Over recent years, the global push for green energy has gained significant momentum as the signs of climate change have continued to become apparent. We have seen governments around the world setting clear targets to encourage the adoption of clean energy – i.e. low carbon – technology. Committing to these targets is the easy bit, but the scale of transformation required to meet them is enormous.
To have any chance of meeting these targets, continued support for renewable energy generation will be vital as the world transitions towards a lower-carbon economy and away from its reliance on fossil fuels. Therefore, investors have a unique opportunity to pursue both financial and sustainability objectives. Renewable energy investment offers an increasingly compelling financial proposition and one of the best opportunities to help tackle climate change from an emissions perspective. This blog sets out how the renewable landscape is changing, the opportunity this presents to investors, and how that will influence potential solutions.
What exactly do renewable energy managers invest in?
Renewable resources are defined as natural sources of energy that are not depleted by use. So, for the most part, this means investing in renewable energy generation projects such as wind (onshore and offshore), solar, bio energy and hydro (but typically not nuclear). A simple example of an investment is buying equity in a brownfield project (e.g. a fully operational windfarm with no construction risk) with returns driven by the revenues from energy production, often underpinned by government subsidies or corporate power purchase agreements (PPAs) [1].
Nowadays, simply acquiring a brownfield project is not as attractive from a risk/return perspective. Investment managers are now more willing to transact earlier in the process, accepting construction risk in order to harvest the required returns (we will pick this up again later).
We are now also seeing investment managers allocate parts of their portfolios across the entire energy value chain e.g. investing in new technologies such as battery storage and technologies that focus on the distribution of electricity, in the search for attractive yields and new opportunities.
There are fundamental forces that are helping drive the transition to a low-carbon world:
1. Increased demand for Clean Energy
As governments and corporates drive towards a low-carbon economy, it is inevitable that the demand for clean energy will increase. Whilst this is not particularly surprising or insightful, the sheer scale of the predicted growth is staggering. To support economic growth through to 2050, an estimated US$9 trillion will need to be spent on energy infrastructure [2]. Even by 2024, renewables capacity is set to expand by 1200 gigawatts (GW) [3] – the equivalent of the total capacity of the US. With this macro tailwind, we are already seeing favourable policy changes globally and expect this to provide an accommodative environment for investment and growth.
These key themes are not only influencing decision-making within governments but also within the corporate domain: last year, corporations across the globe bought a record amount of clean energy through PPAs. As many as 100 companies in 23 different countries signed clean energy contracts, amounting to 19.5GW of power, a 44% increase from 2018 [4].
The use of corporate PPAs has grown substantially
[5]
Such opportunities with large investment grade corporates are attractive, with the best managers able to secure long-term price agreements (reducing the volatility of returns).
2. Improved economics
Renewable energy is increasingly becoming a sound economic choice which is starting to drive investment into the space.
In previous years, the costs of renewable energy were significantly greater than that of fossil fuels, rendering many projects unviable in the absence of heavy subsidies. Due to advances in technology, the difference in today’s landscape is stark as the cost ($ per MW) of clean energy has fallen dramatically. The good news for investors in clean energy (and the human race) is that renewable energy is now most frequently the cheapest source of energy generation, despite the lack of subsidies and falling oil prices. More than half of the renewable power generation capacity added in 2019 achieved lower power costs than the cheapest new coal plants.
The upshot is: why would you commission a coal-fired power station over a clean energy project?
Significant cost decline for Renewable Electricity vs. Coal
The falling price of renewables presents a historic opportunity to build a clean, sustainable energy system that helps to combat climate change.
3. A powerful tool to reduce your portfolio climate risk
Whether you are proactive in the fight against climate change or not, climate impact-related changes (both physical and policy-related) will almost certainly affect your portfolio [7].
Renewable energy investment presents a potential opportunity to offset climate risk exposures inherent in your wider portfolio. Further, the investment horizons of many institutional investors are well-matched to the profile of renewable energy assets.
We estimate that every £1 million invested into a renewable fund would reduce your CO2 production by 523 tonnes (the equivalent CO2 production of over 1,000 transatlantic flights) – see following chart. Our view is that this compares very favourably to other routes for aiming to reduce CO2 emissions via investments, such as engagement with public equity and debt issuers.
Greater climate impact achieved in renewable equity funds vs other asset classes
[8]
Does this still hold true in a post-COVID world?
The fallout from the coronavirus pandemic is having a profound effect across all energy sectors. The oil and gas industry have been hit particularly hard by falling prices, which forced drastic cuts in production. Lockdown measures resulted in global energy demand dropping to 70 year-lows; with the IEA [9] estimating that overall demand will contract by 6% over 2020. Renewable sources (mainly wind and solar) have seen their share of electricity generation increase to record levels in many countries. In the first half of 2020, for the first time, Europe generated more electricity from renewable sources than from fossil fuels [10]. Grid operators have sought the cheapest supply sources to balance the lower demand, and this has increased the share of renewables at the expense of more polluting and costly carbon fuels, despite this being a time of relatively low fossil fuel prices.
