COP26’s boost to the low carbon transition will broaden the range of investment options available to asset owners.
The consensus when the dust finally settled on COP26 was that it achieved less than desired, but more than expected. For asset owners, however, COP26 made one thing clearer than ever: the transition from fossil fuels to renewable sources of energy is about to gather serious momentum.
Investors also heard governments acknowledge that with public funding insufficient to meet their renewable energy targets, private funding has a crucial role to play. “The announcements coming out of COP26 gave a clear indication that energy transition is the key to ensuring that temperatures do not rise more than 1.5 degrees Celsius, and that rising global temperatures will not be controlled without significantly scaling renewables,” according to Rebecca Craddock-Taylor, Director of Sustainable Investment at Gresham House.
The beginning of the end
The watered-down final text at COP26 referred to “phasing down” unabated coal power rather than phasing it out. Nevertheless, the writing is on the wall for coal. COP26 produced commitments to scale up clean power and ensure a just transition, while financial institutions made landmark commitments to cease the funding of ‘unabated’ coal-based power generation.
A coalition of financial institutions under the Glasgow Financial Alliance for Net Zero (GFANZ), with US$130 trillion at their disposal, pledged to set regularly reviewed science-based targets to map their path to net zero emissions by 2050 at the latest.
The conference also delivered a raft of more detailed national determined contributions (NDCs), most notably India’s commitment to deriving 50% of domestic energy from renewables by 2030. The final text envisages new NDCs on 2030 goals next year, and then on the 2035 goals in 2025.
Sector-specific initiatives included the US$8.5 billion financing package agreed by France, Germany, the UK, the US and the EU to accelerate the shift from fossil fuels to renewable energy in South Africa.
Another agreement saw 28 companies including several energy majors join the new H2Zero initiative aimed at accelerating the replacement of highly polluting grey hydrogen with lower-carbon H2. It’s estimated that the pledges made under H2Zero will drive up demand for lower-carbon hydrogen by some 1.6 million tonnes a year.
Meanwhile, the RouteZero campaign brought together commitments from transport sector stakeholders to move towards 100% zero-emission vehicle adoption by the end of the 2030s.
Responsibilities and opportunities
Many of the initiatives that emerged from the discussions at COP26 will offer new investment opportunities that haven’t previously been considered, not least in the development of the solutions necessary to slow deforestation.
When it comes to renewables, asset owners can benefit from helping address project financing gaps within the existing industry to facilitate a just and orderly transition. The investment case for renewables was building momentum even before Glasgow, with energy transition technologies becoming more cost-competitive and consumers increasingly open to alternatives such as heat pumps and electric vehicles.
“We are also seeing some improvements in battery storage and a growing number of emerging market entrants, providing greater diversification and economies of scale,” according to Sarah Peasey, Director of European ESG Investing at Neuberger Berman. “The upside thesis is intact as the demand for renewables is very strong and the resource is a clear winner in the journey to achieving net zero.”
Asset owners generally understand that wind and solar power are the main sectors for investment growth in renewables, and for good reason. With the US aiming for 30% and 45% of all electricity to be solar-generated by 2030 and 2050 respectively, for example – up from around 3% now – the solar market offers clear promise.
But those sectors will only flourish given the funding required to allow energy markets and grid infrastructure to adapt, with storage a key area. Battery storage will become increasingly important in supporting the energy transition by alleviating the intermittency issues associated with renewables, while there are visible short-term gaps in solar and wind energy storage.
“Without significant investment in energy storage, for example, growth in renewable energy capacity could be problematic for grid management, and would lead to increased price volatility and supply-demand imbalances,” Craddock-Taylor points out.
In the UK, for example, existing renewable capacity has to be increased three-fold if the 2050 net zero targets are to be met. As the most cost-effective means of creating new capacity at scale, wind and solar are best placed to deliver the necessary growth in capacity.
“Project developers are aware of this and currently there is close to double the UK’s current utility-scale solar capacity in the planning process,” according to Craddock-Taylor. “Increased solar and wind capacity will also require both energy storage and increased baseload generation (e.g. nuclear) in order to balance supply and demand on the grid.”
The additional appeal of wind and solar is that they don’t require significant funding for unproven technologies in order to achieve scale.
