This article is sponsored by Schroders Capital
Investment behind the energy transition continues to gather pace as the world closes in on imminent climate targets. Wind and solar are still dominating global spend, but newer technologies such as batteries and even hydrogen are increasingly attracting attention. Meanwhile, negative emitting solutions including carbon capture remain in their infancy.
The picture varies significantly depending on location. China’s renewable deployment is moving ahead at breakneck speed, while other regions have experienced a slowdown as supply chain issues and inflationary costs bite. Overall, however, the direction of travel is clear.
Richard Nourse, partner at Schroders Greencoat, Jérôme Neyroud head of infrastructure debt at Schroders Capital, and Ashwin West, head of sustainable infrastructure investments at BlueOrchard, consider the implications as the world continues to embrace the energy transition.
What are you seeing in terms of deployment in traditional renewable infrastructure? Are we on track to meet climate targets?
Richard Nourse: The energy crisis that we have been experiencing over the past 18 months means that accelerating the roll-out of renewables is now a priority for politicians, globally. Security of supply and affordability have joined the climate narrative, and that has led to a big increase in emphasis on the energy transition.
However, while we have seen the cost of renewables drop massively over the past five to 10 years, there have been short-term supply chain issues and price increases which have caused some degree of slowdown in Europe and North America. China, on the other hand, has been moving at an extraordinary pace.
Ashwin West: The situation in emerging markets is a little different. In emerging Asia, excluding China, demand has typically exceeded supply and we have seen limited roll-out of scaled projects over the past three to four years. There was a time when we were seeing a lot of reverse auction processes for wind and solar run by government, but that has definitely now dried up and developers are focusing more on behind the meter, commercial and industrial solar instead.
How has renewables infrastructure held up in today’s more turbulent macroeconomic environment?
RN: Renewables have held up incredibly well in the context of increased interest rates and high energy prices. As you would expect, given their infrastructure characteristics, these assets have ridden the inflationary wave like pro-surfers.
Jérôme Neyroud: We are lucky enough to operate in a sector where inflation positively impacts cashflows. We are also in a capital-intensive sector, which means that interest rate risk is higher. But because interest rate risk is higher, it is also mitigated from the outset. We don’t get caught off guard because it is an intrinsic part of our risk analysis. Infrastructure, and renewables in particular, have fared better than other industries in this macroeconomic environment.
Inflation is a positive for operational assets. But what about the implications for greenfield developments?
AW: Equipment prices have gone up and interest rates have gone up as well, and so there have been some difficult decisions to be made where NPV is now negative. There will be projects that become untenable from a debt perspective and developers will have to decide whether to wait or lose that project altogether.
RN: The cost of concrete and steel have gone up. We have also seen an increase in solar panel costs because of supply chain issues in China and, of course, the cost of capital has gone up dramatically, largely because of interest rates. That all means you need to generate a higher return than you did two years ago. We have seen groups walking away from projects in the UK, in Portugal and elsewhere, citing a rise in costs. Those are difficult decisions. Meanwhile, in other markets where there are no subsidies such as Spain and the Nordics, projects have continued based on expectations around forward electricity prices which have outweighed capex inflation and the increased cost of capital.
Which areas of the energy transition are currently benefiting from the most supportive regulatory backdrops, particularly when it comes to newer technologies?
RN: Whether you are talking about the Inflation Reduction Act (IRA) in the US or various measures being taken at an EU or UK level, impetus is building behind regulatory support for newer technologies such as hydrogen. Green hydrogen today is significantly more expensive than brown hydrogen or gas alternatives and the hope, of course, is that through subsidies or other regimes, we will start to move down the cost curve as we did with renewables.
AW: The regulatory backdrop in emerging markets plays a significant role in determining the opportunity set. We have found that large projects have been slow and difficult to close, which has driven appetite towards the initially unregulated commercial and industrial sectors instead. Regulation is now being introduced in many markets, however, in order to curb the proliferation of customers taking themselves off-grid, or reducing their consumption so significantly that it is adding to the utility death spiral.
Meanwhile, in other markets, such as South Africa, the supply/demand dynamic is extremely challenging right now, leading to brown-out situations. Legislation is therefore being introduced to make it easier to increase commercial and industrial solar capacity when it comes to permitting and licensing. Primarily, what we are looking at in emerging markets is behind-the-grid, distributed solar projects, precisely because of that regulatory mix.
JN: I liken the role of regulation in the energy transition to a child learning to ride a bicycle. When the child is very young, it cannot even walk, so it certainly can’t ride a bike. The technology is unproven and there is no market. Regulation at that point is unhelpful. Then the child reaches a stage where they are ready to ride but still need training wheels. That is the role of regulation. It is what we saw with renewables several decades ago and it is the stage we are now reaching with some of these newer technologies, which need regulatory support to make them bankable.
In that case, how significant is regulatory risk? Are there concerns around what a presidential election could mean for the IRA?
RN: My understanding is that there is very little risk perceived around a potential change in administration. Even when Trump was in office, he just kept extending. Nothing ever stopped. Now, of course, we have a bipartisan agreement which is benefiting Red states more materially than Blue, in terms of job creation, so I think it is almost inconceivable that the IRA will be rolled back.
What challenges does grid infrastructure present across different geographies?
RN: In the US, there are real challenges getting grid across state boundaries. In the UK, it can take years to get a wire approved and we are also seeing issues with offshore wind, where some communities are unhappy about pylons being erected to bring the energy from the beach to the market. We undoubtedly need acceleration in planning speed in order to deliver on climate targets. And that acceleration needs to happen quickly. In Europe and the UK, most of the transition will have happened by 2030 to 2035, so there is a very limited window in which to get the grid fit for purpose.
AW: Many emerging markets lack grid infrastructure and so it is necessary to look at alternative solutions – which means a focus on distributed generation, rather than centralised generation. In other markets, where the grid is more developed such as South Africa and India, grid infrastructure has started to become congested, in part because of the wheeling of electricity between independent power producers and private off-takers. There is potential there for distributed energy projects to relieve that supply/demand crunch as well.
What role do you expect carbon capture and other alternatives to play as we begin to focus on the hardest to abate sectors?
RN: Some hard to abate sectors, where electrification is challenging, will be tackled with hydrogen. We will also see a shift in where things are happening. Iron and steel won’t be produced at the scale it is today in countries where there isn’t an abundant supply of cheap renewable energy or hydrogen. That will shift to Australia, Texas or the Middle East, for example.
Nonetheless, almost every model out there includes around 10 billion tonnes of continued emissions in hard to abate sectors, which leads us to the area of negative emissions. That could involve carbon capture and sequestration. We are starting to see the first carbon capture projects getting off the ground, but they remain skinny in terms of the overall scale of what needs to be achieved. There is also a role for sequestration using natural capital and direct air capture, which is something Schroders spends a lot of time thinking about.
Beyond traditional wind and solar, where do you see the most attractive energy transition investment opportunities today and how do you see that evolving between now and 2030?
Richard Nourse: It is market dependent, of course, but the vast majority of energy transition investment to date has been focused on wind and solar and those technologies will continue to represent a significant proportion of expenditure going forward. We are now reaching a point where renewables penetration is requiring additional investment in the grid.
Battery and hydrogen storage are also becoming interesting components of the transition as focus shifts towards decarbonising transportation and heating, for example. Wind and solar will slowly decline as an overall proportion of spend as those technologies start to come online at greater scale but traditional renewables will still be dominating by the time we reach 2030.