The Secret Sauce – Five Things Stopping Institutional Investors Deploying Greater Capital into Renewable Energy
The Energy Council works with a select group of top tier investment managers and partners who offer the renewable industry access to institutional money being deployed into solar, wind, energy storage, urban mobility and grid edge market technologies. We recently asked them their views on the current investment climate and what the next 12 months have in store when they exercise their discretionary power over their client ESG strategies.
Institutional investors are the battleships of the financial markets. Whether it be large pension funds, insurance firms, endowment foundation funds, hedge funds or investment banks and other investment pools, they are able to move markets like no other because of their ability to invest huge amounts of capital. Getting their attention and confidence matters when mobilising finance for investment and innovation in clean energy, yet roughly half haven’t allocated capital to a renewable energy strategy. If executives are going to successfully access some of the $2 trillion a year in clean energy infrastructure being allocated, knowing what these investors look for is important. Much is written about why they are investing, but we asked our membership what holds them back from deploying capital.
Size matters not just returns
Oil and gas prices are around 40% lower than a year ago. Major O&G companies have written down billions of assets after cutting long-term price assumptions and a predicted 15% reduction in capex seems optimistic. Despite a wall of bad news discussing the final death knell of hydrocarbon investments, they remain stubbornly resolute in attracting institutional capital. Why is this? Imperial College London and the IEA released research as recently as May 2020 demonstrating that rate of return in renewable investments in Germany and France yielded 178.2% returns over a five-year period, compared with -20.7% for fossil fuel. These are markets not heavily weighted with O&G stock, so it was welcome to see the U.S. renewables industry yielding 103.1% greater return based on the same criteria. We asked our members why this hasn’t yet resulted in a huge shift towards renewables?
“There's a shift towards renewables – the fundamentals of prolonged stock price performance, valuations and returns cannot be ignored” said one investment manager headquartered in Paris, “but so does scale.”
The market cap of conventional hydrocarbon businesses in the same IEA research was 75% greater than the renewable counterparts. Furthermore, the headline returns masked less than flattering numbers for large scale power plants. Companies developing technologies for use in, or bolt-on to, clean energy projects tend to have a lower cost of capital and are increasingly attractive to investors, but often lack the scaled opportunities that larger more sophisticated energy investors desire. This partly explains why investment in solar, wind, energy storage, power utility and grid edge technologies remain relativity low. Institutional investors invest at scale in deep liquid markets, as one member commented “we like liquidity for our operations in energy markets, it is simply what we are used to and are able to model.” As the market matures, a greater degree of liquidity will enable better price formation and the benefits of deflationary costs but, as he summarised, “we are simply not there yet.”
A key challenge is how to position your ‘shovel ready’ project, technology or portfolio in a regulatory environment where it's not clear whether more regulation is coming or not. The recent Federal Energy Regulatory Commission NYISO and PJM orders in late 2019 can show how challenging the regulation can be for institutional money, even in mature markets. In this example, legislation masks the true cost-effectiveness of renewables, instantly making 38,000 megawatts of new renewable generation less competitive. Investors are reluctant to put capital to work when fiscal regimes are perceived to be in a state of flux. As one member put it, “how you can price in risk over the long-term is more important than heady returns for the past 5 years.” This is something that the United Nations Environment Programme Finance Initiative has tried to address but it’s a difficult conundrum that money managers face. How does one balance Socially Responsible Investing (SRI) strategies, while at the same time offering long-term investment value to institutional investors that are aligned to the objectives of the portfolio? Judgments that have previously been handed down in the UK, prioritising financial objectives of the investment portfolio over ESG, are in flux. The new Proposed Revision to the UK Stewardship Code looks to ensure that investment manager’s fiduciary duties incorporate ESG factors when fulfilling their stewardship responsibilities. The developing regulatory framework globally continues to develop and is difficult for investment managers to incorporate into their long-term financial modelling. This all has a negative impact on capital flows into renewables as capital is put to work in mature stable regulatory environments.
