ArcLight Capital Partners: Roles for legacy assets and new tech in energy transition

While energy transition is a major opportunity, Marco Gatti and Jake Erhard of ArcLight Capital Partners believe legacy assets have an important role to play.

This article is sponsored by ArcLight Capital Partners

Decarbonising the economy requires investment in infrastructure that facilitates zero carbon energy, responsible management of legacy fossil fuel assets and development of digital technology. All these components will be critical in the energy transition. Marco Gatti, managing director at ArcLight Capital Partners, and Jake Erhard, partner and head of ESG at ArcLight Capital Partners, explain why a balanced approach remains so important.

Is the energy transition market essentially about ESG?

Jake Erhard: ESG is a critical factor in how one goes about investing in the energy market. It needs to be a strategic tool for investors. It is easy to say that ESG is synonymous with energy transition and clean energy, but there are a lot of nuances around these themes. Sound ESG practice delivers outcomes both through investments in renewable assets and responsible management of fossil fuel assets. The goal is to bring about meaningful and impactful improvements on environmental, social and governance aspects.

There is a huge installed base of fossil assets out there that is critical to our economic well-being. Those assets cannot be willed out of existence and are going to be needed for decades to come. They provide affordable low-cost energy and good jobs, and they support local communities.

A lot of corporate asset owners are responding to the ESG agenda by orphaning these assets and divesting. This allows them to declare victory publicly, but it really does nothing systemically on the ESG front.

To us, ESG means being a responsible steward of these assets through the latter days of their useful lives. It also means using our extensive energy transition expertise to allocate capital to new decarbonising infrastructure around these legacy assets.

We’ve seen that some of the best returns in the energy transition segment come out of legacy assets where a number of critical entitlements, such as transmission interconnections, land use designation, and availability of skilled labour are already in place. This is optionality that you often get for free in these assets.

Where are the best opportunities in energy transition?

Marco Gatti: Energy transition has a long tail, rather than being a single event at a point in time. In the 20 years that energy transition has been occurring, primarily in the power sector, it has often been synonymous with renewables. More recently, the remit of the energy transition has become broader and today we see opportunities across the spectrum.

The most advanced opportunities remain at the utility-scale power solutions, especially wind and solar. In the US, there are certain states that are getting to the point where renewable generation is so great that it is stressing the grid. This creates the need for investment in sectors that are less advanced, such as demand-response, virtual power plants and microgrids, and this need creates opportunities for power sector experts to work with developers in defining new business models.

We continue to see a lot of investment opportunities in solar. As far as generation technologies, it is as simple as it gets, but it is not easy to deploy successfully given the tight margins at which most projects are underwritten. Construction is straightforward, but the siting of solar assets, securing interconnections and managing the contracting and so on are more complex.

Solar can be deployed at multiple scales, from GW-scale utility projects down to KW-scale residential ones, and can live both in front of or behind the meter. It is a solution that covers a spectrum of power needs and it marries very well with other technologies, such as batteries, home charging or hydrogen production.

Furthermore, the scale and growth of the solar market is creating compelling opportunities to invest in the entire value chain, including equipment, software and services that enable the deployment, operations and management of the assets.

What is the opportunity with batteries and hydrogen?

MG: Batteries are fascinating. A battery is an active participant in the grid. It is often considered a renewable asset but behaves like a conventional asset, requiring the operator to price inputs and outputs, select the markets in which capacity is bid and manage it actively.

We often find that locating batteries near existing power stations and then scaling them up as the base power station is retired leads to a better outcome than fighting for greenfield sites and then trying to connect to the grid. This should be intuitive, since existing power plants are located at valuable nodes on the grid, but we often see conventional assets trade at values that don’t reflect this long-term optionality.

The appeal of hydrogen is that it can replace other fuels, like gas, oil or coal. The real work is figuring out how hydrogen can be integrated into those production processes and how to get it to the point of consumption.

