2024 Summer Roundtable
INSIGHTS
The Pacific Pension & Investment Institute (PPI) convened in Europe for the first time from July 10-12, 2024. The Summer Roundtable in Amsterdam introduced European perspectives on geopolitics, sustainability, and technology and how these global forces are driving the evolution of investment markets. Conflict and security in Europe were front and center as the war in Ukraine may be at an inflection point. This, coupled with the increasing popularity of the far right in Europe and the possibility of a second Trump administration in the U.S., has cast doubt on Western resolve.
Economically, Europe remains a global powerhouse, with a population of over 440 million and per capita GDP approaching 40,000 USD. While EU structure and the consensus-driven nature of EU policy limit forceful action, Europe’s economic policy choices remain critical factors globally.
CONFLICT AND SECURITY
Europe has not offered a unified response to Russia’s invasion of Ukraine, and current disunity reflects the North Atlantic Treaty Organization’s (NATO) multi-year wavering on the topic. While NATO generally supports Ukraine, Vladimir Putin’s motivation has much more profound and longer-lasting roots: he aims to reestablish the historical Russian Empire, which he believes includes Ukraine. The revitalization of the Russian Empire is paired with a conservative Russian ideology that demonizes the corrupt West and Islamist extremism. Putin views his personal history as a former KGB agent driven from East Germany at the fall of the Berlin Wall and USSR as a precursor to the current geopolitical struggle, in which he must remain resolute.
Logistically, Russia’s war effort is well-resourced by the financial windfall of Russia’s significant energy exports and military support from Iran and North Korea. In contrast, the leadership of Western democracies can be fickle and buffeted by the rise of far-right extremism and isolationism in Europe and the United States.
Meanwhile, nuclear nonproliferation is collapsing. Nuclear weapons serve as a safeguard for autocratic leaders like North Korea’s Kim Jong-un, and increased tension in the Middle East further incentivizes nuclear weapons development in Iran. Effective U.S.-Russia de-escalation mechanisms exist, but other global flashpoints, such as potential conflicts between the Philippines and China, pose risks not limited by the long-established guardrails and communications methods that help contain potential U.S.-Russian conflict.
ENERGY SECURITY AND SUSTAINABILITY
Policymakers face a “trilemma” in setting energy policy: while energy security, sustainability, and affordability are all desirable goals, current energy technology, economics, and political reality typically prevent the concurrent fulfillment of all three criteria. Historically, Europe has emphasized sustainability, yet the conflict in Ukraine and a challenging economic environment have shifted emphasis to security and affordability.
While renewable energy technologies may offer the potential to break the energy trilemma, they still depend on solar panels and rare earth materials, which are typically sourced from China and may present security challenges. Despite the conflict in Ukraine and rising prices, natural gas remains a key and growing source of Europe’s energy.
Other energy sources or solutions may offer better security, sustainability, or affordability but require significant capital investment and multi-year lead times. These alternatives include offshore wind, long-duration storage, increasing grid resilience, and nuclear reactors. In the meantime, natural gas will fill the gaps.
INDUSTRIAL POLICIES
Europe is a significant global trading bloc, with a population of over 440 million and a GDP per capita approaching 40,000 USD. Compared to the U.S., Europe is more diversified across global trading relationships, with 40 large trading partners, in contrast to the more concentrated US base of 20 major trade partners.
Yet, for Europe to lead globally as a cohesive economic force, it must find collaborative leadership from its major economies. France and Germany, united, can effectively lead European industrial and trade policy. However, recent elections in France demonstrate the unpredictably rising and ebbing influence of the extreme political right and left. Meanwhile, Germany’s broad ruling coalition may inhibit firm German policy leadership. Without leadership from Europe’s two traditional powerhouses, new blocs may emerge: a collection of Northern European or Baltic states may guide the European agenda.
Renewed European leadership may need to tackle significant internal challenges before the bloc’s influence can be exerted abroad. Energy prices in Europe are two to three times higher than in the U.S. or China. Tackling this challenge via investment in the grid and the renewable energy value chain—for example, by increasing European lithium mining capacity—may be a necessary first step.
