With the passage of the Inflation Reduction Act, investing in renewable energy is more relevant than ever. While the experts finish analyzing how the legislation will impact renewable energy investment strategies in the US, our "The Rise of Renewables: Considerations for Managing Investment Risk" whitepaper considers the opportunities and risks of investing in renewables.
Energy is in the headlines almost every day. Gas shortages due to the war in Ukraine, OPEC production caps, and the potential shutdown of the Nord Stream pipeline are just a few of the recent developments gaining global attention—and increasing calls for use of renewable alternatives. Coupled with climate change concerns, the topic of green energy is now mainstream.
The focus on renewables certainly isn't new—but it is likely here to stay. By 2050, solar and wind are projected to be consumed almost as much as other fossil sources (petroleum or other liquids, natural gas or coal). Recent trends support these future expectations. The U.S. Energy Information Administration (EIA) reported a record amount of renewable energy consumed in 2020, an increase of up to 45% worldwide. Indeed, the age of green energy is already upon us.
Investment Opportunity, Investment Risks
The combination of growth in renewables consumption (as noted above in the EIA’s projections) coupled with the need for better and more expansive infrastructure present real and notable investment opportunities. Both public and private funding will be required to provide enough capacity for mainstream capture, delivery, storage and use.
Expanded use of renewables may also lead to greater investment opportunities through the commodity or derivatives markets. Similar to fossil fuels like gas and coal, when new or alternative sources like solar, wind, geothermal, hydropower and biomass become more mainstream, they will likely also become more widely traded.
But, as with any emerging and maturing market, pricing, volatility, a lack of transparency and unstable infrastructure can create investment risks. Markets for renewable investment are generally not as deep or liquid as those for their fossil fuel cousins. Political risk is also an issue, as considerations like tariffs or outright bans (such as with China or Russia) and supply chain disruptions make volatility a critical factor. In the emerging, subsidy-free reality of many markets, renewable energy developers and investors will be exposed to a whole new set of market-driven challenges and pricing considerations.
The Emerging Derivatives Market for Renewables
Derivative instruments that use volatility and/or global pricing differences to generate investment return and manage risk will be needed to help address these and other investment considerations.
Within the global gas and liquid energy commodity markets, there are six primary futures contracts, four of which are traded on the NYMEX (WTI crude oil, Henry Hub natural gas, ultra-low sulfur diesel, and gasoline) and two of which are traded on ICE (Brent crude oil and gasoil).
Most renewables are not yet traded on major derivatives exchanges, but those that are can be examined as possible models for newer or developing types. Specific derivatives used for energy hedging or investment include:
- Futures contracts
- Basis swap contracts (including locational basis risk, product/quality basis risk, calendar basis risk)
- Options (call options and put options)
- Power hedges, including congestion revenue rights
Power hedges are perhaps the most significant tool for managing energy investment exposure. In fact, in 2018, a report from McKinsey estimated that the risk from merchant price exposure was up to four times greater than construction risk, and up to 40% of Capex in value-at-risk.
To date, Power Purchase Agreements, (PPAs) have been the surrogate subsidies for power hedges. In essence, not only do PPAs lock in the long-term pricing and stable yields, but they also give project financing banks security to lend against, producing the leverage for equity investors. Going forward, the expansion of renewable energy will almost certainly draw on PPAs.
A Complex Risk Picture
What is unavoidable is that active risk management in renewables is now paramount for investors, but there are no shortcuts. Indeed, the whole operating model for investment has evolved and increased in scope, possibly now including PPA origination alongside finance and asset investment.
There is a completely new layer, too, for reporting. Given the nascent nature of the renewables market, investors will need asset-level energy risk and reporting services as well as the ability to review financial and operating data. With that will come the need for more robust pricing and risk tools that integrate renewables into established trading and investment models.
The ability to monitor, analyze, and then report risk and pricing data in a range of formats is key. Investors will need to partner with professionals who are experienced in building solutions for gathering, normalizing and aggregating their various real assets datasets into an overall data and analytics platform. As well, a thorough approach to risk management means that PPA contracts should be deconstructed into their component parts, and evaluated on both the financial reporting implications as well as the operational requirements needed to service these types of agreements.
Energy is likely to continue to garner significant attention—both in the news and as an investment. For those with the right investment modeling and support, the potential for growth and return is significant.
To learn more about investments in renewable energies, please download our "The Rise of Renewables: Considerations for Managing Investment Risk" whitepaper.
Written by Aparna Parameswaran
Managing Director, Real Asset Services