The energy transition is coming of age and it’s clear why, with renewable technologies maturing and their costs falling allowing much larger applications in the energy mix beyond subsidy-based projects.
Renewable energy developers can now be found in every corner of the planet, far from the sea, deep underground and even in cities. Capital committed to renewable energy projects has increased in both debt and equity markets, albeit with a focus on commercial-scale developments.
Impact funds that invest in public markets have attracted more than $1 trillion in capital commitments from investors, according to a recent report from S&P Global. The IEA meanwhile predicts that this number will double over the next few years to meet the demands of a low-carbon economy.
But with maturity comes some hard truths. One of those truths is that as investors flock to the commercial-scale renewables market, returns are inevitably being squeezed. Large investors will be especially affected by this as they continue to look for ever larger projects to tackle dry dust accumulation.
The UK offshore wind auction, which saw no successful bids, is an object lesson in why this is an issue for all of us. Investors rightly objected to the prices offered, believing they were not being adequately compensated for the risk they were being asked to take. This dynamic means that large-scale projects are becoming increasingly challenging to find.
Big and not so pretty
Smaller-scale projects (distributed generation) at end-user premises can sell power at much higher retail rates. But the problem here is that distributed generation projects are too small for institutional capital. Without means of aggregation, these projects are uninvestable for these large investors.
Historically, in more mature parts of the energy market, asset owners would have moved into the mid-market in search of a more attractive yield, but this shift has yet to occur at scale in the renewable energy space.
One reason investors have not done so already is that there is an artificial line between investment types that does not reflect their risk-adjusted returns. Investors derive infrastructure investments from private equity allocations even when these investments may essentially be in an identical portfolio of assets.
Mid-market energy companies’ approach to transition and the investment solutions they offer do not sit well within private equity allocations, so general investors are failing to identify them, while energy specialists in the infrastructure investment space are focused on large-scale and low-yield projects.
The problem with dry powder
Finding projects that meet the requirements of asset owners is also not easy. While fundraising is challenging, especially in this environment, it’s an open secret in the industry that the bigger the fund, the harder it is to part with.
Limited partners want exposure to high-growth areas and want their allocations to the private markets and energy markets to be uncorrelated with their returns in the public markets. Armed with this mandate, these firms must search for, and often do not find, projects that meet this criteria.
If you think about this problem another way, the money that is dedicated to these unallocated funds is money that could be used to finance other projects. Not only is this inefficient, it’s also losing money for these investors and failing to address climate change.
Big projects may get all the headlines, but most of the rapid progress we’ll see in renewable energy will be in the mid-market where capital can be deployed quickly and efficiently.
To access this opportunity, asset owners will need to have a holistic view of what it means to be a renewable energy investor. The changing investment environment would suggest that they act more holistically and target the best return opportunities rather than adopting myopic thinking about artificial differences between their allocations.
Private equity firms that invest in smaller-scale renewable projects are better able to take on construction risk, operational risks and operate as large companies in the aggregate, with returns that compare favorably with many infrastructure funds. However, they fall into a definite rift when investors are considering where to allocate funds.
Breaking this siled mindset can unlock huge amounts of capital for the transition, and investors don’t even have to look far back in time to find an example of when they’ve done this kind of exercise in the past. Private debt, now the darling of institutional investors, used to not fit well into fixed income allocations, nor did it fit within private equity allocations leaving these investments in limbo.
By creating space for this new type of investment, asset owners opened up a profitable new sector that they are now reaping the benefits of – a lesson we can learn in the renewables space.