Re-architecting society for a low-carbon world

AVAIO Capital founder Mark McComiskey on the opportunities arising from the energy transition, from energy as a service to distributed generation.

This story is sponsored by AVAIO Capital

What needs to happen for us to transition to a low-carbon economy?
Mark McComiskey: Virtually everything about society will need to be re-architected. For example, according to UN forecasts, roughly 2 billion people, 25 percent of the global population, will move into cities over the next 20 years. That creates an enormous opportunity to do things differently: to design those cities to have a zero-energy footprint, to maximise water reuse and minimise commuting and waste.

Some cities in the US are taking this approach with neighbourhood redevelopment plans. This is driving the creation of new district heating and cooling systems, for example, and distributed generation, micro-grids and energy storage. As a build-to-core-focused investor, we are seeing enormous opportunity in the creation of new infrastructure need to facilitate the shift to a low-carbon society.

The easiest way to reduce the carbon footprint is to use less energy. Large companies can afford to analyse their facilities and implement the newest energy-efficiency technology. Small firms sometimes lack the resources to devote to understanding the options available for reducing consumption and creating opportunities for third parties to provide energy savings equipment under long-term contracts.

What about renewable energy itself?
MM: Renewables are exciting in terms of their impact on society. But it has become such a hyper-efficient market in terms of procurement and financing that it has become difficult for traditional private equity or infrastructure funds to invest in that space.

The manufacturing costs of solar, for example, have dropped to the point where it is common for long-term offtake contracts to be below the spot market price of electricity. Mid-to-high single-digit returns have become the norm. And that is perfectly appropriate for certain types of investment mandates. But the returns are lower than you would expect to find in the traditional fund investment mandate.

You mentioned distributed generation and energy storage. What opportunities are being created by the rise of renewables there?
MM: Certain types of renewables, like solar, lend themselves to a distributed approach – on residential and commercial rooftops, for example. That is necessitating a restructuring of both industrialised and industrialising countries’ approaches to electricity transmission and 01distribution. In the developing world, there are opportunities to architect electrical systems based around locally sited clean power, with local micro grids and energy storage. With these sorts of projects there is much less emphasis on large centralised power plants and long-distance transmission.

Renewables also involve a degree of volatility. They produce electricity not on demand, but when the sun is shining or the wind is blowing.

When they do generate, their marginal cost is low and they are displacing traditional thermal-base load-power plants. But when the renewables aren’t generating, the system needs the ability to pick up the slack. That is creating a need for increasing amounts of both energy storage and peaking generation to ensure adequate electricity supplies and grid resiliency.

Utility business models are also being challenged. At a high level, most electric grid operators today recover their costs by charging customers based on the amount of electricity consumed. Many customers are now producing their own electricity or adding storage, displacing their payments for those grids. This has created investment opportunities for the fleet-of-foot, but will also force an evolution in the traditional utility business model.

Virtually everything about society will need to be re-architected. That creates an enormous opportunity to do things differently: to design those cities to have a zero-energy footprint, to maximise water reuse and minimise commuting and waste.

What types of deals are you targeting within these sectors?
MM: We have a build-to-core strategy. We will bring something new into existence but, once it is in existence, it will need to have the characteristics of core infrastructure: long-term cashflows supported through contracts or protected positions. You won’t see us building merchant power plants, for example.

So, where are we looking? Areas like energy storage, which is a hot topic right now. There are lots of different approaches – PPAs, revenue-sharing models, compensation for cost avoidance. It’s an interesting space because the cost of batteries is dropping steadily, and this is leading to a gradual increase in investment opportunities. It seems clear this market will grow.

Energy conservation is another area where we can implement the build-to-core strategy. In 1990, the US consumed about twice as much power per household as Germany. By 2018, the figure has risen to almost three times as much. What that means is that there is a lot of low-hanging fruit in the US, in terms of driving energy efficiency. There is no real technology risk and the returns available are attractive.

You primarily focus on the US, but you invest opportunistically in Europe. Are there other key differences between the two geographies?
MM: Generally speaking, the European market is further along in the psychological and regulatory shifts needed to drive the transition to a low-carbon world. You find a higher degree of regulatory support – not driven by tax structures, as in the US, but by some form of offtake or outright mandates, such as packaging waste regulations.

However, as the economies of scale for renewables, energy efficiency and energy storage have continued to grow, these are all increasingly becoming bankable investments in their own right, independent of incentive structures. Consequently, we see many of the same approaches being implemented in the US, Canada and the UK, for example. Improving cost curves are driving a degree of convergence.

What are the biggest challenges you face?
MM: Unless you are careful, you can find yourself exposed to changing government regulations. We didn’t participate in any UK battery storage investments, but it was a sector we looked at. That market was driven by a system of incentives that allowed customers to save on their overall electricity bill by using batteries to reduce consumption during a few peak hours. The returns were so attractive that there was a rush to deploy batteries, creating a challenge for the pricing mechanism for electricity in the UK. Not only that, but the whole system was declared illegal by the European courts and the complications are still being worked out.

Governments should focus on ensuring their incentivisation programmes are sustainable, and we as investors need to consider carefully the potential vulnerability of a project to changing government policy. Offtake contracts with creditworthy counterparties are very important.

Another challenge is identifying scalable opportunities. As increasingly large funds compete for the small number of big trophy assets, our focus is on the middle market. It takes a lot of work to find companies and assets that are accomplished and differentiated in their niches. But when we do so, they often have a viable pipeline of opportunities to reach critical mass. We spend a lot of our time working to build scale in such platforms.

Where does the future of the energy transition lie?
MM: The roadmap for the next five to 10 years is well established: a continually increasing focus on efficiency and minimising energy usage, deeper penetration of renewables and energy storage as their costs continue to decline, and a gradual but accelerating transition away from oil for transportation.

Increasingly stringent regulations around the energy footprint of buildings, combined with more stringent building codes, will require the re-architecting of neighbourhoods. More progressive places like San Francisco are leading the way, but we expect that to continue to spread as the cost of implementation comes down. It is the same virtuous circle we saw in solar power seven years ago and in wind energy before that.

Carbon-based powerplants will become more challenged economically as coal and gas are displaced by renewables. And the grids themselves will need to change in response to those dynamics, with batteries or quick-start pikers being implemented in ways and places we haven’t seen before.

We will also see the impact of electric cars, ride-sharing and – in the longer term – automated vehicles. That will create opportunities for investors, but challenges too.