaged, through enhancing opportunities, access to resources, voice, and respect for rights. Social inclusion is a challenge facing most economies across the planet. Emerging countries in places such as sub-Saharan Africa struggle to end extreme poverty, malnourishment, and the lack of access to clean water and sanitation, but even in more developed economies we find deprived communities lacking access to nutritious food, transportation, internet access as well as good schools and hospitals. It is no wonder that improving the living standards of half the world’s population to a basic level is a focal point of the UN Sustainable Development Goals. Social inclusion is often referred to under the “S” umbrella of ESG financial products, but the vast majority of sustainable investment today is not focused on funding innovative growth companies and community projects with social inclusion as their primary objective. How can capital be effectively mobilized in this direction?
A three-part model for delivering on social inclusion
Ghosh puts forward a three-part model for delivering social inclusion that engages both the private and public sectors in a collaborative manner. Indeed, addressing the universal challenge of social inclusion requires a transformation of the global socioeconomic system driven by a change in social attitudes, the adoption of inclusive policies and institutions, along with the penetration of new technologies. The scale of the change is such that it will be achieved only with the cooperation of the public sector, international donors, and private sector investment.
The first part of the model is the “graduation approach,” a formula to lift people out of extreme poverty to a sustainable livelihood. The early stage of the program is the transfer to a household of a productive asset, such as livestock, along with the basic skills to initiate a sustainable livelihood through private enterprise. The key idea is to provide the participants with a “big push” over an initial period, which would allow them to begin productive self-employment and sustainably increase their level of consumption. While foreign aid will be needed in the first stage of the process, private investment could scale-up and accelerate the graduation approach through “market-creating innovations,” or activating new consumers by making new products and services which are more affordable and accessible. Consumption is made possible for people who were previously “non-consumers,” unlocking latent demand which ignites economic growth.
The second part is to invest in the enablers of socioeconomic mobility: affordable housing, infrastructure, and key social services such as education and healthcare. According to recent estimates based on the current stock of housing and the expected rates of urbanization and income growth, developing countries need to invest in affordable housing and economic infrastructure USD 2.7–2.9 billion annually over a ten-year period to meet their Sustainable Development Goals (SDGs). Fortunately, the entire burden need not fall on public money. With the appropriate regulation and licensing, private sector investors and infrastructure operators can be attracted to participate in the build-out and operation of large-scale housing and infrastructure projects. At the other end of the spectrum, micro-finance platforms are also becoming an effective tool for funding community-scale infrastructure.
As for education, the fundamental problems facing poorer countries are the lack of schools in rural areas, the limited opportunities for vocational training, and the low attendance rates especially by women. Increasing school attendance especially for women has huge demographic implications given the higher opportunity cost of having children for educated girls. The article also highlights the severe blight on human health in MEASA, measured by the number of lost years of healthy life, showing how the global gap in education and healthcare provisions can be filled by calibrated impact investments.
Social inclusion is under the “S” umbrella of ESG financial products, but most of them fail to address it with targeted investments
The third and final part of Ghosh’s journey to prosperity involves managing a country’s demographics to keep the highest possible proportion of its citizenry engaged productively in the workforce. Failure to tackle this issue will result in youth bulges, one of the most acute challenges of poorer countries. At the same time, if these youth bulges can be harnessed economically through education and gainful employment, they represent a powerful economic force that could lift national output and generate new funds for critical socioeconomic investments. In short, these countries have the potential to enjoy a “demographic dividend.” The author concludes that in order to reap a sustainable demographic dividend by maintaining a high proportion of the population in the workforce, countries badly need a vibrant private sector, as the case of Saudi Arabia clearly illustrates.
