All change please?

Fossil fuels and renewables in a decarbonizing economy

As the world sets its sights on decarbonizing economies, are fossil fuel investments being entirely displaced by renewable-related plays?

Energy transition across the world is picking up pace. Last year, the world added more than 260GW of renewable capacity, according to the International Renewable Energy Agency, a rise of 50% on 2019. Further, as much as 80% of all new electricity capacity installed in 2020 was renewable, as falling costs make clean sources of power the preferred type of generation in many markets.

But what does this, combined with political and societal pressure for decarbonization, mean for private markets investment in the energy sector and beyond? It’s clear that many LPs are taking a long, hard look at their energy exposure, in particular as they look to the long term and as they integrate ESG considerations into their investment processes.

While there have been some geographic nuances around LP appetite for different energy assets in the past, some of these are starting to fade. “Historically, we’ve seen a difference between European and North American LP demand for energy investments,” says Evan Corley, Partner at Pantheon. “In Europe, the focus on ESG has led to considerable declines in demand for traditional energy investments for some time, yet over the past two to four years, we have also started to see a reduction in demand from North American LPs, in particular for upstream-related

investments. Many have used the volatility in traditional energy as an opportunity to reset their investment policies and this is being led by endowments and foundations especially.”

The end of the road?

Given this, it would be easy to draw the conclusion that traditional oil and gas investments have run out of road. Yet this is not necessarily the case. For Michael Felman, President and CEO of family office MSF Capital Advisors, it’s a question of supply and demand. He points to US auto sales figures over recent months, which have picked up considerably, and the majority of these involved gasoline-powered vehicles. “That means we’ll still see demand for oil for many years to come,” he says. “Electric vehicles will certainly increase their share, but it will take many years before they reach anything close to parity.”

There is, therefore, opportunity in increasing operational efficiency in more traditional energy sectors. “If you can save a dollar on operational cost, you can create $20 of value,” says Felman. “The oil industry has historically lacked this – in the past, if prices were high, companies increased drilling and when prices were low, they reduced it. Now, out of necessity, there’s much more focus on efficient use of capital

capital and there will be opportunities there. We tend to favor natural gas, which will be needed at least over the medium term, over oil. But I wouldn’t write off oil anytime soon because there will still be demand for gasoline from autos and airlines.”

Water is the new oil

The continued demand for hydrocarbons for some time to come means that some investors are looking at associated areas. “We have investments in a couple of frack water companies,” explains Felman. “Disposal wells are not permitted any longer and so it’s getting harder to get rid of waste water and fluids. That means there is tremendous potential in finding ways to use water more efficiently. Water is the new oil: the West is running out of it.”

Water is also a theme Barings has a close eye on, albeit with some caution. “Americans now pay 30% more for their water than 10 years ago,” says Mina Pacheco Nazemi, Managing Director at Barings. “Anywhere you can conserve water is a great opportunity, but it is tricky as an investment. It’s clearly a public good and you have some places, such as Pennsylvania, where citizens are charged not just according to their usage but also according to their income levels.”

We clearly need to think about terminal values at exit, but we also have to consider whether risk is sometimes being mispriced in renewables, where there is a lot of capital currently.

- Evan Corley, Partner at Pantheon

Moving on

Yet while certain pockets of more traditional energy-related investments hold some attraction for investors, many are increasingly focused on what comes next, as forces for energy transition and moves towards net-zero economies gather pace.

Large-scale renewables projects have already attracted significant funding over recent years, and this is leading some to question how attractive this space remains. “We are subject to our LP demand,” says Corley. “But we also have to think about where the risks are. So, we clearly need to think about terminal values at exit but we also have to consider whether risk is sometimes being mispriced in renewables, where there is a lot of capital currently.”

However, there is a whole raft of opportunity around the switch to more sustainable energy production that doesn’t involve funding solar or wind projects themselves. Batteries and storage are clearly an important area to address, given the intermittency of renewable power sources. Here, investors are looking primarily at smaller scale projects. “We’ve been moving away from larger projects towards funding smaller managers and investing in small and niche opportunities,” says Pacheco Nazemi. “We’ve invested in a battery project in Brooklyn, for example, and we believe that once you get the model correct, you can replicate that across different parts of the country. We’re also looking at areas such as pump storage in hydro-electric dams to fill intermittency gaps.”

