An Attractive Option

Offering unexciting yet stable revenue streams, infrastructure investment has always been seen as a safe asset class. A number of factors lie behind this perception. Long-term contracts are a classic characteristic of energy infrastructure investment, which enables investors to plan far ahead. Furthermore, historically there has been a serious under-investment in this sector and catch-up is necessary. Around the world many power plants, transmission cables, and pipelines will soon reach the end of their lifetimes and will either have to be updated or replaced — potentially requiring €2 trillion of investment in Europe alone. The EU has admitted it expects 450 GW of power to go off-line by 2015 and the pan-European electricity industry lobby group, Eurelectric, has said that the EU will need about 520 GW of new capacity by 2030.

The need to replace and improve infrastructure is already resulting in record levels of expenditure, and meeting increasing power demand growth is going to require considerable investment over the coming decades, too.

Governments globally are also now mandating billions be spent on renewable energy infrastructure. The International Energy Agency (IEA), among others, is calling for urgent investment in energy technology. It warns that without a US$35 trillion energy technology revolution, the world could face a 130% surge in carbon emissions by 2050. All in all, this leaves an enormous energy supply gap.

Bruce Jenkyn-Jones, director of investments at Impax Group plc says: ‘There is a huge spending requirement in infrastructure as a whole, and in environmental infrastructure in particular. According to OECD estimates, spending will rise by nearly 50% each decade, fuelled by population growth and globalization.' The major appeal of the sector to investors is the cash-flow that can be generated from such investments, as well as the relatively low-risk nature of such deals. Certainly, environmental energy infrastructure offers investors a class of investment with predictable, asset-backed revenue streams that are underpinned by government regulation, as well as long-term off-take agreements or power purchase contracts. Jenkyn-Jones continues: ‘The key issue is balancing risk versus return, and a regulated risk in a developed country is one of the best risks there is.'

Different legislation within countries can obviously have an effect on returns. If, for example, a region has a feed-in tariff then investors have a known price to work with; if utilities must buy all renewable power generated then there is no demand risk; and, if there is a standardized development process, that results in minimized development risk. Ernst & Young's 2007 Renewable Energy Attractiveness Index — which identifies risks, analyses the extent to which there is favourable and stable legislation in a country, as well as the reliability of a region's natural resources, and how successful the renewable energy industry has been — deemed the US the most attractive market, followed in turn by Germany, India, Spain, the UK and then China.

Risk evasion

The energy sector clearly has a constrained future, as increasing demand coincides with a focus on the negative implications of fossil fuel use. Power prices are high and we're unlikely to see a price collapse in the near future, which will increase investor returns on traditional fuels. There's no question that there are currently higher returns to be made from oil and coal than from renewable energy. However, as the market continues to evolve, the price of carbon could change that.

Identifying the best investment opportunities requires a close understanding of the environmental infrastructure business, including an in-depth knowledge of the different regulatory regimes and market drivers that affect the sector.

Jenkyn-Jones accepts that there are risks, including, ‘failing political commitment to long-term environmental policy and legislation, as evinced by the lack of an international policy post-Kyoto.' Yet, already, regional governments are taking independent action — the EU is reviewing legislation requiring at least 20% of energy to come from renewable sources by 2020, as well as a 20% cut in carbon emissions. Jenkyn-Jones says: ‘The three key drivers for effective renewable energy investments are those of environmental policy, or the ever-tightening ratchet of legislation, market liberalization and the falling cost of technology.' In order to identify the best investment opportunities, it's important to pinpoint markets where these three drivers interact.

It's also necessary to understand the practical aspects of what differentiates markets by region, from levels of economic support, to requirements for upgrades or new infrastructure, to the ability of new power plants to access the grid. In 2007, the US led the league table in new wind capacity, adding 5.2 GW, followed by Spain with 3.5 GW and China with 3.3 GW. However, up to 30% of all wind projects in China are not connected to the grid, owing to a combination of slow planning progress and little state support. Even when power plants are connected, the existing grid can have problems handling variably generated power.

