Energy Transition Funds Need To, And Will Ironically Have To, Go Further Out On The Technology Risk Curve
In recent years, over 75% of energy transition investment has been in renewables. With those returns declining and funds not wanting to close up shop, we may see more investments in new tech.
When funds announced investing in the energy transition, they didn’t mean mining experiments, grid optimization software, hydrogen, or modular nuclear reactors. They really meant that they were comfortable investing in wind and solar. The nuances of the private equity carry structure, though, mean this isn’t working for their upside and will likely push them further out on the risk curve. This means more solutions should finally get funded.
Emissions Decisions is a newsletter reviewing our thesis on environmental solutions and providing tools/insights to accelerate emissions reductions. Thank you for reading it!
Existing subscriber? You don’t need to do anything, but please share.
Was this forwarded to you? Become one of our subscribers by clicking below.
For the majority of funds, “energy transition” meant renewables
The global shift toward decarbonization accelerated investments in cleantech. Energy transition funds have been at the forefront of this movement, with cleantech funding from venture and private equity funds representing one of the fastest-growing subsectors for funding. New funds were created, and old funds rebranded, as money was readily available for these mandates from governments to sovereign wealth funds to family offices. Even 64% of oil and gas investors incorporated energy transition strategies. This is all great, as capital is needed for experiments, and that’s how we get actual progress for complex problems such as the energy transition. The problem is that a good chunk of the funds aren’t comfortable with much outside renewables.
When funds announced that they invested in the energy transition, they didn’t mean mining experiments, grid optimization software, hydrogen, or modular nuclear reactors. They meant wind and solar. Mature renewable energy projects now offer relatively stable but low returns, especially in the solar and wind sectors. This has meant a lack of funded solutions in areas such as hydrogen, carbon capture, and advanced battery storage while reducing returns in pure play renewables as the space became crowded. Competition from more prominent institutional players such as Brookfield, BlackRock, and pension funds has driven down the margins of these projects, leaving little room for the high returns that private equity managers seek. Many of these more prominent players also benefit from lower capital costs, allowing them to accept lower returns while meeting their investment mandates.
This has created a structural challenge for smaller energy transition funds that rely on higher returns to generate carry: renewable investments don’t work under the historical private equity carry structure at these rates. To understand why, let’s take a look at the different dynamics. Carried Interest (Carry) is the portion of profits earned by the General Partners of a fund after a hurdle rate, plus invested capital returned to the Limited Partners, is cleared. All that means is that the way for Private Equity partners to get rich is for them to meet a specific return rate on their investments and then, and only then, start getting a more significant percentage of the returns after that. If this hurdle rate is high single digits, you may never hit it with a renewable investment today. This means that funds will likely have to take more risks, which is good for energy transition progress.
The steadily higher interest rate environment has compounded this issue. Some of the benefits of renewables are the exact things that make them more susceptible to this recent hiking cycle. Historically, the long lifespan of renewable assets was a boon. Yet, in this high discount rate environment, the value of these assets diminishes.
Another formidable challenge for the renewable industry is the heightened carry costs stemming from high interest rates. Although renewable projects have always grappled with a stringent permitting process, it was manageable when the cost of capital was minimal. This is one of the reasons the industry got comfortable with obscene permitting timelines; people cared less when the time value of money was negligible. However, with rising interest rates, prolonged evaluation periods have emerged as deadly to the financial viability of these projects. Project developers need faster approvals, or the returns on the projects steadily get ground down. Higher debt service costs also consume more of the project’s ongoing cash flows. These factors make it increasingly difficult for private equity funds to meet their hurdle rates in renewable energy investments, limiting the opportunity for earning carry.
The need to go further out on the risk curve
To achieve meaningful returns and meet their carry targets, energy transition funds must move further along the risk curve and invest in less established, more innovative technologies. These emerging solutions, while riskier, offer the potential for higher returns, aligning more closely with their traditional return profile. It is also better for all of us if more energy transition solutions are funded instead of everyone pretending that they have an edge in the part of the space that is increasingly a pure cost of capital decision.
Despite the growing recognition of the need for innovative cleantech solutions, these technologies have needed help to attract financing. In 2022, over 75% of all energy transition investments went into renewables, with less than 25% directed toward emerging cleantech. Complex cleantech solutions such as hydrogen, CCUS, and advanced battery storage are essential for decarbonizing hard-to-abate sectors like heavy industry, long-distance transportation, and power generation. These technologies are still in their early stages of commercialization, meaning they involve significant technological and market risks. However, the potential upside is substantial if these technologies prove scalable and cost-effective. The bulk of future decarbonization efforts will require breakthroughs in these more complex cleantech areas.
Declining renewable returns, given the mature state of the industry, combined with fund structures that incentivize a certain amount of risk, will hopefully be one factor that accelerates cleantech funding over the next decade.
Impact Logic, a technical recruitment leader for impact-driven founders, sponsors our jobs section below. Reach out to them here as you look to fill critical roles.
Jobs that are worth looking at today include
Ops roles with Carbon Upcycling
Marketing, Finance, Technical, and Engineering roles at Hydrostor
Engineering and Finance roles at CarbonCure
Engineering, Finance, Ops, and Manufacturing roles at Crusoe
Was this forwarded to you? Become one of our subscribers by clicking below.
Thank you for your time and your thoughts!