Demographic decline presents a need for additional labor, yet anti-immigration rhetoric threatens any resolution to the labor shortage. Fortunately, Europe may continue to import skilled labor out of economic necessity despite the heated political debate on the topic.
Finally, while Brexit threatened European unity, the practical challenges the United Kingdom faced following its departure may have had the opposite effect and deterred future defections from the bloc.
EUROPE-CHINA TRADE TENSIONS
Europe, as a large, consensus-driven trading bloc with a wide diversity of trading partners, historically has and continues to be a trade-oriented economy. While geopolitical tensions with China are rising, and Europe and China are directly competing in strategic sectors such as electric vehicles and the renewable energy supply chain, there are also incentives for both partners to maintain cordial trading relationships.
The electric vehicle (EV) sector provides examples of the multifaceted aspects of competition and collaboration. Both markets produce EVs, and tariffs or subsidies related to the industry are hotly contested. Similarly, strategic elements of the supply chain, such as cobalt mining, battery manufacturing, and rare earth metal refining, are also perceived as strategic and crucial to national and economic security and consequently are contested.
However, substantial collaborations exist within the sector among automakers, suppliers, technology providers, and other players. Ultimately, automakers are incentivized to cooperate, as access to each other’s markets is critical to corporate success. Corporate lobbying for continued market access can be significant across Europe, and Germany, Europe’s largest economy, is export-driven and dependent on access to the Chinese market.
Factors external to Europe and China may also harm the relationship, especially China’s perceived support for Russia’s invasion of Ukraine and the economic and security threat that Russian belligerence poses. U.S. pressure on Europe to take a tougher stance on China, likely from either a future Republican or Democratic administration, may also be a determinate factor.
THE FUTURE OF EU-UK RELATIONS
Brexit was a politically motivated, contentious, yet highly technical process. Despite these challenges, the UK’s departure from Europe has proceeded smoothly enough to leave substantial goodwill for policy collaboration between the UK and Europe. This is fortunate given that the UK and Europe share many economic, political, and security objectives and are incentivized to collaborate opportunistically.
In climate negotiations, Europe and the UK are aligned and can exert more influence on global policy, working together than working separately. An additional substantial area of potential cooperation is security. External factors, such as Russia’s invasion of Ukraine, have accelerated this cooperation. Beyond responses to such crises, security cooperation could also extend to more technical and policy-driven efforts, such as collective defense procurement. Other less high-profile areas may present the most accessible opportunities for increased collaboration, including coordination on data privacy regulation and agricultural data sharing.
CLIMATE POLICY
Europe has established itself as a climate policy leader over the past few decades, and its carbon emissions have declined about 1/3 from 1990 levels. Europe has demonstrated technical leadership by implementing climate standards across industries and has been a leader in establishing a corporate reporting framework for sustainability.
Further progress depends on breaking the “tragedy of the horizon,” i.e., making incremental progress on material issues over a horizon longer than a typical policymaking cycle. Regulatory stability will be essential to such progress. However, the rise of extremist parties is increasing policy uncertainty.
Subsidies and trade dynamics outside of Europe can also destabilize Europe’s climate progress. For example, subsidized biofuel imports from China have recently reduced European investments in the sector.
Achieving further carbon reductions in emissions will require increasingly sophisticated climate policy implementation. For example, carbon border tariffs will be necessary to equalize the external cost of high-emission products, such as cement and steel, produced abroad. Such policies require long-term planning, coordination, and robust carbon emissions data.
The United States has implemented significant climate legislation with the Inflation Reduction Act. It is investing heavily in clean technology and infrastructure, and such legislation may enable it to close the gap with Europe gradually. While Europe’s climate spending is significant, the bloc cannot implement fiscal policy at the European level. Instead, it must focus on national-level fiscal policy and implement more sophisticated pricing mechanisms and carbon trading systems rather than subsidies. Leveraging pan-European institutions like the European Investment Bank may also allow Europe to implement complex risk-transfer mechanisms and other investor-oriented solutions to support green growth.