E is for …
Opportunities are likely to emerge in the energy efficiency space too, particularly around the performance of buildings and the capture of methane emissions and ‘fugitive’ carbon dioxide.
The investment case in sectors supporting electric vehicles (EVs) is similarly compelling, but the need for additional infrastructure investment is again pressing, particularly in developing nations.
“Electrification of existing infrastructure is a key element, along with improving access to and driving usage of alternative fuels such as green hydrogen and establishing a fully accessible EV charging network,” says Elke Pfeiffer, Senior Project Manager for the UN-convened Net Zero Asset Owners Alliance.
Hydrogen has a much broader role to play in the energy transition, with applications in areas including heating, transportation and electricity. Hydrogen currently accounts for around 1% of total energy consumption in Europe, and many of the processes required to scale up are not economically viable, as it stands.
That will require both public and private finance to support the development of technologies such as the carbon capture, utilisation and storage (CCUS) that enables lower cost low-carbon hydrogen production. For asset owners to step forward with confidence, greater regulatory and policy clarity will be needed.
Despite encouraging signs, says Pfeiffer, CCUS are “yet to become economically viable, though we are seeing encouraging progress on this front”.
The potential for growth is obvious, however; in a renewables-based energy system, hydrogen production could grow 8% year-on-year, according to Bloomberg New Energy Finance, most of which will be green hydrogen (made using renewable energy-powered electrolysers).
Means and methods
The channels through which investors can participate in the transition are widening as the market matures and new strategies emerge. The forms of financing available to asset owners include direct debt or equity financing, as well as fund solutions where risk is diversified.
Blended (public/private) finance structures are a vital instrument for scaling up these solutions and helping manage risks that investors are unable or unwilling to support. “This is especially the case for new technologies or in emerging markets, where schemes tend to come with a higher degree of risk,” Pfeiffer explains. “Risk capital is rare, therefore de-risking from the public sector supports bringing these solutions to scale.”
With governments ramping up spending on clean energy projects, there will be income and growth on offer in areas including infrastructure debt. In the UK, for instance, around half of the £600 billion of infrastructure projects in the development pipeline are expected to be financed by private investment.
Fund solutions remain patchy, with relatively few expert fund managers in this space. However, research by investment consulting firm bfinance found that more than 65 renewable infrastructure strategies were fundraising in early 2021, up from about 50 two years earlier, with a particular growth in strategies focusing on ‘energy transition’.[1]
In addition, the Sustainable Finance Disclosure Regulation (SFDR) and the imminent rollout of the EU taxonomy will make it easier for investors to allocate capital appropriately, while also hastening the shift in value to less carbon intensive sectors. “Corporates and investors have long been calling for a consolidation of sustainability reporting standards and for greater regulatory support for those standards, and now it is happening,” says Peasey.
Growing pains
A concern for many investors is the price impact of high demand in renewables sectors where investment opportunities remain in relatively short supply.
The availability of renewables projects for funding is affected by issues including grid connections, the long timelines for planning permissions and the need for substantial technological innovation (such as in cement production) that remains expensive and unproven at scale.
Investors are also wary of how falling costs and the related phasing out of subsidies in certain renewables markets affects the risk-reward trade-off. Some fund managers are responding by moving up the risk spectrum to early-stage opportunities and away from the more developed projects attracting increased capital.
Yet it’s already possible to access high-quality assets and achieve attractive financial returns from renewable energy funding, says Craddock-Taylor. “We are confident that the subsidy-free renewables era offers a clear opportunity for significant investment with clear financial and environmental benefits,” she says.
Some solutions will be more investable than others, and much will depend on the evolving policy approach in different areas. Diversification is crucial, through offshore and onshore wind, utility scale solar and residential solar, infrastructure and equipment and service providers.
“The growth potential in renewables presents a multi-decade opportunity,” says Peasey.
“The key is for investors to be selective and very mindful of the potential headwinds and tailwinds over the long term as the global power sector transitions to lower emissions.”
[1] https://www.institutionalassetmanager.co.uk/2021/03/18/297376/renewables-sector-has-transformed-diverse-and-highly-competitive-asset-class
