Energy transition report
We’ve been living with low interest rates for some years now and let’s be honest – yield compression is omnipresent and has reached all traditional asset classes. But this is not a problem without a solution for those willing to be innovative and go where other investors don’t yet roam. The challenge? It’s not easy being innovative and tackling new asset classes is perceived as risky.
With this short article I want to argue the case for new asset classes within a by now well-known existing one – energy efficiency retrofits and energy storage investments as part of the larger asset class of energy transition infrastructure. Finally, I want to provide an outlook on the coming investment opportunities along the value chain of energy transition.
Today, if we are not overly optimistic, you can expect a return of between 5 percent and 7 percent in most Western European countries when buying an operational wind farm or solar park. Even if you go offshore and invest in one of the large wind farms in the sea, returns max out at 7 percent.
Of course, you can score some additional basis points by ‘believing’ in higher electricity prices in the long-tail of your investment, but I would argue that electricity will not be more expensive in the future than it is today, and that’s partly because the levelised cost of energy of new renewable energy assets continues to fall.
We also see fund managers buying at P50 estimates but let me be straightforward on this: at SUSI, we always calculate at P75 and over the past nine years, on average, we were 0.6 percent above our predictions. That’s a great result, but it shows that the data set is not yet complete enough to calculate with anything less than P75.
Energy efficiency: High yield/low risk
So, where can investors get a more attractive risk/return profile? Let’s talk about energy efficiency retrofits. We introduced a business model in this sector four years ago and since then have invested more than €200 million of equity successfully. We’re not getting double-digit returns, but our investments come with an average investment-grade rating of BBB+.
As such, we are currently preparing our second fund and there still isn’t any serious competition around. Why? Because providing capital, be it equity or debt, is not good enough. What is needed is a contracting model with off-balance-sheet financing. Sound complicated? Well, it’s not, but only once you have gained the necessary experience. In energy efficiency, every deal is different and scalability and project size could be higher. So, it’s not a good environment for direct investments, but for funds it’s scalable enough.
Here’s how our business model works: an infrastructure owner (public or private) wishes to upgrade its infrastructure (e.g. street lights, buildings, technical facilities) but wants to do so without using its balance sheet. Leasing or bank loans still would have to be shown on the balance sheet, so they are not an option.
To achieve an off-balance-sheet structure, a fund provides 100 percent financing for the needed measures and takes the installation (e.g. the street lights, a heating/cooling system, etc.) on its own balance sheet. The fund then enters into a service agreement with the infrastructure owner (e.g. street lighting) and receives part of the resulting savings over a pre-defined period.
The nice thing about this business model is that the savings are guaranteed by the technology partner. Therefore, an energy-efficiency investment has no technology risk and only takes counterparty risk (e.g. the city which needs to share the savings resulting from the new LED streetlights over the next 10 years).
For the fund, the long-term contracting agreement allows for stable annual distribution; for the infrastructure owner, it means energy and financial savings without any capital or balance-sheet exposure and the technology partner is happy selling a project with a 10-year maintenance contract. Last but not least, the CO2 savings are high and easily calculable – it’s a truly ESG-friendly impact investment.
Energy storage: returns like 2008 solar
Another energy transition area where competition is not yet too fierce is energy storage. Solar and wind farms do not necessarily produce electricity when it is needed, so adding decentralised storage capacity to the renewable energy mix is a must.
Before we launched our Energy Storage Fund, we performed a deep-dive together with ETH Zurich, Switzerland’s version of MIT. The research resulted in the SUSI Energy Storage white paper and has guided our investment strategy in energy storage since then.
What we found allows for excellent investment opportunities: various business models generate stable annual distributions and are already today cheaper than fossil-fuel solutions such as diesel generators or gas ‘peaker’ plants, which only run some days per year.
Thanks to the fast roll-out of electric cars, significant battery production capacities have been and are being built. The learning curve and economies of scale make large industrial-scale batteries affordable. Most important, though, is that large players such as Panasonic, NEC or GE provide strong lifetime warranties on batteries and other mature energy storage technologies. With this, the technology risk is manageable and with capacity contracts you can plan cashflows far ahead. Which is why we think decentralised energy storage installations should already be considered infrastructure investments today.
So far, banks are not (or are only reluctantly) providing project debt for energy storage projects and this is good for us investors. We are now in a position where we can negotiate double-digit project returns with excellent downside protection without debt financing – and it’s obvious this represents potential upside in the future once banks decide to enter the market. We see relatively few investors in the market and no specialised ones (except for SUSI, of course). This allows early investors to pick the most attractive projects from a risk/return perspective and to build a track-record and network ahead of future competitors.
A bountiful value chain
What we currently see happening in the energy transition space is nothing short of exponential growth.
Over the next 10 years, 50 percent of new cars will be fully electric (thanks again, Elon Musk), nearly all electricity meters will be replaced by smart meters (much supported by an EU directive), and a smart grid will be rolled out. Next to this, behind-the-meter solar will power factories together with local batteries and wind parks built between 2000-06 will experience a repowering with 3MW turbines instead of the old 400KW vintage ones.
For institutional investors, all of this means attractive investment opportunities. Over the next decade, massive investments in smart meters and e-charging infrastructure will be needed and billions will go into the repowering of wind parks and the smart grid. And did I mention that we can use Blockchain technology for the efficient asset-management of all this?
It’s an exciting time to be a player in the energy transition. Let’s finance it together!
This story is sponsored by SUSI Partners.
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