Catching the First U.S. Wave of ESG Investment: Lessons Learned and Challenges Ahead

Values-driven or ESG-focused finance, despite its nascency, is already ubiquitous and vast (measure in trillions). While new ESG equity indices, and the performance of ESG-focused companies, have channeled investment, they remain inadequate to satisfy investor appetite. As a result, pressure on private equity ("PE") fund managers and general partners to increase investment in ESG-focused platforms has grown. With this rapid increase of ESG investing, certain trends and lessons have emerged.

First, passive investment is anathema to mission-driven ESG investors. The types of investors that are making ESG a priority want more control and collaboration than traditional limited partner ("LP") status typically affords. To bridge this disconnect, PE funds have relied on LP advisory board participation, side letters, and co-investment structures.

While use of such structures will grow with ESG investment demand, reducing the LP control gap remains a notable differentiator among funds. Likewise, the focus on control—and collective action—will drive evolving investment models and structures. ESG investing will begin to find traction in alternative finance models—e.g., syndication and securitization vehicles—notwithstanding the complexity and opacity of some of these structures.

Second, ESG investments will continue to be driven by innovation—a core attribute of leading ESG investors. These investors expect innovation to inform fund behavior and to drive solutions. Few funds today can do without an ESG policy, but those policies must be as innovative and solution-oriented as LPs expect, particularly in defining and measuring investment success. Indeed, measurement uncertainty is an innovation gap that investors expect funds to surmount and share. Reliable, verifiable ESG metrics will need to be addressed and implemented on a regular basis, likely modelled on fairly advanced efforts in the clean energy, water, and climate sectors.

Third, public-private partnerships remain underused in the ESG investing space. As venture capital funds and clean energy developers have long known, public-private partnerships ("P3s") can drive success. Governments and sovereign funds offer a quiver of high-quality arrows to advance the deployment of ESG-focused capital, particularly for infrastructure projects in developed and developing companies, such as the wind, solar, and storage projects that have dominated new global installed capacity for almost a decade. The spectrum of nondilutive government grants to loan guarantees, not to mention concessionary capital, has been too little understood and used in the broader ESG investing space to date. Such underutilization should dissipate, as demand for sustainability investing continues to grow.

Finally, ESG standards, criteria, and metrics are an overstated barrier to values-driven investing, at least in clean energy. The ability to measure the effects of greenhouse gas and other air emissions from power generation with accuracy, combined with the clean energy sector's ability to deliver on metrics, is occurring at an inflective moment for the broader ESG market. As a result, clean energy projects are a key target of ESG investing, and they offer the scale, P3 potential, and capital demand suited to ESG investors today. This dynamic will continue to accelerate as we near the end of tax credit-driven finance, particularly tax equity investment in the renewables sector.

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