A capital allocation dilemma in energy transitions

Financial professionals from around the world gathered in Paris last week for the annual UN Principles for Responsible Investment conference. Participants discussed opportunities and challenges for investing in a more sustainable future, and one message that was heard clearly was that institutional investors such as asset owners and managers – representing more than $85 trillion of funds – will play a key role in meeting the objectives of the Paris Agreement and other Sustainable Development Goals (SDGs).

IEA’s World Energy Investment 2019 highlighted that energy investment was stable at $1.8 trillion in 2018, but financing gaps are emerging in key energy areas. In order to realise what is outlined in any of the IEA scenarios – based on energy security and sustainability goals – energy supply investment needs to step up.

Global energy supply investment by sector in 2018 compared with annual average investments needs by scenario, 2025-2030

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Realising the accelerated decarbonisation and electrification under the IEA’s Sustainable Development Scenario (SDS) would require investments to shift towards capital-intensive low-carbon power, including a doubling of spending in renewables and increases in grid infrastructure. Investments would also need to rise in energy efficiency, a sector where smaller transaction sizes can make it difficult to attract finance.

There is substantial appetite for such investments. As the financial community increasingly seeks strategies for allocating capital in way that is consistent with the Sustainable Development Goals, green bond issuance has surged to $650 billion cumulatively. Actors are paying more attention to climate-related risks and institutions responsible for trillions of dollars have announced divestments from fossil fuel holdings.

However, these trends and ambitions raise fundamental questions. Is there a trade-off between increased financing for sustainable energy and long-term returns? What potential new risks and financing models will investors need to navigate along the way?

An analysis of returns on invested capital (ROIC) and weighted average cost of capital (WACC) illustrates the potential trade-offs and shows that the risks and profitability of investments can differ dramatically across energy sectors (ROIC measures the profitability of investments while WACC indicates the cost of financing them, which is a function of investor risk perceptions and macroeconomic factors. Their difference signals an industry’s ability to create shareholder value, a driver for company investment decisions and investor decisions to finance the companies).

Top 25 power companies by renewable ownership, 2006-2019

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Top 25 oil and gas companies by production, 2006-2019

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While individual results depend on company and market factors, the top oil and gas companies as measured by production historically enjoyed higher returns relative to the cost of capital, but with greater volatility. Since the start of the decade, returns dropped as market fundamentals weakened. Despite a recovery over the past three years (thanks to higher oil prices, cost reductions and careful project selection) higher equity financing costs and stagnant returns in the first half of 2019 suggest a more challenging investment environment compared with a decade ago.

In comparison, power companies – the top owners of solar PV and wind – have exhibited lower profitability, but with lower cost of finance and less volatility. Recent metrics suggest better financial performance by the power companies, with returns edging upwards and declining cost of capital, with a mixture of structural and cyclical factors at play.

As with oil and gas, returns in power also declined as thermal generation holdings were exposed to weaker market fundamentals. But more investment in assets with greater revenue certainty (e.g. renewables with long-term contracts) and higher power prices in some areas, have boosted returns in 2019 to a decade-high relative to a cost of capital that has declined due to the improved maturity and risk profile of renewables, and also low interest rates.

These trends and other factors are leading some industry players to change the way they approach investments. For example, many utilities, whose assets were previously oriented towards thermal generation, are boosting renewables, grids, and end-use services. Likewise, a few European oil and gas majors now plan to invest more in power and gas (though to date their activity has come more from acquisitions and renewables comprise less than 1% of capital spending).

Despite this financial backdrop, market signals have not yet spurred the substantial reallocation of capital towards energy efficiency and cleaner energy sources that would be needed to bring investments in line with the Paris Agreement and the SDGs. While low-carbon sources comprised one-third of energy investment in 2018, this share would need to rise to nearly two-thirds by 2030 to realise the SDS.

Asset allocation that increases the supply of finance can help improve the cost of capital and support industry decision making towards such goals. But this would need to be accompanied by a scale-up of profitable clean energy investment opportunities and suitable financing mechanisms to absorb new capital.

Governments, in the design and implementation of policies, play a crucial role in shaping such opportunities. Much will also depend on the capacity of investors to provide new financing solutions and navigate risks over the future direction of energy markets and technologies.

Consider that recent trends have shown that demand for oil and gas remains resilient and even on a sustainable pathway, oil and gas is likely to attract investment to offset natural field declines and serve difficult-to-decarbonise applications such as gas in industry. Many oil and gas companies see operational improvements and a focus on higher-return core assets as a better recipe for long-term profitability than investing elsewhere in energy.

Evolving characteristics of low-carbon investments also raise their own challenges to creating such opportunities, and there are several areas particularly ripe for further work. These include:

  • Financing new business models. Policies guaranteeing long-term revenues have underpinned most renewable power investments. As incentives and market design shifts in some jurisdictions, such as Europe, and flexible technologies such as grids and battery storage come increasingly into play, investors may need to grapple with new business models, less cash flow certainty and potentially changed financing costs.
  • Securitisation of small-scale assets. Energy projects can be aggregated into portfolios that can be securitised to give investors a route to financing small-scale assets while spreading risks and lowering financing costs. Such mechanisms could play a greater role in efficiency, but require clearer policy signals, and performance contracts and guarantees that help clarify the financial case.
  • Managing investment risks in emerging economies. Financial flows under any energy pathway are set to grow strongly to meet the fast-growing needs of emerging economies, where the cost of capital is higher, financial systems are less developed and public financial institutions play a greater role de-risking investments.

Overall, scaling investible opportunities aligned with long-term goals will require better coordination among investors, companies and governments, as well as good data and analysis to support decision-making. These are areas where IEA investment work can help, from tracking and scenarios through policy advice and engagement.

Related commentaries in the coming weeks and months will continue to explore the key factors shaping the value chain for energy investment and finance, including changing business strategies in the oil and gas and power sectors, trends in venture finance across energy sectors and addressing investment risks in emerging economies.