SWF challenges in the energy transition
The case studies section of the report opens up with a contribution by Massimiliano Castelli on a fundamental topic for TIL and all hydrocarbons-based economies, namely SWF investment strategies in the course of the energy transition. Indeed, navigating the energy transition is a real challenge for SWFs and their political sponsors: diversification too fast could quickly turn the commodity into a stranded asset, impacting future revenues, and, ultimately, SWF funding. But a slower exit from hydrocarbons could generate even greater risks in the long run, given the current projections on fossil fuel demand. Castelli provocatively discusses the implications of the transition in the global energy sector as the world accelerates towards a Net Zero world. The key message of the analysis is that the conventional stabilization mandate attributed to SWF needs to be upgraded from short-term management of oil price fluctuations to “structural diversification”. Over the long-term, stabilizing the economy involves funding the energy transition and the development of non-oil sectors with a much higher focus on domestic investments to support the transformation of the economy.
On a similar vein, Yilmaz and Luomi provide our readers the perspective on the energy transition and ESG challenges from the largest oil economy, Saudi Arabia. While acknowledging the necessity to embrace the transition towards sustainability through ESG practice and tools, the authors point out that diverging views on its definition and classification is creating bottlenecks for the mainstreaming of sustainable finance in the Arabian Gulf. Indeed, originating outside hydrocarbon-based economies, ESG taxonomies (including the one released by the European Commission when this report goes to press) reflect a general focus on energy sources tout court rather than the source of emissions. Of relevance for Gulf countries is that they largely fail to explicitly include many emission management technologies that are important for the region, for other major hydrocarbon exporters, and for cost-effective net-zero pathways worldwide, including carbon capture, use and sequestration (CCUS) and hydrogen. A more inclusive definition that can address country- and sector-specific issues could be much more effective in countries that are currently seen as incumbents in the energy transition, as well as sectors that are hard to abate worldwide, including heavy transport and industry.
A more inclusive definition that can address sector-specific issues could be much more effective in countries that are currently seen as incumbents in the energy transition, such as Saudi Arabia
Saudi Arabia, which still generates more than 40% of its electricity from oil, has set ambitious targets in terms of energy mix. In this direction, it has embraced the concept called the “circular carbon economy (CCE) based on four Rs – reduce, recycle and reuse, and remove – and focused on minimizing and, ultimately, preventing atmospheric carbon dioxide and other greenhouse gas emissions while ensuring each country can leverage its strengths in the most cost-effective way and in some cases also creating economic value while reducing emissions. The Saudi Vision 2030, along with its Vision Realization Programs, and more recently the Saudi Green Initiative, represent ambitious initiatives that promise a historic change with several trillions of US dollars of investment in various sectors, including industries, energy, and tourism. PIF and Saudi Aramco are taking their fair share of the financing of many of these projects. However, attracting global sustainable funding will continue to be critical to turn the vision into a reality.
As stated in the TIL mission, private markets are a qualifying feature of transition investment. The report closes with a contribution by Global Ventures’ CEO, Noor Sweid, on a paradigm shift that is taking place in the venture capital industry. The traditional start-up rules conceived in the Silicon Valley and universally applied are starting to lose relevance as successful businesses and tech hubs are emerging from the MEASA region, from Cairo to Singapore. This new breed of talented entrepreneurs shares a key feature: they build companies that are global from the get-go. Indeed, for many of these start-ups, staying local is not an option as global growth is a requirement for survival. But even more importantly, emerging market founders build for a global market because the problems they are addressing usually affect millions of people globally.
Proximie, a company that developed an augmented reality tool that allows surgeons to virtually scrub into any operation theater across the globe, is a case in point, showing clearly how these start-ups can quickly generate incredible impact by scaling globally at a faster rate than their counterparts in more mature markets. Proximie, as many other similar ventures, are proving that solid business models can address effectively even the most severe societal challenges, combining profit and impact.
We hope that our readers will enjoy this inaugural issue of the report. More research and analyses will follow, with the hope to consolidate the relevance of transition investment in academia and in the financial community. For what has been achieved so far, we warmly thank our sponsors Mubadala Investment Company and Al Maskari Holding, the TIL Steering Committee, and the continuous support from NYUAD leadership.