The Road Ahead for Private Equity: Energy Transition

The energy transition posts a tremendous opportunity for private equity investors. The scale of the investment requirement makes private capital a “must have” and a broad spectrum of energy transition opportunities, particularly in “hard to abate” solutions, where direct electrification does not provide an efficient solution, offer a risk and return profile well suited to private equity fund expectations with significant value enhancement and upside potential.

Energy transition investments do, however, present novel or enhanced risks that will need to be well understood and carefully managed to ensure that they facilitate and do not hamper successful return generation and a timely exit.

These include uncertainty over the transition’s trajectory and timescales; exposure to first-of-a-kind technology risks; merchant feedstock and offtake volume; price and revenue risks; reliance on and access to key natural resources; stranded asset risks; heavy dependance on government policy, financial or regulatory support creating potentially material political, regulatory and change in law risks; greenwashing and reputational risks; and specific ABC and modern slavery risks.

With such a wide spectrum of investment opportunities available, fund managers will need a clear vision of how the global energy mix is changing and where they can best add value, manage and mitigate key risks and find synergies to build strong growth.

An “In Demand” Asset Class

A recent report from McKinsey & Company estimated that the transformation of the global economy from fossil fuels to clean energy will require about $9.2 trillion of annual investment in physical assets through 2050, which is a $3.5 trillion yearly increase on current investing.

With governments limited in their capacity to step up and completely embrace the risk necessary to advance some of the emerging technologies and markets necessary to advance the energy transition, these potential investments present a huge opportunity for private equity and other private capital.

A key trend in private equity fundraising in recent years has been the development of energy transition focused funds specifically targeting investments in energy transition solutions across the energy, infrastructure, natural resources and transport sectors, with recent, successful examples, including familiar names like BlackRock, KKR, TPG and Brookfield Asset Management, all highlighting the scale of LP appetite to investment capital and seek returns in the sector. 

While this period of higher interest rates has resulted in an overall slowdown in transactional activity by private equity as the market seeks to readjust pricing expectations, we are seeing no let-up in appetite for good energy transition assets with the potential for solid rates of return and growth. This is coinciding with growing demand from investors for investment in energy transition assets that deliver on both environmental, social & governance (ESG) principles and fund financial return expectations.

Incentivizing Energy Transition Investment

Through Government Support Mechanisms In an ever increasing number of jurisdictions (including the U.S., U.K. and the European Union (EU)), governments and regulators continue to introduce and expand clean energy strategies and support private investment into energy transition assets, creating tangible investment opportunities out of projects and businesses that were previously considered commercially unviable, without significant government intervention and providing opportunities for developers to scale and optimize new technologies to de-risk future deployment and drive assets along the cost reduction curve. 

Just as more mature clean energy markets like wind, solar, energy storage and battery manufacturing once needed significant policy and financial assistance to advance and now are thriving, the goal of these strategies is to catalyze in private investment to facilitate emerging energy transition technologies to eventually get to a similar place in the market—commercial viability without any or significant government intervention. It is this period of uncertainty in which private equity can play a pivotal role in bringing these emerging technology solutions to market.

In the U.S., the Inflation Reduction Act (IRA) introduced a wave of incentives evidencing a clear enhancement of government support for energy transition investments, including in emerging areas like carbon capture and green hydrogen. With the IRA setting out a framework for a huge amount of tax incentives yet to be fully developed, albeit, with IRA guidance either opaque or not yet understood, there is significant policy development still to come to crystalize the IRA incentives that were intended to jump start the energy transition in the U.S. This creates opportunity and risk for investors. 

The U.K. and the EU are also developing and delivering their own clean energy strategies, having led the way in government support to date, including via the EU’s new Green Deal Industrial Plan. In the U.K. and the EU, policy is generally targeted at earlystage investment support and then at insulating developers from offtake price and price volatility risk (and sometimes
also offtake volume or feedstock price risks) using, for example, contract-for-difference mechanisms or regulated asset-based models, rather than the tax credit model currently favored by the U.S., to bring energy transition investment to market.

