Managing capital risk in the race to net zero

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The race to net-zero emissions has begun, and the Great Reallocation of capital is underway.1Playing offense to create value in the net-zero transition,” McKinsey Quarterly, April 13, 2022. In addition to the moral imperative of reallocating capital to help progress the goals of the net-zero transition, a growing number of asset owners and investors are responding to the fact that conventional strategies can offset only some of the factors causing climate change. Yet the path to change is not so straightforward: stakeholders are demanding rigorous and transparent reporting, and the public is alert to any hint of greenwashing.

Heightened uncertainties are an inevitable part of capital reallocation, and many of the most pressing uncertainties around the net-zero transition are related to capacity. To begin, 30 million new jobs in renewable energy and energy efficiency must be mobilized by 2025.2 Production capacity of the materials required to ramp up renewable power must also be increased. Other uncertainties are associated with scaling new or significantly improved technologies at a far greater pace than past prudence has allowed.

Navigating this hazardous mix of speed and uncertainty will require asset owners and investors to come face to face with the net-zero capital expenditures conundrum: how to make prudent and profitable investments while addressing the effects of climate change. This conundrum is further conflicted by uncertainties over which owners and investors have limited control.

Key difference: Risk vs. uncertainty

The terms “uncertainty” and “risk” are often used interchangeably, but some studies define them differently. An uncertainty is created by a range of possible outcomes for which probabilities cannot be reasonably estimated. A risk, in contrast, is created by an event for which the probability of occurrence—and the impact if it should occur—can be reasonably estimated. This distinction is particularly important for net-zero portfolios, where capital investments are often exposed to higher-than-normal levels of uncertainty. Although the goal of both uncertainty and risk management is to maximize the probability of success, they are often managed using different strategies.

Let’s start with uncertainty: Imagine an asset owner planning to approve funding for a portfolio of renewable-energy projects. Looming legislation could change the current tax incentives on which the project’s economics depend. Despite extensive scenario planning, the owner can provide neither useful estimates of the probability of each scenario, nor the potential impacts on tax incentives. This is why the goal of uncertainty management is resilience, mainly stress testing via scenario planning, off-ramps, and investments in real options.3

Next, let’s consider risk: Imagine the same asset owner negotiating a renewable-energy project with a site owner. The asset owner identifies a medium risk of an unfavorable negotiation outcome—for which the impact would be high. In this instance, the goal of risk management is mitigation by reducing the probability of the most critical risks and the impact they would have if they should occur. Mitigation techniques the asset owner might use include risk surveillance, probabilistic analysis using Monte Carlo simulation,4 and a risk register.

Uncertainty surrounds technologies and market incentives crucial to net-zero portfolios

Unraveling the net-zero capital expenditures conundrum starts with deconstructing uncertainties in the capital expenditures portfolio. Net-zero financing road maps published by the UN Framework Convention on Climate Change (UNFCCC) provide a useful way to look at net-zero portfolios in terms of business risk and uncertainty (Exhibit 1).5

Of the decarbonization archetypes, maturing technologies in emerging markets will need the lion’s share of global investment.

Each decarbonization project archetype will require rapidly scaling new or nascent technologies. For example, carbon capture, utilization, and storage (CCUS) technologies will be critical to fighting climate change—but reaching targets will require CCUS to grow by a factor of 20 as soon as 2030.6 Another critical but nascent technology, direct air capture, will need to be scaled from 5 metric tons (MT) of CO2 per year today to 980 MT CO₂ per year by 2050.7 It’s an ambitious leap.

Already, the rapid transition of the transportation sector to battery electric vehicles is requiring huge investments in battery technology and manufacturing and in charging infrastructure. Overall, the transportation sector is responsible for 24 percent of direct CO2 emissions from fuel combustion, and it is also undergoing significant transformation.8

Other new technologies are required as well. Consider aviation, which is arguably the most difficult form of transportation to decarbonize and is therefore an important part of the net-zero-emissions puzzle. The demand for jet fuel is expected to double by 2050. One solution is drop-in sustainable aviation fuel (SAF), which can be used with no changes to aircraft or infrastructure. Recent research shows the viability of wet waste as a source of SAF, and airlines are working with scientists to make SAF a reality.9

That said, rapid scale-ups can create “valleys of death” for investors, which require some form of government guarantee to reduce uncertainty. Decarbonization projects are already creating major challenges to supply capacity for commodities such as lithium, copper, nickel, and cobalt, as well as critical metals such as tellurium, which is essential for solar photovoltaic cells. Although the supply of tellurium increased by 130 percent from 2010 to 2020, a further increase of 850 percent will be required by 2030 to meet the energy transition demands expected today.10The raw materials challenge: How the metals and mining sector will be at the core of enabling the energy transition,” McKinsey, January 10, 2022. And it’s far from clear what the source of these additional supplies will be.

Different archetypes can illustrate various types and levels of uncertainty (Exhibit 2).

The maturity and scale-up of new technologies affect market uncertainties.
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Public–private collaboration can help resolve uncertainties surrounding net-zero investments

Stable and effective public policy can play a role in translating business leaders’ commitments into concrete investment decisions. Business leaders have an increasingly important role to play, and new ideas on how and why to play that role are evolving, as illustrated by the examples below.

Business leaders are trusted—and expected—to lead on climate change

The 2022 Edelman Trust Barometer (a survey of 36,000 respondents from 28 countries) indicates that societal leadership is now a core business function; people want more leadership from business, not less. For example, 68 percent expect CEOs to inform and shape policy debates on global warming and climate change. While business is rated a competent and effective driver of positive change, most respondents said business leaders are not doing enough to address climate change. The only institutions that saw an increase in public trust were NGOs.11

High-impact coalitions help business and government collaborate effectively

Fighting climate change requires global solutions and collaboration. The United Nations provides one forum for dialogue between government and business, and it has launched numerous public–private initiatives to facilitate the energy transition. For example, the Energy Compact Action Network is a coalition of governments and businesses that has pledged more than $2 trillion in six months to meet energy-transition goals.12

Business leaders today also have new models for addressing societal imperatives. Research led by Rosabeth Moss Kanter, founding chair of the Harvard Advanced Leadership Initiative, recently outlined the role of an emerging organizational form, the high-impact coalition, that reaches across business, governments, and nongovernmental organizations (NGOs).13 Voluntary and relationship-based, these coalitions align disparate actors in support of a moral imperative, such as achieving net-zero emissions.

High-impact coalitions are characterized by open boundaries, which allow participants to engage when and how they see fit. Because proven approaches to addressing global imperatives seldom exist, a “loose-tight” management model keeps structures and rules loose while emphasizing tight relationships. The combination of open boundaries and loose-tight management enables diversity of participation while allowing each participant to work in the most effective way.

If everything seems under control, you’re not moving fast enough.

Mario Andretti, world-champion race car driver

The race to net-zero emissions, like all races, is forcing participants to move faster than they would have previously considered prudent. And, just as in Formula One, the whole world is watching, the measures of success are clear, and the risks are significant. Racing teams all start with the same set of rules—winners are those who execute strategies with the right balance of innovation, consistency, and the management of uncertainty and risk.

Like Formula One teams, asset owners are operating with the same set of rules, technologies, uncertainties, and risks. By starting now to develop portfolio strategies that face risks and uncertainties head-on, asset owners can help ensure the industry moves fast enough to achieve net-zero-emissions goals.

This article is part of Global Infrastructure Initiative’s Voices on Infrastructure.

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