Meanwhile, renewable energy markets are fragmented and growing fast. In both the US and Europe, many renewable initiatives focus on regional and community projects that require alternative sources of financing—and create fertile ground for investors.
Inflation Reduction Act Is a Game Changer for Renewables
In the US, the shift to renewables will further benefit from incentives provided by last year’s Inflation Reduction Act (IRA). The IRA is a game changer for the US industry because it extends tax credits for at least 10 years for developers of clean energy projects and technologies. Before these provisions, the industry was plagued by uncertainty as tax credits were being phased out.
Every segment of the industry should benefit. The legislation addresses traditional renewables as well as new technologies that must scale up and become cheaper over time, such as green hydrogen, sustainable aviation and biofuels.
Battery storage is a great example. Before the IRA, many battery-storage projects weren’t economically viable because of cost inflation or supply chain delays. Now, these initiatives will benefit from a base tax credit of 30% that can be increased for projects in low-income areas or within communities that have significant employment in fossil fuel industries.
There are different ways for investors to put private capital to work in supporting the energy transition. Some opportunities involve the purchase of “hard assets,” such as solar and wind facilities or battery storage installations. Others involve lending—for example, to homeowners installing residential solar facilities or to businesses, where private debt is backed by renewable energy development projects and equipment. Private financing can also be deployed to finance commercial energy efficiency improvements.
Owning Hard Assets: Investors in the Driver’s Seat
Investing in hard assets offers several advantages. First, private investors gain the ability to conduct thorough due diligence on the assets being purchased, allowing for a comprehensive valuation analysis. Second, the degree of control afforded by private investment allows the owner to actively manage the asset and influence its cash flows. Third, active asset ownership provides investors with direct means to reduce downside risk.
Controlling an asset puts investors in the driver’s seat of a project. For example, by purchasing a solar project, we can install a storage battery adjacent to the solar facility that enables the facility to sell power for more hours a day. That translates into more revenues for investors and potentially a stronger value proposition for power offtake counterparties that are contractually engaged in purchasing the power.
Repowering assets is another way to enhance value. This process typically refers to existing operating projects that may not have aged gracefully and could perform better. By upgrading technologies and equipment, we can improve the project’s efficiency and extend its life. This, too, may produce higher returns for investors.
Purchasing hard assets also provides control over critical contracts. Contracting revenues for five, 10 or 15 years typically affords more visibility on pricing and profitability. Alternatively, investors can take more risk by selling power into the more volatile spot market.
Controlling an asset also allows private investors to take a hands-on approach to reducing risks. By staying on top of operations and management, an asset owner can identify and address problems. If a solar facility suddenly sees a drop in production, we can troubleshoot in real time—maybe there are trees shading the solar panels, or perhaps an inverter has broken down.
Private Lending Helps Communities Go Green
Debt financing is another key component of the energy transition. Commercial developers are finding attractive alternatives to bank lending from private investors. The economics of these deals can be quite favorable for borrowers and creditors alike.
For example, a wind farm operator in Texas required a financing package after suffering damage from a superstorm in 2021. We structured a loan to provide return of capital at attractive yields that didn’t rely on operational improvements or stretched price assumptions, and also gave us an equity interest in the project. Creative structuring of the deal helped the wind farm sponsors avoid a formal debt restructuring that would have destroyed value to tax equity.
Community solar projects are another example of an area where private loans can make a big difference. In these projects, homeowners don’t install solar panels on their rooftops. Rather, a solar farm is established in the community that produces power, which can be purchased by homeowners, renters, businesses and even municipalities. The power may also be sold for distribution through offtake agreements to an investment-grade utility in the area.
Loans can also facilitate the energy transition for individuals. Think about a homeowner who wants to install solar power on their rooftop, possibly with battery storage to optimize the power use. Depending on the size of the home and the preferred setup, this could cost between $20,000 and $50,000. Financing the installation with a loan makes good economic sense; often, the monthly loan repayments are meaningfully less than the cost of the monthly electricity bill.
Private investors play a role through purchases of loan portfolios to provide liquidity to lenders and capture attractive long-term return potential. In some cases, securities can be created from the loans and cash flows, which can be sold in the asset-backed securities market.
How Do Private Investors Evaluate Opportunities?
Evaluating any investment in public or private markets is all about the risk/reward trade-off. For private investing or lending in renewable projects, analyzing an asset or project is a particularly complex affair. On the one hand, there is relatively good visibility into the factors that drive a project’s revenue streams and underpin its financial prospects. However, it takes highly specialized technical expertise to fully appraise a renewable opportunity, whether buying into a project or lending against it.
What will it cost to shepherd the asset through its development stages? Are the contractual elements and regulatory environment favorable? Can we identify and address the relevant risks? Answering these questions is vital to determine the economic viability of a project.
Assessing the costs requires input from engineers. Conversations with engineering, procurement and construction firms help cost out the components and materials. Financial incentives are another key input, as some projects that wouldn’t have been economically viable are in fact profitable and attractive when tax credits are applied to the equation.
For hard assets, the quality of offtake agreements—through which power is sold for a fixed price for an agreed term, typically over many years—offers a pillar of security for investors. Since these agreements are typically made with investment-grade counterparties, they should hold up well during an economic slowdown or recession, because the credit quality of the entities purchasing the power is solid. These contracts also mean the project—and investors—aren’t subject to the risk of falling commodity prices during the term of the offtake agreement.
The regulatory environment is another critical component. In the US, utility regulation is a state-by-state phenomenon, which adds to the intensity of the due diligence. In Europe, we need to understand EU-wide regulations as well as country-specific nuances. No two projects are alike, and the economics of very similar projects can differ drastically depending on local rules.
Identifying Private Portfolios: A Checklist for Investors
Investors seeking to dive into the private opportunities being created by the energy transition can benefit from a diversified portfolio that spans a variety of projects. But how can you know whether a portfolio manager in private assets has what it takes to invest in this highly complex market segment?
Check that the portfolio team has the experience and domain expertise to understand the assets. Engineering expertise is essential, as well as a clear grasp of the contractual ecosystem and legal landscape of renewables projects.
Having this type of expertise is vital for the thorough due diligence required to properly value private assets. Make sure the portfolio manager can clearly articulate how they project a range of outcomes for various types of investments. A proficient private portfolio manager should be able to outline the risks—from supply chain snags to trade tensions or possible delays in connections to power grids.
Ask how macroeconomic factors will affect outcomes. These days, interest rates are obviously a critical variable. Changes to credit spreads in the clean energy market or the cost of financing when investing or lending against an asset can make all the difference in the viability of an investment. Similarly, find out how the assets would hold up in a recession; robust contracts can help hedge macroeconomic risk, but private assets or loans that are vulnerable to recession risk or declining energy prices can undermine an otherwise solid holding. Finally, not everyone can efficiently tap into the tax credits that the federal government offers in the US, and state-by-state or country-specific incentives and regulation can make or break projects.
Patience Is the Private Investor’s Virtue
In our view, the key to successful private investing is not pricing opportunities to perfection. This principle is always important, and even more so in today’s complicated markets. Having a cushion for uncertainties that may arise can help a private portfolio withstand a range of conditions and deliver on the return potential over time.
Private investing requires patience—especially when focused on a multi-decade energy transition. But the flip side of illiquidity is that private investors don’t have to chase markets. With a flexible approach and a clear discipline, a private portfolio can pass over projects that don’t make the grade and gradually deploy capital toward the most attractive opportunities. Investors in private portfolios like these will benefit from a sustainable allocation to return streams that are uncorrelated with publicly traded assets, along with a front-row seat to the global energy transition.
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