In that sense, hydrogen is very similar to natural gas. You need infrastructure, and that infrastructure is already in place in existing natural gas pipelines. In Europe, which is probably three to four years ahead of the US in the implementation of hydrogen, the most active players in hydrogen are the gas transmission and distribution utilities.

Getting power from remote renewable generating sites on to the grid is one of the challenges for energy transition. Are there significant opportunities in this type of infrastructure?

MG: There have been waves of attempted investment in transmission infrastructure and there is a new emergence now on the back of President Biden’s infrastructure bill. It is critical that it happens in some parts of the country, but it is proving to be a sector that is slow to move.

You need to align landowners, you need to align communities and most importantly you often advantage one utility or state to the detriment of someone else, so there is a lot of politics in transmission. We would love to see it move faster because it would involve a lot of opportunities, but the number of projects moving forward is limited.

These circumstances create an opportunity for solutions that are closer to load, such as demand-response, virtual power plants, batteries and microgrids, all sectors where we see substantial investment opportunities.

How big an opportunity is the transition to electric mobility?

MG: It is hard to overstate how large the addressable market is. Currently, there are about five million electric vehicles in a market of 300 million vehicles, less than 2 percent of the market. It is an enormous market, highly underpenetrated with a lot of momentum.

Electric vehicles are generally high quality – they last longer, they are more fuel-efficient and they provide a superior driving experience. There is room for improvement but they are already very good vehicles and that is driving the pace of adoption.

Electric vehicles are also highly dynamic and require dedicated equipment, software and services to integrate them into the grid. First, there is the charging and logistical infrastructure required to enable market adoption of electric vehicles.

Second, there is a technology play, where you can invest in companies that are providing software, equipment and services that are highly differentiated. We have invested in Inspiration Mobility, a company that provides passenger vehicles for fleets as well as the associated charging infrastructure. By having captive demand for the infrastructure, you bring up the utilisation of that infrastructure much faster.

Fleets have very predictable charging patterns – they typically charge at night because they are then used in the day, so those chargers are available for public use in the daytime, meaning you can get your base return from the fleet and then upside from public charging.

As electric vehicles penetrate the market, they will drive up demand for electricity. Full electrification will drive up demand by 20-40 percent, which is a lot, but most impressively it will also bring capacity to the grid. If all vehicles were to convert to being electric you would have 30TWh of battery power available.

You would have this massive battery out there that is sometimes connected to the grid and sometimes not and that is going to dramatically alter how the grid works. This creates significant opportunities for providers to supply the software and equipment that is required to integrate and manage this kind of distributed resource.

The development of a more complex grid with energy moving in both directions will be very different from what we are used to. Do you see digital technology as an opportunity in energy transition?

JE: If you think about the mobility space, the complexity of managing batteries around their design constraints, managing fleets on the road in real-time and managing interfaces with dynamic power markets, then you can see that it is really data and software that is the glue to enable efficient cost-effective solutions to be implemented.

There are businesses that come out of Silicon Valley with traditional tech underpinning that need to be married with both infrastructure expertise and knowledge of energy markets.

The decision-making on power flows to and from the grid will become increasingly decentralised and you will need technology to enable that. The same dynamics are at play around data centres, residential solar and microgrids, to name a few. The challenges and opportunities around the grid and grid-edge applications are enormous.

How important is it that legacy assets continue to play a role in energy transition?

Eastern Generation
Eastern Generation: ArcLight’s portfolio company has a number of natural gas and dual-fired generating facilities

JE: There are a lot of themes at play here, such as the interchangeability of legacy assets with energy transition. With natural gas, there is a raging debate about the role it will play in the coming decades as we march towards decarbonisation.

Gas itself has a relatively low emission profile that has helped us move meaningfully down the path of decarbonisation. Gas has been the single largest driver of the approximate 30 percent reduction in carbon emissions from the power sector over the last 15 years, displacing coal generation cost-effectively and without subsidies.

Gas infrastructure can also play an important role in a world of decarbonisation because of its inherent compatibility with emerging pillars of transition, such as hydrogen, synthetic natural gas, and carbon capture.