INVESTING IN WATER INFRASTRUCTURE
Current global investment in water infrastructure totals about 250 billion USD annually, and the international investment needed to provide clean water and sanitation for the world’s entire population approaches 1 trillion USD annually. Approximately 80 percent of the world’s population cannot access potable tap water. Increasing investment is complicated by climate change, shifting infrastructure needs, and the sector’s global fragmentation.
Technology allows shorter-horizon and smaller-scale investments to improve water infrastructure. Innovations include using smart meters and deploying AI and acoustic sensors to reduce water leaks and improve infrastructure efficiency. However, most investments, like desalination, are large-scale and long-horizon.
Market innovations will also help speed the modernization of investment in the water sector. In areas of water scarcity, gray water and wastewater will become tradable commodities, and their use in agriculture and industry will increase. Public-private partnerships are also expanding in the water sector, and the build-own-transfer infrastructure model is spreading and drawing in private-sector capital.
Ultimately, given the sector’s fragmentation, the most impactful and scalable method for investors in the water sector may be to invest in operating companies and improve their water use.
INNOVATION AND VENTURE INVESTING
Europe’s technology investment landscape is robust, with ample early-stage venture capital investment. With an existing emphasis on sustainability and an established regulatory environment, this capital availability can attract technology talent to the European market. However, capital is less available in Europe for later investment rounds, which may limit the ability to scale businesses in Europe past stage C in the venture and growth stages. Capital scarcity may drive later-stage companies to seek capital in the U.S.
There are also cultural changes taking place in Europe. The rise of the tech sector and generational change are causing some European markets, including the Netherlands, to become more entrepreneurial. While AI innovation may remain controlled by large businesses because of the high capital cost involved, the benefits of AI application may extend throughout tech and other sectors in the coming years.
Europe has implemented more significant artificial intelligence regulation than the U.S. market. The regulatory environment in Europe is more substantially related to AI and other aspects of technology, and more generally, Europe has a more robust regulatory environment across multiple sectors, such as sustainability. This regulatory approach has strengths and weaknesses, but on the positive side, it provides greater stability.
PRIVATE CREDIT AND PRIVATE EQUITY
While the global economy has remained solid, several measures of activity in the European private equity market—IPOs, distributions, fundraising—have remained sluggish. The European market has remained slower than the market in the U.S., both because it is smaller and less mature and because local economic conditions have been less favorable. In many ways, the European market feels “stuck” with a unique set of economic challenges, slowing exits and growth.
Investors have turned to the secondary market and innovation in response to these challenges. The secondary market is growing quickly based on LPs’ overallocation, boosted by strong performance and a lack of exits over prior years. The market has grown from approximately 20 billion USD in 2010 to about 100 billion USD, and the growth trajectory remains equally rapid.
Continuation vehicles are emerging as an additional method for GPs to generate liquidity for LPs, and the market is growing quickly. The structure for continuation vehicles has shifted from a tool for GPs to manufacture an exit to one that can transform GPs and LPs into actual owners who aim to create corporate value over the long term.
TAKEAWAYS FROM
ASSET ALLOCATORS
Asset allocators highlighted investment risk focused on increasing policy and geopolitical uncertainty. These risks magnify one another, with geopolitical uncertainty presenting a wide range of potential outcomes. The diminished incentives for nuclear nonproliferation and resultant catastrophic risks are chief among them. Global investment needs across the various topics discussed in Amsterdam—water infrastructure and climate—also present real risks. Still, they are long-term and less abrupt than geopolitical conflict.
AI and technological innovation offer promise. Given its high development cost, large-scale enterprise-level applications of AI present the most immediate opportunities for increased efficiency.
The changing global risk environment has caused allocators to reconsider several aspects of their investment models: benchmarking methods are changing, and approaches to diversification are evolving to incorporate new risks. In an uncertain economic environment where fundamentals around entire asset classes such as private equity are being considered, CIOs are contemplating even more dramatic revisions to portfolio construction, including approaches based not on asset classes but on themes discussed during the seminar.