This positive outlook for renewables has been supported by strong evidence from managers in this space that the income profile has been maintained during the pandemic.
Looking forward, we have seen some EU COVID recovery packages actively encourage spending on the decarbonisation of infrastructure and building flexibility into the grid system, for example improving storage options.
How is the landscape changing and what are the risks facing investors?
One of the most significant risks with investing in renewable projects is exposure to market power prices. Historically, asset owners could mitigate this by purchasing assets which were linked to government subsidies and, whilst there are many available assets still out there, we expect to see fewer assets of this type in future.
There are other ways to manage this risk: one is through the growing demand for corporate PPAs (which we touched upon earlier); another is by going global, for example, the Asia-Pacific region offers very attractive opportunities due to the availability of 20-year feed-in-tariffs [11]. Therefore, despite the overall reduction of subsidies, managers are still able to build portfolios that are supported by strong contracted cashflows and manage the risk of volatile power prices.
Current asset prices also represent a potential risk, as yields continue to compress due to the wall of money making its way into renewables. An increased demand for renewable assets is putting upward pressure on valuation multiples and we are seeing asset returns undergo significant yield compression in many regions across the world. This further supports the case for going global, as it enables managers to consider the relative value of investments.
In today’s market, brownfield (operational) assets are not necessarily the low-risk investment they once were. Due to the demand from core infrastructure and first-time institutional investors, yields have reached a point where there is no margin for error and mitigating any downside risks, due to the lack of operational levers, is becoming increasingly difficult. Greenfield projects have often been perceived as higher risk investments, however, our research indicates that this isn’t always the case. Renewable projects, aside from offshore wind farms, are generally less complex and have shorter construction times than many other infrastructure assets. We also believe that assets acquired at the late development/construction stage offer managers strong opportunities to de-risk projects, via construction contracts & offtake agreements, before a shovel is even put into the ground.
What are we looking for in a renewables manager?
The days of low-hanging fruit in renewables are over (simply buying fully operational assets and living off the cashflows is not going to harvest the returns it once did) but that doesn’t mean that attractive opportunities are not out there.
As the world moves into the next phase of the renewable energy transition, the risks involved will change. We believe the focus should not be on avoiding all risks, but to invest with managers that understand and are best equipped to manage those risks.
From our conversations with investment managers over the last 12 months, it has become increasingly evident that the best opportunities currently lie at the construction and late-stage development phase, however, we also recognise that managing such greenfield projects through to operations does require a specialist skill-set.
It is also clear that different countries are at different stages in their transitions to renewables, reflecting supply and demand and the pace at which they adopt new climate policies. Therefore, our preferred route of implementation is through global managers who can take advantage of relative value opportunities and look to avoid areas of overheating. Allocating to managers that have strong local teams and sector experience will enable investors to take advantage of the most attractive opportunities available as the asset class continues to evolve.
What does all this mean for me?
With traditional fixed income assets offering relatively low yields, many institutional investors are in search of alternatives to help meet their objectives. Renewable projects offer a unique opportunity to generate a diversified stream of long-term stable (contracted) cashflows and make a meaningful contribution to the fight against climate change.
That said, with all the flows into renewables, there is a risk of ultimately being left disappointed with the return on investment. It is now more important than ever to select a manager who can realise attractive yields and navigate potential headwinds appropriately.
Provided it is consistent with your long-term investment objectives, we believe an allocation to renewables could be a timely addition to your investment toolkit.
[1] A PPA is a contract between an energy producer and a corporate (e.g. Facebook), whereby the energy producer supplies energy at an agreed unit price for a set time (usually between 10-20 years).
[2] Source: Bloomberg New Energy Finance, 2018 New Energy Outlook
[3] Source: International Energy Agency, 2019 Renewables Report
[4] Source: Bloomberg New Energy Finance, 2019 New Energy Outlook
[5] Source: Bloomberg New Energy Finance, 2019 New Energy Outlook
[6] Source: Lazard, IRENA
[7] This discussion could last many pages so we have tried to keep it focussed for now. Our colleagues will be following up with further thoughts on this topic.
[8] To estimate the CO2 reduction of a renewable equity allocation, we calculate how much electricity the £ investment could generate and then assume this renewable energy source replaces the current UK energy mix. For public equity engagement, we take the carbon emissions per £1m GBP investment in the MSCI ACWI (derived from MSCI carbon intensity) and apply a haircut to account for the fact you would not achieve 100% emissions reduction/company engagement. For debt, the engagement impact is assumed to be lower and an adjustment is made for this.
[9] International Energy Agency
[10] From January-June 2020 renewables (wind, solar, hydro and bio energy) generated 40% of electricity across the 27 EU member states compared to 34% for fossil fuels. Source: Forbes.
[11] A subsidy in which the renewable energy provider will enter in a long-term contract and receive a fixed price per MWh of electricity they supply to the grid.
