“This time around renewables is part of the recovery as a job creation strategy” – Pooja Goyal, Head of Renewable and Sustainable Energy, Carlyle Group
Renewable energy has sparked a lot of interest in recent years. Due to the coronavirus pandemic, the energy transition has received even a further push, fastening the shift from fossil fuels to renewable sources of energy. Over the last ten years, new global investments in the renewable energy sector amount to $3tn. Moreover, the sector benefits from a tremendous investment growth of 44% in 2020 compared to ten years ago. Commitments in solar and wind capacity are still leading the way. Interestingly, 2020 represented a record year for offshore wind, while investments in onshore wind declined sharply. In the light of those developments, the following questions arise: “What role does private capital play in the energy transition?” and “How has the pandemic changed the investment approach of private equity firms?”.
“Commodity price exposure is today generating more volatility and wreaking havoc on energy PE funds” – Mark Florian, Head of Global Energy and Power, BlackRock
Symbolic for the shift away from fossil fuels is the recent consolidation of the oil and gas sector in North America, following the sharp decline in oil prices in which the private equity sector did not take part:
- ConocoPhillips took over Concho Resources for $9.7bn.
- Pioneer Natural Resources paid $4.5bn for Parsley Energy.
- Cenovus Energy acquired Husky Energy for $2.9bn.
Even before the Covid-19 pandemic, private equity faced some headwinds as oil prices softened in 2019. Exiting oil investments was hindered as at the same time, public oil companies faced high pressure from shareholders to commit to emissions reduction and sustainability. Thus, private equity firms had difficulties to find buyers. Clearly, the oil market turmoil in the spring of 2020 put highly leveraged companies under great pressure as fossil fuel exploration and production was impacted by struggling demand. This resulted in more than half of the US oil and gas companies which filed for bankruptcy being private equity backed. With regards to multibillion-dollar bankruptcies, they even accounted for more than two thirds of all defaults.
Prominent bankruptcies with aggregated $5bn in debt were Unit Corporation, Ultra Petroleum and Chesapake Energy which were backed by Partners Group, Fir Tree Capital Management and Carlyle Group, respectively. This evidence does not only support the claim that utility companies need to reassess their strategies, but also that private equity firms need to shift from investments in fossil fuels to investments in renewable energy. Taking into consideration the global electricity generation outlook of 2020, non-hydro renewables will lead the global power generation and are expected to generate 12,872 terawatt hours in 2040, which represents a 22% increase compared to the 2018 outlook. This again underlines the megatrend towards renewable energy sources.
Investments in renewable energies can be executed in two different types:
- Investing in fully developed and contracted assets ready to operate or already operating.
- Investing during the development and construction phase.
While the 2nd investment strategy clearly faces higher risk and uncertain cashflows, it also offers much higher return expectations. As multiples of established wind parks, for example, are very high and the internal rate of return for private equity firms may not be sufficient anymore, private equity investors are increasingly emphasizing development-stage investments.
Furthermore, we must differentiate between renewable energy sources: while hydro investments are not too attractive for private equity investors, – due to large early-stage investments and the sustainability of biomass being controversially discussed – private equity firms are mostly focused on solar and wind energy.
Investment reasons for renewable energy
The reasons for investing in renewables are multifarious:
1 – ESG criteria
Alessi, Ossola and Panzica (2020) performed an analysis on European stocks and discovered that investors are willing to accept lower returns in order to hold greener and more environmentally transparent stocks – i.e., stocks of firms which disclose most of their environmental information and which have a low emission intensity. Possible explanations for these results are the following:
a) Holding greener and more transparent stocks is a potential hedging strategy against climate risk.
b) Investors decisions may be driven by an emerging “taste for green”.
These explanations go hand in hand with the trend of many limited partners (LPs) implementing ESG criteria in their investment philosophy. Coller Capital’s Global Private Equity Barometer 2019/2020 showed that around 40% of LPs planned to modify their investment strategies in response to climate change by decreasing their investment in the oil and gas sector, while increasing their investment in renewable energy over the next five years. The shift of LP interest from oil and gas to renewable energy sources is backed by the recent fundraising data: while oil and gas-focused capital raised has been steadily declining since 2014, fundraising for renewables has peaked at a four-year high in 2020 according to PEI data. Moreover, funds increasingly eliminate fossil fuels from their investment strategy and forbid themselves to invest in this sector.
2 – Low costs and promising outlook
Costs of producing electricity from wind and solar energy decreased by 55% and 85%, respectively, in the last 10 years. In many cases, these renewable energy sources are now close to be cost-competitive with fossil fuel power generation. According to the World Energy Outlook 2020 by the International Energy Agency, the cost per megawatt (MW) to build solar plants globally is below that of fossil fuels for the first time, making solar the “cheapest electricity in history”. This is a clear indication that the renewable market is becoming more mature and is much less dependent on public subsidies and government support-schemes. Because of the technology improvement and cost reduction, much more renewable transactions are now structured without state support.
Another key point to consider when talking about investment opportunities in renewables is the promising outlook: power generation from renewables is expected to grow from 7% to 50% of the total global power generation in the next 20 to 30 years as part of the transition to net-zero emissions. Furthermore, Bank of America estimates that renewable energy capacity could grow 20 times by 2050.