A broad range of energy technologies could be used to achieve the national and international targets set for the generation of renewable energy. However, fuel cells have yet to live up to their long-awaited potential, while potential geothermal capacity is limited by geography, and biomass projects can be limited in size by feedstock limitations. Marine power has a long way to go before its costs can be brought down sufficiently to make it a worthwhile infrastructure bet. Indeed, Ian Simm, chief executive of Impax Asset Management says of marine power: ‘It would be impractical to expect a large contribution within a decade, although by then we should have operating small-scale farms in both wave and tidal. We need a twenty-year vision for marine power.' Therefore, the key technologies currently providing the most interesting infrastructure investment opportunities are wind and solar-based devices.

The relative capital costs of solar and wind remain far higher than those of coal or natural gas projects, but it seems likely that fuel costs will continue to rise. And once a wind or solar project is up and running, there is no fuel requirement — capital investment and ongoing maintenance are the only costs. If capital costs of wind and solar continue to fall, then renewable energy could rapidly become competitively priced.

There are clearly significant benefits to wind as a source of renewable energy. It is cheap; it is utility-scale; load factor and efficiency are far higher than for alternatives, and manufacturing costs can be paid off in months rather than years. There have been high hopes regarding the offshore wind market. However, these have been dampened somewhat by Shell's recent withdrawal from the £2 billion (US$4 billion), 1 GW London Array project, although its partners E.ON and Dong have since agreed to buy out Shell's stake. The wind market operates on thin margins, but problems in sourcing sufficient turbines, and in planning, construction and grid connection are beginning to seem endemic. Increasing costs in the global commodities market are also likely to take their toll on renewable energy devices.

For example, the price of offshore wind turbines has risen by 48% to €2.23 million/MW ($3.45 million/MW) in the past three years, according to Denmark's BTM Consult APS, while onshore turbines now cost €1.38 million/MW after rising 74% over the same period. Cambridge Energy Research Associated (CERA) predicts that turbine costs are likely to increase by at least a fifth in the next 2-3 years. This could cause problems if input costs increase while energy prices remain constrained by fixed tariffs. In Germany, for instance, local feed-in tariffs were supposed to be coming down 2% per year. Now the government is being asked to increase the tariffs, and even to index-link them to the cost of steel and copper. Non-feed-in tariff markets retain more flexibility, as the price of power can be raised to reflect increased input costs.

The UK would seem to be just such a flexible market, but the slow pace of change in the UK market for developing onshore wind seems to have put off all but the most experienced players. In parts of Europe, many of the sites with the highest potential wind resource have already been developed, so for many the US is the most attractive wind market in the developed world. Successful developers in the wind market will be those with the expertise to develop power projects in specific markets or utilities, such as Endesa for example, which has particular experience in Latin American markets.

William Young, wind analyst at New Energy Finance warns that the market may prove tight for new entrants. While he believes that wind energy will prove a safer investment than many others, margin squeeze will remain strong over the next couple of years. The position for those with an existing portfolio is robust, generating cash at a fixed rate, but in the short-to-medium term, a more worthwhile investment could be in technology companies that target cost reduction and manufacturing in the supply chain. Capitalization of developers remains a key issue, as equipment manufacturers often require payment (or part payment) up front in order to secure supply — and usually long before a project is generating any cash flow.

Investment and opportunities increase

Despite the difficulties, investment flows continue to increase. New Energy Finance reported $24.8 billion of activity in Q4 2007 — with almost $1.8 billion of refinancing. Refinancings were almost double the amount of the previous quarter and acquisitions accounted for $3.5 billion. There was also a jump in the volume of new wind financing in Q4 2007, from $8.3 billion to $12.6 billion, with most activity in China, India, Italy, Spain and the US. While turbine costs may be increasing, this is partly due to increased demand. As demand grows, it's likely that more resources will be allocated to manufacturing, eventually restoring the supply-demand balance and bringing prices down.