Felman agrees. “The holy grail will be micro-grids,” he says. “There will be a need to create what will almost be mini-power systems. There are some challenges on the technology side, but this is getting better. We tend to view these more as venture opportunities for now – and that’s OK for us, but may not be great for those looking for utility-type investments with visible cash flows.”

Hydrogen is another area that may provide deal potential, with some investors seeing this as a viable energy source for the future. There are still obstacles to overcome, given the significant energy consumption needed to make it, and while there is a lot of talk about developing ways of producing green hydrogen, the reality may be some way off. However, investors are exploring early-stage solutions in this space.

“We have made a small venture-type investment in hydrogen fuel cell technology,” says Felman. “One of the reasons for this is that we have investments in shipping, where it’s no longer possible to use high sulphur fuel and mitigating this is expensive. There is a limit on viability for lithium-ion batteries in areas such as aviation and shipping, even as they reduce in weight, and so we see hydrogen fuel cells or a combination of these with lithium-ion batteries as a solution.”

Looking further afield

As Matthew Saverin, Associate Director at UTIMCO, points out, energy transition is estimated to account for between 50% and 55% of the decarbonization required. “Energy transition clearly is not the only solution and the market has to decarbonize the other 45-50%,” he says. “When you look at the sources of greenhouse gas emissions, it is clear that this will impact every sector, and every industry. That means it affects every part of our organization as an LP, covering public equity investments, fixed income, hedge funds, venture capital, private equity, infrastructure, real estate – everything.”

For UTIMCO, decarbonization does not necessarily mean investing in some of the more obvious segments, such as electric vehicle infrastructure, which Saverin sees as holding a “limited opportunity set” for now, in particular as it is starting to attract funding. “We like to fund pockets where there is less capital,” he explains. “These tend to be areas with greater complexity, that are smaller scale and where you can create simplicity through value-added operations and portfolio aggregation. Additionally, we look for solutions that are tangential to decarbonization and required as energy transition occurs.”

UTIMCO invests, for example, in small-scale hydro-electric power generation and natural gas peaker assets and in metals and mining. “There is no capital flowing to metals and mining – it can take two to three years to raise a fund here – yet metals such as copper and nickel are key enablers of decarbonization,” he says.

Saverin also points to more broad opportunities, reflecting Felman’s views around efficiency. “Decarbonization is creating massive waves of innovation across the board,” he says. “This is one of the biggest themes we’ve ever seen globally and it is going to take more than $100trn dollars globally over the next 30 years – that’s $3.5trn annually, or 4% of 2019 GDP levels.”

He adds: “There are great opportunities in emerging technologies, say, or renewables, but simple business decisions are highly relevant here. Even if it isn’t the primary driver, decisions to reduce costs can often result in decarbonization anyway. If you take food production as an example, technologies already exist that can produce goods such as coffee, chocolate, alcohol, etc, at a lower cost and those processes also happen to decarbonize in a significant way – in several of these cases, the processes are 30 times less carbon-intensive than traditional production.”

Real estate offers another example, in which building owners can improve the energy efficiency of their properties. “This has existed for decades, but not everyone does it,” says Saverin. “We expect to see a higher adoption rate for solutions that make good business sense today and believe there are places where investors can play that don't include technological and more isolated risks.”

The transformation necessary to achieve decarbonized economies clearly offers significant investment potential across sectors, company development stages, geographies and asset classes. This will even include traditional energy segments for some investors, but the overall theme will be capital flowing towards companies and projects that lower or remove greenhouse gas emissions.

“There is ever-more capital coming into the renewables and decarbonization space,” says Pacheco Nazemi. “LPs are lining up to put their money into this strategy. Many investors, including retail investors, want to feel that they are funding the revolution. There is so much interest here – and that can only propel growth.”

What subsectors within real assets and energy are attractive to LPs now? Watch our exclusive interview with Mina Pacheco Nazemi, Managing Director at Barings to find out more about the LP views on real asset investments and how LPs are shifting their allocations and due diligence processes as we enter into the post-pandemic era.