Renewables in a time of high energy costs

What impact might high oil and gas prices have on investment in green energy and infrastructure funds?

By Caroline Biebuyck

7 minute read time

The nine-fold rise in the wholesale gas price during 2021 has spooked financial markets. The benign period of wholesale power prices that characterised the past decade has come to an abrupt halt, revealing the risks in energy pricing and delivering a wake-up call to infrastructure funds.

According to Phil Grant, Partner, Energy Advisory, at Baringa, gas prices will drive power costs for the next decade. “A relatively small proportion of the power price today is driven by local factors; 60% – 70% of European power costs depend on actors outside Europe,” he explains. “That relationship will break down longer term, but it’s going to be 10 – 15 years before a decoupling from global to more local influences.”

At the same time, all fund managers, whatever their strategy, are facing up to high inflation for the first time in more than a decade. Rising energy costs are one of the main factors behind the current high inflation rate, putting pressure on central banks to hike interest rates and leading to increased financing costs.

Funds with interest rate hedges will mitigate some of the worst impact of this rise. These hedges are individual to each fund, says Bradley Davidson, ESG Lead at RBS International, but he adds: “Long term, we need to see all funds assessing which of their investments are most dependent on carbon and look at their transition plans to mitigate increasing traditional energy prices as we move to a net-zero economy.”

Renewables returns

Not surprisingly, some funds investing in renewables have fared better than their core infrastructure counterparts during the recent energy market turmoil. This is partly because renewables are less vulnerable to price shocks- especially subsidised projects which benefit from inflation linked payment mechanisms for assets already in operation.

Whilst Power Purchase Agreements – where a utility or business contractually buys electricity directly from a renewable energy generator – have helped to mitigate the impact of low energy prices to generators in the past, we are now seeing increased performance from those clients that have maintained an element of merchant market risk; , says Bryan Fashola, Director of Institutional Banking at RBS International. In addition, some clients who have locked into shorter term PPA’s could now have an opportunity to either reprice those agreements, or consider taking on more merchant risk at the point of renewal in order to maximise returns. This development raises the question for lenders and asset owners alike on whether there is some merit in financing assets with higher merchant risk attributes. Could this be the turning point for renewables and is it possible for increased acceptance of merchant risk to lead to more renewables deployment and contribution to the grid, thereby enabling renewables to dictate future power prices? That is certainly food for thought Fashola says.

 ‘’Although we are seeing funds that have had a more traditional infrastructure remit investing more in renewables to provide a hedge and stability of yield, the higher price of traditional energy, such as fossil fuels, continues to have an impact on the renewables sector given its use in the production process, for instance when making wind turbines. This raises interesting questions about life-cycle assessments” he says.  

 

“Investing in reducing carbon dependency today will pay dividends in the future. There’s increasing evidence that the earlier you act and the more orderly your transition to net zero, the less negative impact you’ll face” 

Bradley Davidson, ESG Lead, RBS International

 

Over time, funds that have a greater influence during the whole process of renewable production will be in a good position to reduce the impact of macro-economic pressures, says Davidson. “These are the funds that have sway throughout the renewable energy supply chain, from manufacturing to transport and logistics as well as energy production. There’s a lot to be said for the huge influx of investment in renewable production, but it would be worth funds looking at the whole supply chain to ask: where are the better investments for growth, and how can they diversify by looking at the end-to-end process?”

Clean energy journey

The perfect storm of low wind generation last year, combined with increased demand for gas, hit the UK hard. But it has opened up opportunities for deployment into different types of technologies as funds that have traditionally looked at more established wind and solar are now looking at battery storage units and energy efficient assets.  

Meanwhile, pension funds – which, historically, invested only in operational assets – are also changing their outlook. “We’re seeing them move earlier into the development life cycle of renewables and take on some of that development risk,” says Grant. “They’re struggling to get access to projects downstream so need to move upstream in order to deliver the opportunities the funds require.”

It has been said that one of the reasons for the current energy crisis is the increased focus on decarbonisation and the subsequent falling investment in fossil fuels. This could potentially be used as an argument to slow the transition to net zero. But Fashola points out: “If you think of renewable energy deployment as a longer-term solution, we should be accelerating towards net zero because energy self-sufficiency could mitigate the impact of rising oil and gas prices.” 

Using energy self-sufficiency as a tool to mitigate geopolitical risk has increasingly come into focus. It is worth noting that arrangements such as Contracts for Difference (CfDs), a government scheme incentivising investment in renewable energy, could help create a natural hedge to high gas prices, Fashola says. For the first time, we have seen substantial payments flowing from renewable energy generators back to energy suppliers which can be viewed as proof that the scheme could help alleviate some of the shocks caused by rising energy costs, with continued incentivisation for renewables deployment also leading to less reliance on external gas supply over time.

The current situation is a good test of the triple bottom line approach to investing, says Davidson. “The energy market now is a perfect example of where society’s climate ambitions need to be incorporated into our measures of value, so that incentives for private markets prevent our historic drive for solid financial value without factoring in the financial impacts of climate change.”

Re-evaluating risk

Where renewables were seen as niche and high-risk investments just a decade ago, they now offer a more attractive and lower-risk proposition suitable for pension funds and insurance companies.

The appetite to deploy capital is very strong, says Grant. “High carbon and gas prices have shown the returns that can be achieved in renewables, and this should accelerate investment. However, these high prices have shown the fundamental volatility in the market and made some question the underlying market structure.”

Davidson points out that some funds still see value in oil and gas infrastructure. “We need to reduce our reliance on fossil fuels, but we still need oil and gas to transition,” he says. “We would like to see investment in the efficiencies of existing oil and gas infrastructure – improvements in transportation and storage that will help the transition to net zero.”

Greater interest in renewables, especially after the COP26 UN Climate Change Conference in November 2021, has led to more fundraising, with competition for funds creating capital-raising efficiencies. Investors are keen on the stable cash flow that renewables offer, which is not subject to the same squeeze on yields found in fixed-interest products. “If you’re looking for something that provides stable long-term yield, but which isn’t correlated with a wider macro environment, you should certainly be adding renewables to your investment mix,” says Fashola. Furthermore, increased investor demand for fund managers to demonstrate stronger ESG credentials via their investments has not gone unnoticed and will certainly drive a switch towards more investment in renewables. The message is clear; Investors want to see more commitment to tackling environmental and social issues, and managers will have to deliver on those commitments.

Davidson says it’s becoming easier for renewables to demonstrate the kind of key performance indicators (KPIs) and sustainability targets that potential investors want. “Investing in reducing carbon dependency today will pay dividends in the future,” he adds. “There’s increasing evidence that the earlier you act, and the more orderly your transition to net zero, the less negative impact you’ll face.”

There are also risks in not adapting to technologies that fit into the new net-zero economy, he says. “We’re starting to see funds clients looking at industries that may not be intrinsically green now, but which have the potential to improve their environmental credentials. Investing in renewable energy is central to this, but there are other types of environmental investments that haven’t had the attention they need.

“Markets want comfort and they want to look at reliable data that evidences value. A lot of newer technologies don’t have those credentials yet. But they will.”

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