When I first assessed the financial merits of a large solar infrastructure project in 2004, the results were not impressive – even though the $75 million investment would have generated glowing headlines for our LPs.
Oh, how times have changed.
In 2015, renewable energy investments in the power sector were 30 percent greater than investments in all other forms of conventional power combined (BNEF, 2016).
As a result of the economic attractiveness of renewable energy, its annual electricity production is expected to grow over 600 percent between 2016 and 2040. During that same period, hydropower, coal and natural gas power production are projected to grow roughly 27 percent, 11 percent and 0 percent respectively (BNEF, 2016).
Why is renewable energy infrastructure growing so quickly?
First, let’s be clear: capital allocation to this sector is not about sacrificing market-based returns in favor of lofty environmental or social missions.
Instead, investors run the gamut from niche private equity firms and publicly traded companies to the biggest banks in the world and diversified asset managers. As examples, Goldman Sachs, Citi and Bank of America have made public commitments to invest $350 billion in renewable energy by 2025.
The key drivers include:
● Falling costs of capital to finance renewable energy infrastructure
● Falling costs of renewable energy components and projects
● Increasing national renewable energy targets, policies and incentives
● Changing public sentiment
Consider some examples:
● The number of country-level renewable energy targets is up roughly four-fold – from 43 countries in 2005 to 164 countries in 2015. Interestingly, developing countries account for 80 percent of these targets (IRENA, 2015).
● The levelized cost of electricity (LCOE) for solar has fallen 82 percent since 2009. See Figure 1 below from Lazard.
Figure 1: Falling costs for solar power (Source: Lazard)
What is holding back renewable energy deployment?
There are several factors, but we will focus on misperceptions regarding risk and return.
Despite the mainstreaming of this sector, I am surprised by the persistent negative perspectives I hear about this sector when I speak at investor conferences and talk with potential new investors.
I believe this is due to the disproportionate influence of three factors:
● Subversive yet isolated retroactive renewable energy policy changes, such as retroactive cuts to feed-in tariffs in Spain and Italy.
● Poor venture capital returns in the late 2000s, such as bankruptcies by solar panel makers such as Solyndra.
● Environmental groups are often the sector’s leading proponents. Investors respond to data from Greenpeace differently than if produced by the financial industry.
Renewable energy infrastructure offers attractive risk-adjusted financial returns.
As is well known, most infrastructure funds offer limited downside risks with predictable returns over a long period of time and below average correlation to broader financial markets.
The figure below illustrates how the aggregate net IRR for infrastructure funds (red line) compares to five other asset classes — less variability and above-average net IRRs for the aggregated fund performance shown.
Figure 2: Net IRR for six asset classes by fund vintage: 2004-2013 (Source: Preqin)
While renewable energy investments do not constitute the entirety of the infrastructure category, their fraction of all infrastructure investments has grown two-fold in the last 10 years – from 19 percent in 2006 to 38 percent in 2015 to 54 percent in Q3 2016.
I would suggest that the risk-return profile of the broader infrastructure sector is a respectable proxy of the appeal of the renewable energy sector as well.
Emerging trends in renewable energy infrastructure investing
Most infrastructure investors who are comfortable with this sector place capital only in large solar and wind projects. In mature markets, this creates increasing competition for projects and is partly to blame for yield compression.
As a response, an increasing number of GPs are looking at new ways to raise and place capital with different investment strategies within the renewable energy sector. Here are three areas worth consideration:
● Developing countries
● Energy storage
● Smaller scale solar
Consider some examples:
● Developing countries are attracting greater investor interest due to the potential to achieve higher absolute financial returns and place more capital with less competition among investors. Because of these factors – in addition to higher GDP and energy demand growth – renewable energy investment in the developing world exceeded capital allocation in the developed world for the first time in 2015 (EY, 2016).
● Despite more than 70 different battery chemistries in the lab or in the field, there are far less actual technology risks than many perceive. As an illustration, consider that 96 percent of batteries installed in the U.S. in 2015 were based on lithium-ion chemistries (GTM, 2016). With battery costs expected to fall 40 to 50 percent between 2015 and 2020, market analysts project that battery installations will undergo a 25x growth from today to 2028, with a market valued at $250 billion (Lazard, 2016; BNEF, 2016).
● Growth in the global solar market has been surprising to most international energy agencies and conventional energy giants. For perspective, consider the rise in annual solar installations in the figure below. This market expansion has been dominated by large utility-scale projects. In the U.S., the residential market has also scaled rapidly with more than one million homes equipped with solar. However, the commercial solar market in the U.S. and some other countries have experienced relatively little expansion, largely due to higher transaction costs and challenges in underwriting credit.
Figure 3: Annual solar installations globally (GW). (Source: GTM, 2016)
Don’t look back.
For decades, renewable energy has been relegated to a tiny niche viewed as expensive and irrelevant. Those days are over – yet most investors are still looking backward, not forward. Many do not see the dramatic changes in the global energy mix accelerating right now.
If the goals agreed upon by nearly 200 countries in the 2015 Paris Climate Agreement become reality, the world will need to invest roughly $1 trillion per year between now and 2030 (IEA, 2015). This amount is almost three times as large as today’s annual renewable energy investment.
As the author William Gibson has noted, “The future is already here — it’s just not very evenly distributed.”
By Chris Wedding, professor of the practice of strategy and entrepreneurship and founder and CEO of IronOak Energy, a renewable energy investment advisory and research firm that helps investors place capital in the solar, energy storage and electric vehicle sectors via deal origination, diligence and market analysis.
This blog contains excerpts from “The Mainstreaming of Renewable Energy Infrastructure Investing – Risks, Returns and Emerging Sectors,” published in the November 2016 issue of Preqin’s “Real Assets” newsletter.