The regulatory environment for investors toward reducing risk levels shows no sign of letting up. Institutional investors maintain a preference for operational assets as part of their risk mitigation strategies and look to avoid early stage start-ups. This is a challenging conundrum for asset managers who need to deliver superior returns within an ESG strategy. As one investment manager told us, “there are simply not enough good green assets kicking around,” which exposes investors to risk. The rise of loosely defined green bonds is a worrying trend as issuers flood the market with “light green” bonds. Teekay Shuttle Oil Tankers’s much publicised Green High Yield Bond in late 2019 was issued on the basis that the capital would be deployed to build highly fuel-efficient tankers. Is that really what investors want? Balancing risk with innovation when shifting portfolio allocations is nothing new, and there will always be a preference to focus on a portfolio of operating assets. However, with fewer quality underlying assets coupled with strong governance processes, we may see investors having to dial back investments until suitable investments come to market. The use of a consistent taxonomy of what constitutes green will help address “greenwashing” but the mere fact it exists doesn’t offer financial market participants an instant array of bankable deals. In Europe, the European Central Bank (ECB) has recently attempted to contribute to the debate with the publication of the ECB Guide Climate and Environmental Risks where it outlined climate-related taxonomies as being heterogeneous with confusing tools and methodologies. This is not all bad news for the renewable industry but does mean investors with different time horizons and more aggressive structured strategies may become more commonplace in the renewable industry moving forwards.
Institutional investors are becoming more engaged with activism strategies as they pay closer attention to SRI. A gap still remains between embedding climate-related issues into an organisational management structure. Active managers, through stewardship, are looking to do that but do more than simply offering board oversight on proposals. In the U.S. major asset managers like BlackRock, Vanguard and Fidelity have started to be more active in their supports for ESG policies. Aberdeen Standard Investments in the UK is one of many examples where it placed huge pressure on BHP earlier in 2020 for policies it deemed were inconsistent with global climate change limitation goals. U.S. Hedge, Fund Elliott Management Corp., placed pressure on utility Evergy to change direction in order to “help facilitate the company's deployment of renewables and reduce its carbon footprint.” Activist shareholders though are not just reserved for conventional energy and mining, ENKRAFT in Germany placed pressure on the board of renewables group Energiekontor as recently as May.
“Sustainable investing isn’t ‘set it and forget it.’ The materiality of sustainability issues is changing constantly,” noted Investment Adviser Association’s President & CEO Karen Barr. “Active managers can help investors stay on top of these changes and achieve their long-term goals.”
The trend where institutional investors are increasingly looking with their advisers to do the proper due diligence around SRI to differentiate between those asset managers is only set to increase.
New regulations, such as the European Commission’s Disclosure Regulation that comes into force in 2021 on sustainability-related disclosures, are forcing institutional investors and their asset managers to manage assets more closely. New rules seek more transparency on how investors and financiers consider environmental risk in their investment decisions. The Regulation defines a “sustainability risk” as: “an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of an investment”. This requires an increased amount of data disclosure moving between the institutional investor and so-called financial market participants, something that will require investment in infrastructure in order to ensure effective monitoring and reporting on ESG-related obligations. Investment managers are being asked all the time to have a combined focus on fee reduction. In particular, the manager of a Dutch fund says “[managers] already face performance challenges in the current market setting. Engaging in a race over who has the best transparency is important but the timing is terrible'.”
Issuing more green bonds and embarking on ever more ambitious SRI targets doesn’t just create a market for viable green portfolios to be funded. Strong management teams, viable projects with supportive policy makers do. The Energy Council takes a view that any definition of green investment taxonomy needs to be pragmatic as well as expansive, in particular how it views scope emissions. KPI definitions and target-setting are as supportive mid-term as clear binary interpretations of any portfolio alignment with the Paris Agreement. This can act as an incubator by allowing issuers to raise capital against assets and operations that can form part of an overriding strategy that looks at sustainable finance mobilisation. This offers scale short-term and encourages brown bonds to start to become a slightly different shade on the spectrum.
The Energy Council network is committed to getting corporates and investors in the room to ensure the continued growth of renewable energy projects and tackle the very issues being discussed. It is imperative that we foster the right environment for private institutional capital to be deployed into renewable projects. Corporates come to meet investors, and each other, through membership of the Council. Around them, investment managers of all shape and size come to meet with them to discuss ESG and overriding SRI goals. The Energy Council membership is by invitation-only to qualified executives. To discover more and apply to be a member to join the discussion please apply for membership here http://climatecouncil.com/membership/