Therefore, private capital is going to be a key driver of this development as it has the ability to be patient and to hold on to investments for a longer time period. Moreover, the decrease in government subsidies for renewables, for example inflation-linked feed-in tariffs or tradeable renewable energy certificates, changes the financing of renewable projects. Unsubsidised renewables are first and foremost a sign of the success and maturity of the industry as they are now able to compete against fossil fuels due to the decrease in technology and operating costs. On the one hand, the continued withdrawal of subsidies leads to less stable cash flows and higher revenue uncertainty; on the other hand, it may lead to a shift of investors towards less risk-averse investors, such as private equity firms, and away from previous sources of capital, such as low-cost institutional money and bank debt.
3 – Regulatory and monetary environment
The regulatory support for renewable energy is huge – now on both sides of the Atlantic.
The European Union (EU) member states have already cut its greenhouse gas emissions by about a billion tonnes a year between 1990 and 2017. Under the European Green Deal – an unprecedented project in terms of scale, costs, and required co-operation – the European Commission (EU) aims to transform the bloc into a low-carbon economy. To demonstrate the framework’s scale, the EU estimates its cost at €1tn.
On the other side of the Atlantic, hopes for clean energy were revived with the election of President Biden. The new President aims to ensure the U.S. achieves a 100% clean energy economy and reaches net-zero emissions no later than 2050.
The aims are no doubt very ambitious, and execution might differ, but regulators are lining up behind the transition and willing to make commitments once again.
On the monetary support side, liquidity is abundant both on the private equity side and on the public market side, interest rates are at an all-time low, creating appetite for riskier projects.
Empirical evidence – selected deals
Valuations in the renewables sector have climbed high, especially when contrasted with some of the leading oil and gas companies, demonstrating that the market is increasingly interested in the energy transition megatrend. In part, the spread in valuations comes from optimism around future earnings growth for renewable energy companies, while oil majors are lagging behind and trying to diversify their energy portfolio.
The weaker cash generating ability of oil companies due to the oil price volatility shown in the Brent price chart above might further widen this spread.
Furthermore, investors such as CPP Investments – one of the most active investors in the sector – allocate a greater portion of their funds available to renewable energy companies.
CPP Investment says they are pursuing opportunities that are created by the energy transition and by the growing demand for clean energy. The company sees the potential in renewable energy as it is becoming a larger share of the energy market. Deployment costs are falling, the technology infrastructure is improving, and demand is increasing. The investment horizons and the scales characterising utility-scale projects create promising opportunities for long-term, ESG conscious investors who have enough dry powder, such as CPP Investments.
According to industry professionals and Bloomberg New Energy Finance, after subdued PE investment activity especially in the development phase, activity has been picking up in recent years – partially due to the high current valuations of operating phase projects. An important deal from 2020 is Carlyle’s $374m strategic growth investment in Amp Energy. Amp Energy is a global renewable energy infrastructure manager, developer, and owner. Since 2009, Amp Energy has successfully developed over 1.8 gigawatt (GW) of distributed and utility-scale renewable generation projects, hybrid generation plus storage projects, and stand-alone battery storage projects around the world. The deal is not only important because of Carlyle’s willingness to invest in the riskier development phase, but also because it hints at where private capital might be heading next. Storing the generated energy remains a key issue for renewable energy companies. Amp Energy is a leader in battery technology – which Carlyle considers strategically important. European industry professionals see these technologies particularly attractive to private capital. The asset manager has also acquired eight solar projects in Maine, as they are capitalising on the state’s expanding renewable energy market. The projects are expected to cost more than $130m to build and will have a total capacity of 100 MW. Carlyle, however, is not the only major player who is willing to take the higher risk involved for the higher returns in the development phase. Apollo Global Management invested $265m in US Wind Inc., an offshore wind energy development company. The funds will be used for the development of a major offshore wind energy project off the coast of Maryland.
Investment in operating assets, however, remains attractive to private capital, and deals are of much larger scale for this investment phase. Deals such as KKR’s $1.4bn deal with NextEra Energy Resources LLC, and Macquarie’s deal with CEZ to acquire the largest onshore wind park of Europe – with total installed capacity of 622 MW – are the landmark deals of 2020. KKR invests $1.4bn to acquire equity interests in portfolios of contracted utility-scale wind and solar assets. Macquarie and CEZ have not disclosed the transaction value, however the installed capacity is significant. One might wonder about the “why’s” and “how’s” valuations of these parks are already high – meaning there is little room for error. The answer is two-fold:
- Projects with contracted capacities have stable cashflows, and sufficient de-risking remains a priority for private capital deployed in the sector.
- With the industry maturing, transactions have decreased in complexity and became scalable.
High valuations however will remain a key constraint for private capital inflow to operating phase projects.
As an industry professional puts it: for the first time in history, we have high global liquidity, the maturing of renewable energy as an industry, and enormous regulatory support overlap. This shall create a favourable environment for capital inflow from private equities. Notwithstanding the environment, the high valuations of operating phase investments can represent an important limiting factor to traditional buyouts.