Energy transition: Opportunities abound

Can you afford to miss it?

Mark Watts, CFA

Investment Partner

It is not often you get to see a megatrend signposted so clearly and so early. Often you only see a megatrend in the rearview mirror. But the energy transition is one of the great megatrends that will persist for at least the next 30 years.

The investment market is open for business and our inaugural Energy Transition Investment Manager Survey provides us with important insights and underscores the need for advice in this complex area.

In order to reach our net zero targets, Bloomberg’s NEF report estimates that we will need to invest USD200 trillion over the next 25 years. As asset owners and investors, it is incumbent on all of us to understand the transition and the opportunities that it presents. Not only will this likely reduce forward looking downside risks to both the economy and financial markets, but it will also provide ample opportunity to invest in new markets with strong return characteristics.

As asset owners and investors, it is incumbent on all of us to understand the transition and the opportunities that it presents.

What is the energy transition?

Energy transition is a collective term for a series of activities that are designed to take the world from high greenhouse gas emitting activities to much lower levels, decarbonising how we produce energy and use it. By decarbonising, we seek to hold “the increase in the global average temperature to well below 2°C above pre-industrial levels” and pursue efforts “to limit the temperature increase to 1.5°C above pre-industrial levels” as per the legally binding Paris Agreement.

Why do we need energy transition?

According to Climate Action Tracker’s November 2022 report, based on its current path, the world will miss the 1.5-degree limit by a sizeable margin. Modelling suggests that there will be severe impacts on both global economies and global financial markets from a failed transition and even partial progress will still not be sufficient to avoid considerable downside. Studies we look at show cumulative global GDP declines of up to 28% in the case of failed transition, and cumulative declines of up to 40% in a 60/40 bond/equity portfolio over the next 40 years.

Is energy transition an attractive area to invest in?

Investment attributes of the transition mirror that of the infrastructure space. There are investment opportunities available across the ecosystem, in generation (windfarms, solar PV etc), storage (batteries, or pumped hydro) networks (undersea cables etc) and demand (home energy management systems etc) each has their own drivers of revenue. Below, we look at key findings from our 2023 Energy Transition Investment Manager Survey which was conducted in August and September and covers some 73 managers and 103 strategies with AuMs of circa GBP228bn invested in the transition. The survey is a vital resource helping asset owners to understand the market and how and with whom they should invest to achieve their goals.

Returns

LCP's survey results indicated that most managers expected returns to be in the 9-11% IRR range, but we were interested to note that the pure play energy transition managers were more bullish, expecting returns in the 11-12% range, a small but meaningful premium to more traditional infrastructure focussed strategies. Some managers are even suggesting 15% is possible. Irrespective of the precise number, in today’s environment those types of return stack up well.

Risks

Broadly speaking we see the risks inherent in the energy transition space to be similar to those in the infrastructure space, especially in the generation, transmission and some of the storage segments. These areas tend to be larger in scale, with income streams often based on long-term government backed contracts. The policy environment and cost over runs are risks on the generation side, in the demand segment technological and a related risk, poor adoption, are present.

How can investors access the energy transition market?

Structures

In our survey, we found that private equity structures dominated but were by no means the only way for investors to gain access, open ended funds, segregated mandates and fund of funds were also present. Over half of the managers that we surveyed reported that their strategies were dedicated to the energy transition whilst the rest allocated from a more traditional infrastructure base.

Size

We are encouraged by the fund sizes that asset managers were reporting. Over the survey period we collected data about where managers were in their current raise and the targets that they were expecting to achieve. We were encouraged to see strong numbers building, with a number of strategies in the USD1.5-5bn range, and a similar number exceeding USD5bn in size. We believe that this provides ample opportunity for us to build diversified portfolios of exposure across a range of clients of differing asset sizes.

Geography

The majority of managers offer global or multi region products. Worthy of note is the large part that European exposures play in fund structures possibly driven by a clearer regulatory environment, good transparency and clearer public policy support and objectives.

Sectors

In terms of where funds are placing client money, looking at the four energy system sectors (generation, storage, networks, and demand) can see that across the energy transition investment space that generation dominates with the other segments gaining some traction but currently with clear distance between them. This is not surprising as they are largescale, tried and tested, and backed by government revenue.

% allocated to energy transition categories

Source: LCP Energy Transition Investment Manager Survey September 2023

Subsectors

Our analysis of the detail of where managers were allocating has yielded some surprising results. Within generation, solar and offshore wind were the most popular (not surprising), but outside of that, there was a good spread of subsectors. In the storage segment, co-located battery storage was the most popular choice for managers, with a good spread of alternative technologies also gaining attention.

The evolution of energy transition investing

We believe that we are in the foothills of energy transition investing with the vast bulk of the mountain still ahead of us and the climb. To illustrate the point, the chart below shows the amount of investment in 2022 in the energy transition space which was circa USD1.5 trillion globally. It was split fairly evenly between energy demand and the generation side, and perhaps more interestingly, for the first time equal to the investment expenditure on fossil fuels. We agree with the International Energy Agency that annual level of investment needs will triple from last year’s levels and that the need for fresh capital will continue unabated for the two decades after that, reaching 5 to 6 times 2022 levels.

Scale of investment needed - the challenge of a generation

Source: International Energy Agency NEO 2022 Net Zero Scenario

Conclusion

Energy transition is a mega trend that investors cannot afford to miss. There is already a striving ecosystem for energy transition, the technology exists, and methods of access have already been tested. The global policy environment is supportive, and we stand ready, willing and able to help asset owners on their journey to commit capital to the energy transition.

Find out more...

Hear more on the topic from Mark Watts at our 2023 Investment Conference.