The news that Breakthrough Energy Ventures, backed by investors including Bill Gates, Jack Ma, and Jeff Bezos, would seek to invest at least $1 billion in transformative energy solutions has re-ignited hopes about a role for private equity in climate finance. Will this bold move come to mark a breakthrough moment for the industry?
Private equity investment in renewable energy grew to $3.4 billion in 2015. While that’s nothing to sneeze at, the amount is a small fraction of the assets under management by private equity in total, which sat at roughly $2.4 trillion in the same period. A growing number of the largest generalist funds are adding renewable energy projects to their energy-focused investment vehicles. Examples in this grouping include Blackstone’s Onyx Renewable Partners, TPG Alternative & Renewable Technologies and KKR Infrastructure and Real Assets. Once a rarity, there are also firms such as Hg Capital, Denham Capital Management, and Hudson Clean Energy Partners with specific clean energy mandates.
Despite the rapid growth of the renewables industry, the track record for private equity investments in the space is generally considered to be poor. This is illustrated by the performance of the California Public Employees Retirement System (CalPERS) Clean Energy and Technology Fund, which showed negative returns in 12 out of its 14 commitments.
Given weak performance amongst big players, it is unsurprising that some PE investors have dismissed renewable energy entirely, with the Financial Times going so far as to declare private equity investment in renewables a ‘fad’. The recent U.S. election result of Donald Trump has thrown further uncertainty into the overall sector’s profitability, with many renewable energy stocks cratering after the results were announced.
We believe that investors should be careful not to jump on any bandwagon of conventional wisdom about renewable energy. Structural shifts within the clean technology industry likely make the selection of 2006-2009 vintage funds – the benchmark by which the industry is largely judged – a poor indicator of future performance for the sector. Going forward, these investments will be operating in a very different market environment compared with the previous decade.
The first step to a clear perspective on the future of PE in the renewables sector is to start by disaggregating Venture Capital and PE. They are often grouped under one heading, but have very different mandates and profitability potential.
VC is best-known for investments in information technologies and biotechnology – sectors which often come with minimal barriers to entry, enormous potential for innovation, and relatively low upfront costs. However, in the mid-2000s, a combination of high energy prices, rising awareness regarding climate change and enabling legislation resulted in a surge of VCs raising funds focused on clean energy technology (“cleantech”).Many investors believed that society’s growing need for energy represented an exciting growth opportunity for their VC fund management skills, with the side benefit of alleviating the threat of climate change. Money poured in, and expectations rose accordingly.
The results, however, fell short of expectations, and a recent MIT study noted that “cleantech companies developing new materials, hardware, chemicals, or processes were poorly suited for VC investment because they required significant capital, had long development timelines, were uncompetitive in commodity markets, and were unable to attract corporate acquirers”. Applying the venture capital model to energy’s high barriers to entry, tendency to evolve in increments, and high upfront capital expenditures was, in hindsight, bound to be problematic.
The typical approach to VC investing is very different from the average (growth) private equity fund. By investing in more established technologies, growth PE typically has a different risk profile and is less dependent upon emergent technologies. PE funds generally focus on providing capital to more mature businesses seeking to grow and execute their business strategies. These funds can also facilitate buyouts of existing companies, or purchase distressed businesses and restructure them.
The second area for consideration when assessing the role of PE in today’s renewable energy market is to recognize the distinction between current and past funds. The track record for private investment in renewables is largely evaluated based on the performance of funds raised between 2006 and 2009. However, in assessing the attractiveness of the sector, it is important to better understand how the market environment has evolved through various vintages. Three principal drivers of underperformance – investment focus, maturity of the industry, and exit opportunities – stand out as worthy of consideration. In all three factors, the risks are substantially reduced today.
First, early vintage funds invested substantially in biofuels and technology, both of which proved to carry substantial market risks. The former – a liquid fuels business – is inherently volatile and subject to fluctuations in prices of both inputs and outputs. Technology did not fare much better. Many companies were highly dependent on uncertain outcomes as they developed first-of-a-kind products. Unsurprisingly, the share of biofuels in all clean tech investing peaked in 2006 and has since declined.
Second, the relative immaturity of the clean energy industry in 2006 meant that investments were overwhelmingly dependent upon government subsidy. The emerging subsidy programs targeting clean energy were highly effective in terms of sparking an investor response. Investment surged in markets such as Germany, Spain, and Italy where feed-in tariffs were most generous.
However, policies were heterogeneous, with varying tariff levels and mixed abilities to control deployment of capacity. In select countries, this resulted in large support payments to clean energy generators which, during the recession of 2009, proved unsustainable for strained government budgets and households with diminished incomes. The well-documented retroactive changes in tariffs which followed led to asset impairments for many PE investments in these markets.
A fortunate outcome of the scaling of the industry through its rapid expansion in the 2000s has been dramatic reductions in the costs to generate power (levelized cost of energy or “LCOE”) from onshore wind and solar PV. The cost of Solar PV modules has declined, on average, 24% for every doubling of industry capacity. Solar PV is now 80% cheaper than it was in 2008. Going forwards, the International Renewable Energy Agency (IRENA) forecasts an additional 59% decline in the LCOE for solar PV and 26% decline for onshore wind by 2025. These cost reductions have already eliminated the need for public subsidy in clean energy. At the same time, the increasingly global industry is making large strides in systems performance and efficiency. In response, the approach by governments is shifting from a fixed premium pricing structure to competitive tenders. This evolution in market structure is providing stability to the industry by reducing the risk of retroactive policy changes.
The third factor contributing to the underperformance of clean energy investments was a lack of a clear exit strategy for investors. Again, this has changed markedly since 2009. New sources of capital are moving into this sector to take advantage of the stable and predictable yields of operational assets. Private equity is well positioned to fund development risk and exit projects (once operationally de-risked) to a variety of buyers, including utilities, sovereign wealth funds, infrastructure funds and publicly traded “yieldcos”.The latter has emerged only within the past three years, allowing public investors to access portfolios of renewable generation assets which were previously inaccessible due to size, concentration risk or liquidity concerns.
Infrastructure funds, another form of private equity capital which targets lower-return assets relative to PE, have become increasingly interested in wind and solar PV assets as their risks have become better understood.
Looking forward, the future challenge for PE in renewables is arguably less related to shifts in government policy, but rather achieving high returns in a more mature market. As with PE investments in other sectors, generating solid risk-adjusted returns will depend on partnering with excellent management teams, persistence in project execution, access to proprietary deal flow and financial innovation. There are no obvious reasons why PE investors will be unable to continue to hold these competitive advantages. In a world of declining generation costs and increased awareness of climate change, savvy investors should be attuning themselves to a reality where renewables will not only be the most environmentally-friendly option, but also among the most profitable. The wealthy CEOs backing the Breakthrough Energy Ventures fund see such a future unfolding and are molding their investment model to suit. We suspect they will be well rewarded for their perseverance. And where these individuals go, others are bound to follow.
Dr Charles Donovan is Director, and Joel Krupa is Visiting Researcher, at the Centre for Climate Finance and Investment at Imperial College Business School.