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The emerging cycle of energy transition and climate investing is being “born in the dark.”
Published: April 18, 2023
While impact funds operating in public markets have attracted more than $1 trillion in capital commitments from investors, it is the $260 billion raised for targeted private equity funds that may have the bigger impact on the speed and shape of energy transition and climate infrastructure rollout over the coming decade.
The emerging cycle of energy transition and climate investing is being “born in the dark.” While impact funds operating in public markets have attracted more than $1 trillion in capital commitments from investors, it is the $260 billion raised for targeted private equity funds that may have the bigger impact on the speed and shape of energy transition and climate infrastructure rollout over the coming decade.
Both traditional private equity firms and new private capital platform structures at firms such as Brookfield Asset Management or Apollo Global Management Inc. are committing tens of billions of dollars to energy transition funds and cleantech. The prerogative of limited partners has pushed many private equity funds to invest in the energy transition. Firms have grown increasingly sophisticated and have adapted well to the evolving challenges of energy markets, adopting longer time horizons for some funds and launching multifund strategies. This enables privately backed energy companies to maintain funding and stay out of public markets from an early, pre-revenue stage through to an investment-grade credit play.
Freed of the obligation that publicly owned companies have to regularly report on operational and financial performance, a business can focus on a longer time horizon. The absence of this data makes it challenging for investors to value these investments against other public or private companies.
Large investments made by energy companies require patient capital and a nuanced understanding of complex value chains. New energy assets have extraordinarily long tail repercussions for energy markets and the larger economy. An investment of several billion dollars in an LNG terminal, a hydrogen facility or a battery metals refining facility requires a minimum of several years of operations before investors see a return. While these assets tend to have very long operational lives that provide long-term returns on capital, patience is not a strength of public markets. To fund these investments, private equity firms have developed longer capital cycles by maintaining ownership in energy assets at different stages of development and maturity within their portfolios.
For energy and natural resources investors, the absence of data in private markets can create unexpected challenges. Take the example of an investor trying to forecast the installation of wind and solar in various power markets around the world. The quantity of wind and solar power added to grids in global power markets has been consistently higher than consensus forecasts by a double-digit percentage in the past few years. For a firm traded in public markets by funds with energy transition mandates, capital expenditure monitored by those funds would be publicly disclosed and available within forecasts for the entire energy market. The availability of those public filings for investor use would make the ultimate flow from allocation into infrastructure deployed more transparent. The numbers are available in public filings. But when a private equity-backed company buys a thousand solar panels and puts them on the ground, an investor will not necessarily know until a power purchase agreement is made public in a regulatory filing or solar power is being delivered onto the grid. Investors or regulators who only look at public markets to anticipate supply are missing critical data. From a pricing perspective, this can lead to capital misallocation due to the inaccurate assumptions created by including certain price and asset deployment curves in models.
Public equity funds that buy shares and map their environmental, social and governance performance against targets or the broader market find their investments are not easily correlated with changes in corporate capital expenditure that impact the fundamental supply-demand picture for the energy transition. Private funds seeking outsized returns by more effectively pricing cleantech and climate risk in their investments have consistently backed projects and firms that directly impact energy transition fundamentals.
Private markets and cleantech are currently a good match because of the misalignment of returns and capital requirements. Cleantech generally requires large, up-front capital expenditure based on anticipated revenue. Qualified private investors are more likely to take and be able to afford that risk. These investments do not necessarily suit the retail or institutional investor who customarily invests in the public markets. Ultimately, these dynamics may result in more of an overlap of investment activity between public and private markets as energy companies make use of both public and private capital while the markets develop.
Private equity funds that target energy transition and climate infrastructure investments have deployed only a fraction of the capital they have raised. Their fundraising significantly outpaces their deployment, even as investment out of funds has steadily accelerated, public sector support has become increasingly generous and the broader fundraising environment has been difficult. Given the influx of private capital into green energy, private equity funds in this space are taking on different risks, which can contribute to lower outright returns.
General partners and limited partners in private markets are both captives of the fundraising cycle. Limited partners seek exposure to high growth areas and have allocations to private markets and energy markets. General partners either accept investment from limited partners when it is offered or risk losing potential future investment allocations to a competitor. Once a fund has closed, the private equity firm is under pressure to either invest out of the fund quickly or risk returning allocations to the limited partners.
This cycle may not match up perfectly with a pool of desirable investments in the energy and cleantech sectors. The influx of private investment in these sectors over the past five years has created a substantial capital overhang referred to as “dry powder.” While an overabundance of money sounds like a good problem to have, it has caused issues for the burgeoning cleantech industry. When lots of investors are competing for the same asset, the price goes up.
Some believe this dynamic has led to a valuation bubble in cleantech. Asset valuations have undoubtedly risen quickly, scuppering a few deals in the last six months. Some cleantech transactions have been called off because the underlying price changed before the deal was completed. This is good news for private equity firms that already own assets such as wind farms, bad news for firms with money to invest and a complicated situation for firms that are both holders and buyers of cleantech assets.
There are a range of estimates for dry powder currently waiting on energy investment opportunities, and the amount of available capital is probably higher still. Institutional investors and sovereign wealth funds have orders of magnitude more money to allocate to private equity if they believe in the opportunity. There is no shortage of money for cleantech investment if the market stays frothy.