While the wind market may well prove tight in the short term, James Vaccaro, managing director of renewable energy investor Triodos Renewables Fund says: ‘One area where the potential for growth is also most exciting is within existing wind portfolios.' A cost of wind projects which is often ignored is the cost of decommissioning. According to Vaccaro, the point of decommissioning a project in fact provides a unique opportunity to increase return. He says: ‘An existing project which has reached the end of its lifetime is far more likely to pass planning hurdles than a new project. Repowering that project can mean a greater value of that project at termination than cash income over the operational life of the project. New turbines are far more powerful than those of 15 or 20 years ago.' It can even be possible to make a decommisioning profit by taking down old turbines and selling them off to developing markets. Vaccaro adds: ‘The possibility is that realization value can even be ahead of deployment.' For those with existing wind portfolios, this could have an enormous potential for increased return.

The solar market has far higher potential for new market entrants than wind. A solar PV installation is less likely than a wind project to create problems with the local community, either in the planning process, or in relation to concerns about wildlife and the local environment. Barriers to entry are coming down, and there have been improvements in technology and efficiency, creating a huge potential for costs to fall. PV production has been doubling every two years, increasing by an average of 48% each year since 2002, making it the world's fastest-growing energy technology. With increases in efficiency, and large amounts of solar manufacturing coming on line, the price should continue to fall. Investment is following suit — solar financings in Q4 2007 hit $2 billion, mostly in Spain, with a handful of deals in Italy, South Korea and the US.

PV is not the only option in the solar market. While prices have declined an average of 4% per year over the past 15 years, it remains relatively expensive, impacting on installation costs. According to a 2007 report from Photon Consulting, solar is already at a cost level that makes it competitive with residential grid prices in the OECD's highest-priced markets and could even reach widespread grid parity by 2010, though many disagree. Nonetheless, according to Jenny Chase, senior associate, solar, at New Energy Finance, global silicon supply is likely to quadruple by 2010 due to new capacity coming on-line in China, Russia and Germany, bringing about at least a 30% drop in module prices.

There is also growing interest in the potential of large-scale solar thermal energy generation (STEG), also known as concentrated solar thermal power (CSP). In fact, the biggest deal in Q4 2007 was Abengoa's $287 million financing of its STEG plant. Sebastian Waldburg, of private fund SI Capital R&SI agrees. He says: ‘Capital costs have been falling in the renewable energy market and even a few percentage point drops means huge profitability gains.' Solar thermal power is far cheaper to generate than PV power, at 12-14 cents per kWh, but PV is competing against the retail price of electricity while STEG is competing against utilities directly, and there is still a price gap. Utilities can typically generate power around the 5-7 cents mark.

Waldburg, who invests predominantly in Spain, sees a huge opportunity. He says: ‘As a country, Spain has seen growth rates of 250% compound annual growth rate for renewable energy; it has feed-in tariffs for 25 years and guaranteed 100% renewable energy off-take.' He emphasizes the importance of looking at the gap between existing renewable energy infrastructure and specific country targets. Again, looking at Spain, he says, ‘If you multiply that megawattage by regional feed-in tariffs, you can identify the scale of investment needed - by 2010, €16 billion needs to be invested in Spain in biomass, biofuels, CSP, PV, wind and small hydro.' He is particularly excited about the opportunity in CSP.

Although only one concentrating solar thermal power project is currently in operation in Europe, a 10 MW plant operated by Abengoa, there are approximately 2.9 GW of such projects currently in planning. The returns are high, driven by a market with solid policy support combined with the ability to generate fairly competitively priced renewable power. SI Capital invested in Enerstar, which is currently developing three 50 MW CSP projects, at an early development stage. The projects are now nearing construction and, when Enerstar raised additional capital recently, the valuation was considerably higher than when SI Capital made the original investment.

In the US, coal-fired plants generate at 5-7 cents per kWh. The US-based CSP plant Nevada Solar 1 is selling (peak) power at 18 cents per kWh — so it must be generating power below that level. There is still a significant price differential, but it is narrowing. Spain has a regulated tariff of €0.27, guaranteed off-take and country targets of 500 MW — which may soon be increased to 3 GW. Waldburg says that CSP is only profitable in large installations, but the opportunity is enormous and the risk low. He adds: ‘There are growing opportunities for innovation and development in terms of heat storage in salts.'