Nonetheless, the goal remains the same—to support deployment and crowd in private capital—and the opportunity abounds for private equity. At the heart of the initial deployment of capital to support the energy transition sits a core assumption
that government support will continue to incentivize the flow of capital into the asset class. This can, in turn, lead to political, regulatory and change in law risk across jurisdictions and some forum shopping to obtain (and combine) the most generous government support regimes taking into account the specific risk profile for the relevant technology in the applicable region.

The U.S. is currently leading the way in the generosity of the government intervention, but continues to play catch up with Europe on overall aggregate investments in transition to date. For now, we also see investors trying to combine various programs to maximize the potential return on investment and hedging bets on cross-jurisdictional synergies in advancing the technologies, for example, manufacturing clean hydrogen in Canada and then exporting it into the EU, taking advantage of subsidies at both ends, or using green hydrogen in the U.S. to generate green ammonia for export to the EU.

Projects with higher perceived risk/reward profiles and newer innovations in areas like green hydrogen, ammonia and carbon capture and storage are increasingly attractive to private equity investors; provided that, as mentioned above, government support mechanisms are in place to de-risk and/or create financial incentives to undertake such projects and other key risks can be well understood and carefully managed.

In addition, we are seeing a growing interest from private equity in potential abatement or sequestration technologies in hard-to-abate sectors such as aviation, maritime and heavy industry, where emissions are either prohibitively costly or very difficult to affordably reduce with currently available abatement technologies (such as electrification supported by an increasingly green electricity grid).

Transactional Considerations for Private Equity

While government support is critical to enhancing the commercial viability of the relevant technology or project, understanding the spectrum of novel or enhanced energy transition specific risks associated with the relevant investment (including e.g., technology risk, policy and regulatory risks (including change of law), merchant feedstock and offtake volume, price and revenue risks, greenwashing and reputational risks; and ABC and modern slavery risks) is key in a transactional context.

This is ultimately a focus for investment due diligence where a tailored and targeted approach may be needed. As an initial step, investors should understand the underlying regulatory frameworks and determine what risks government support is seeking to eliminate or minimize and how and when that support will be provided versus what risks will remain with the project.

Typically, we see asset delivery risk (intensified by supply chain uncertainties) and technology risks remaining with the target—in particular, in the U.K. and European models. Offtake and pricing support only come into play once the asset is operational. 

On recent deals, we have seen investors focusing more intensely on the extent to which revenues are enhanced or guaranteed by government support, how much is contracted to stabilize counterparties and how to value energy or commodity price risk and merchant volume and revenue risks (if this is not mitigated through a government-backed instrument, for example, a contract for difference).

Although private equity players are no strangers to investing in energy & infrastructure assets, investment in emerging clean energy technologies does often necessitate a shift in the traditional method of private equity investing looking at longer hold periods to realize value and different investment structures to mitigate risk (e.g., risk sharing through joint venture structures or deferring investment tranches to certain milestones).

The “exit” can also be more complicated. Risk allocation and the traditional “clean break” approach can be tested where decommissioning and environmental liabilities may be prevalent (with insurance unlikely to cover these risks) and the sector also tends to result in greater regulatory scrutiny (and regulatory change), typically engaging foreign direct investment regimes and often involving consents from specific energy related regulatory authorities, which can drive extended timelines for deal-making and reduce the pool of potential suitable buyers.

Taking a step back, we also see a critical role for private equity in instigating a transition story for traditional fossil fuel assets through investing in and implementing new technologies. Examples include evaluating existing enhanced oil recovery assets for permanent sequestration, installing on-site renewable power or using existing rights of way for the development of carbon pipelines to sequestration sites.

Private equity is well placed to capitalize on these types of investments, adding value through responsible ownership during their hold period and entering a subsequent sales process with a more valuable asset with access to a greater pool of buyers.