Bubbles are not always bad things. For the past 30 years, there has been notable underinvestment in energy infrastructure. To some extent, current inflated prices will incentivize investment to catch up with infrastructure needs in the US and Europe. That may lead to the overbuilding of some energy assets, but eventually it should lower energy prices overall, promoting economic growth. Governments are offering substantial subsidies that allow private equity firms and the owners of these assets to de-risk infrastructure investment. A degree of investment capital misallocation may be the price we pay to modernize the energy grid.
Being able to avoid constant revaluation may cushion private equity portfolios as they take on more technology and market risk, but it also raises questions about how far private valuations are from market value, and it increases the risk of dislocations that could feed into broader markets.
Europe, the US, China and India have clearly signaled that they are going to compete in the cleantech economy.
The 2022 Inflation Reduction Act signed into law by US President Joe Biden was criticized by EU politicians for favoring cleantech from American firms. European and Chinese governments have histories of supporting their own cleantech industries through policy, demand creation and public/private partnerships. Because a lot of these technologies are being developed and funded by companies that have remained in private market ownership structures, particularly in the US and Europe, this growing geopolitical competition has prompted investors who want exposure to these growth areas to turn to private market funds.
Two divergent trends are shaping the energy transition. Through the Conference of the Parties process and Paris Agreement on climate change-alignment, almost the entire world is now, at least rhetorically, committed to the energy transition. This process demands reindustrialization through investment in new infrastructure that is clean, digitally enabled and fits into a more efficient and climate-hardened economy. All major economic blocks signed up for this change, even if the specific mechanisms are politically controversial.
The flip side is that not every country can capture the value created by this transition. There will be winners and losers in technology and manufacturing. Governments are attempting to boost their individual economic growth pathways by directly investing in cleantech infrastructure.
Since the passage of the Inflation Reduction Act, investment that might have gone to other sectors has been redirected. Money earmarked for investment in hydrogen production in Europe may now be shifted to hydrogen production in the US, and European companies with plans to open facilities in both markets are now accelerating their US development timelines. This is advantageous for US companies and US markets, allowing them to capture a big piece of the global market for hydrogen, but other regions risk being dependent on the US for energy in the future, just as they are currently dependent on Middle Eastern oil-producing countries. The energy transition, even if it results in meaningful climate action, will not change human nature — countries and economies will still compete for markets and influence.
Governments have largely held back from directly building clean energy infrastructure. The US is incentivizing the creation of clean energy assets through the tax code and tax credits, meaning a market action must be taken before a qualifying tax credit can be issued.
Around the world, governments are attempting to de-risk the production of clean fuels. The US federal government has proved agnostic about who will benefit from these incentives. Tax credits will aid large oil companies that want to transition into hydrogen and carbon capture. Private equity firms have been moving aggressively into cleantech because the de-risking of production allows them to potentially generate higher returns with less downside. A lot of cleantech incentives are flowing into private equity-backed companies for the simple reason that private equity firms have dry powder ready to commit to new projects or already own the clean energy firms that could benefit from policy changes. As governments try to incentivize clean energy investments, private equity looks to increase its exposure to them.
There is little doubt that a much higher proportion of the energy economy will stay in private hands than in the past. Incumbent incentives to exit into public ownership are no longer so universal. There will still be IPOs of private firms, and there will certainly be a lot of M&A activity as those newly public firms use their equity to buy established ones. But private capital as a guiding force in the energy transition is here to stay.
This phase of acceleration in the energy transition may be the first major industrial and technology investment cycle that occurs primarily in opaque private markets dominated by private equity funds and specialty asset managers, rather than through capital raises in public equity markets.
The Inflation Reduction Act will boost these markets. Developed and middle-income economies are focusing investment away from consumption at the services level and back toward industrial infrastructure investment. Except for China and South Korea, most economies have done little for their industrial base over the last 30 to 40 years. Energy infrastructure investment has long lead times, but the acceleration of activity over the past six months has been remarkable. There were zero hydrogen deals six months ago, and now there are dozens. There was also only a handful of utility-scale battery plays, and now there are well over a hundred. This pace will only pick up.
In the immediate term, the biggest private equity firms will get bigger. The capital expenditure requirements for cleantech energy investment are massive. Smaller funds will be limited to investing in midsize firms that may be unable to take advantage of scale or government incentives at the same level. A huge amount of capital is required to develop, own and operate energy and industrial assets of all kinds, and only the biggest private equity firms can commit for the longer term.
There remains a misunderstanding that private equity firms are investing in cleantech energy infrastructure due to an ambition to achieve net-zero carbon emissions. The concept of a single, global movement into a climate-friendly and cleantech-enabled capitalism was always a political conceit rather than a grown-up investment thesis, but it took hold as a global investment theme during the last two years.
Now, the investment story for energy is increasingly one of superior technology. In many cases, modern cleantech is significantly more efficient than old energy sources. While estimates differ according to battery type and usage, battery-powered electric vehicles can be 300% more efficient than internal combustion engines due to improved performance and a lack of heat loss. When you turn on a wind turbine, energy appears with zero ongoing fuel cost. A giant solar farm is pretty much self-sufficient once it is operational, while it takes dozens of highly trained and highly paid individuals to operate a coal-fired power plant.
This efficiency-boosting role for cleantech in the energy economy is still being tested. Fifteen years ago, these technologies were new, and each project was expensive to deploy. But we have reached the point of turning energy production into a manufacturing, rather than a resource extraction, process. This is a very different type of economic consideration — one that private equity firms with lengthy experience in technology and innovation are well placed to profit from.
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