When the world economies move towards a change in macroeconomic and geo-political fundamentals and, in particular, when such changes lead to a generalized inflationary environment, with the rise in the prices of common utilities such as energy, businesses and citizens are the first to be affected in the short term.
This raises issues concerning national energy security and independence, and corporates and households’ energy sustainability.
Just few weeks ago the European Council reached an agreement on the proposal, presented by the former PM Mario Draghi, concerning the creation of an aggregate platform for gas, a price cap for the latter and the further development of the renewable energy sector.
Could this growing governmental and pan-European attention, not only to the regulation of gas prices but also to the promotion of renewable energy sources, lead to consider the latter no longer as alternative to traditional energy rather as substitute?
Considering the efforts, at least through shared sustainability programmes and objectives, such as those of the EU for the UN to achieve zero carbon emissions by 2050, and other climate and environmental sustainability plans under the various NRRPs drawn up by EU Member States, the entire energy industry and related sectors will receive more attention and capital allocation in the coming years, both through government intervention and private market funds.
In the private equity landscape, this greater curiosity about investments in renewable energy was already observable in the trend expressed in recent years, reported hereafter. According to reports from Pitchbook, in 2021 a total amount of 12.8 billion were invested in this sector in Europe, distributed over 189 operations, reporting a CAGR 16/21 equal to 9.58%.
European PE investments in renewable energy sectors (Source: Pitchbook)
Although the data show a slight decrease in the amount of investments made in the first half of 2022 in Europe, further research by BloombergNEF published last August, which extends the data globally, highlights how investment by PE and VC in the first half of 2022 reached $226 B, the highest value ever seen compared to the first half of previous years.
Moreover, the investments in renewable energy made by operators belonging to the private market seem to have an upward trend in the amount invested in the last two quarters each year, this is why it would be easy to expect a substantial increase in investments in Q3 and Q4 in Europe.
Global new investment in renewable energy sectors (Source: BloombergNEF)
In recent years, many PE funds have explored the energy sector with investments, both minority and buyouts, in companies operating in the energy transition, with a focus on industrial decarbonisation and renewable energy.
Although investments in renewable energy have increased steadily over the past decade, the contribution from private equity operators was largely stagnant until last year, but in 2021 private investments in renewable energy reached its peak since the financial crisis of 2008.
The first wave of private market investment in this sector, between 2010 and 2015, was different from what is happening in the current two-year period. It was mainly driven by investors seeking high-tech investments and the solar energy sector, for example, was well suited to these needs.
Today, however, this growth is not only driven by reasons involving national energy security with consequent movements at national and supranational level, and issues of public awareness about climate protection and environment sustainability.
The issue of capital allocation by PE firms in the energy sector appears to be LP specific: on one end of the spectrum, some LPs want none of their investments to be in fossil fuels-based businesses, whereas other LPs believe in an incremental shift away from fossil fuels to investments in industrial decarbonization businesses such as hydrogen blending and renewable competing alternatives.
Other argumentation attains the historical return rates from investments in traditional energy. Over the last 10 years, the return on investment in the traditional energy space has not been encouraging, especially taking into consideration steady, low gas prices (barring the impact of recent world events in hiking prices). In making their investment decisions, LPs not only look at the ESG policies and goals of the businesses, but also their potential return on investment.
Despite the many benefits of clean energy and renewables, the energy transition sector faces its own challenges and unintended consequences, which cannot be ignored. For instance, transitioning from gas powered to electric vehicles results in a proliferation of lithium ion batteries, increasing waste, and creates issues around how such waste is disposed.
When investing, PE firms should look to make not only incremental changes, but also practical changes. One example is to invest in reducing and eliminating waste through recycling plastics. Another area of opportunity is in the recycling of lithium ion batteries, which are used to power various devices, including smart phones and electric vehicles.
Notwithstanding, PE firms can play a very important role when it comes to the transition from traditional to cleaner forms of energy. PE firms may have the ability to assist traditional energy companies in making incremental improvements to help decarbonization efforts. They understand that traditional energy companies trying to making significant investments in non-fossil fuel-based businesses can be hampered, given that traditional energy companies are generally not set up to experiment with new technologies or processes outside their core business of fossil fuels extraction and production.
Moreover, the valuation expectations at energy transition companies are much higher in comparison to traditional energy companies, which trade at a much lower level. PE firms are often better equipped to evaluate early-stage companies through due diligence and organizational management, which can help those companies grow and become viable investments for traditional energy companies.
At last, the current rise in inflation is a problem for new energy as costs of raw materials have gone up. Also, the Russia-Ukraine crisis has highlighted the importance of energy security as a national security concern for Europe and other large economies. In the next future, countries will be less willing to rely on unstable regimes as their sole or primary source of energy, and this creates an incentive to invest in both transitional energy and traditional energy in order to ensure energy security and independence.
However, when global macroeconomic and geo-political factors eventually normalize, will renewable energy investments still be so attractive for private equity?
Source: Bloomberg, Pitchbook, ReedSmith, Climate Policy
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