In the short term it's likely that PV will continue to outstrip CSP investments, due to the relatively long lead time required for such a development — about three years. However, there are a growing number of regions with specific CSP feed-in tariffs — Spain introduced these in late 2006 and both Italy and France brought in tariffs in early 2008. The technology's potential at a utility scale and the increasing number of subsidies and targets make it an exciting opportunity.

For most forms of renewable energy, variability remains a problem and energy storage is a crucial hurdle to overcome. Energy storage, by acting as a buffer between the source of power and the user, can smooth out spikes in power supply, strengthen the grid by storing power near its point of use and transform intermittent and erratic output into smooth predictable power flow. The technology remains expensive, but some systems are becoming competitive. For example, Canada's VRB Power Systems has developed an electricity storage system that allows for the storage, management and integration of variable power within the grid system. This can dramatically improve the economics of renewable generators, as electricity can be sold at the highest available price, making them more appealing as an alternative to fossil fuel generators.

Investment requirements and the carbon market

In choosing a renewable energy investment there are several key things to consider: a large gap between actual deployment of a technology and country targets; a long-term stable economic framework; off-take guarantees — and the potential to generate carbon credits or allowances of some kind.

In terms of global investment in renewable energy infrastructure, this is one mechanism that no investor can afford to ignore. They are a tool for bringing in large streams of mainstream finance and offer potentially exciting returns. Furthermore, while the carbon markets provide an opportunity to transfer technology from the developed to the developing world and support sustainable development, they also provide an additional stream of finance to mitigate the risk of investing in developing markets. The World Bank has reported that, to date, $33 billion of investment in renewable energy has been due to the Clean Development Mechanism (CDM).

In 2007, global carbon markets were worth in excess of €46 billion, up 100% from 2006. The bulk of the market is represented by the European Union Emissions Trading Scheme (€36 billion for 2000 mtCO₂e) and the CDM (€9.4 billion for 791 mtCO₂e). Around two billion Certified Emission Reductions (CERs) were originally expected to be generated by the end of this phase of Kyoto in 2012, generating around €23 billion-worth of CDM credits over the period. However, CER prices have gained nearly 25% since January this year (January-June 2008) and Point Carbon has projected that record high oil prices and a lower-than-anticipated supply of international carbon credits mean carbon allowances will trade at €32 on average during the second phase of the European Union's cap-and-trade scheme. This means the return on such credits is only likely to increase.

According to Tom Hill-Norton, partner at carbon project investor Plane Tree Capital, the reason for the success of the CDM is simple. He says: ‘Offsets in developing countries are economically efficient, therefore cheaper, which provides enormous benefits for developing economies.' Effectively, the CDM creates a free subsidy providing incentives for the developing world to move towards clean energy.

By doing so, the process can decouple emission reduction from economic growth, and ensure that developing economies continue to grow, while helping to decarbonize the global economy. And, while the early days of the carbon market saw the registration and financing of many industrial decarbonization processes (such as destruction of HCFCs), clean energy projects accounted for 64% of CERs generated in 2007 (33% in 2006 and only 14% in 2005).

The CDM has been criticized for funnelling money to projects that might have been developed anyway, even without carbon credit-based funding. However, Hill-Norton is clear: ‘It is the addition of revenue from the sale of CERs that enables marginal renewable energy projects to become viable.' He adds that some projects derive as much as 50% of their revenue from carbon credits. The appeal of carbon credit financing is not only that these projects contribute significantly to addressing global environmental problems, but they also offer equity investors another class of investment, providing relatively predictable, asset-backed revenue streams underpinned by government regulation.

Increased interest in the environment, coupled with the recognition that climate change presents a compelling business opportunity, means that investment in environmental solutions is becoming a key theme for all investors. The growth story in environmental investment — combined with rising oil prices, concerns about energy demand growth and security, legislation and global climate change — make renewable energy infrastructure investment an attractive option.

Felicia Jackson works with Carbon International in London, UK
e-mail: felicia.jackson@carboninternational.com