Infrastructure Energy: Finding the right source
Energy infrastructure can be an attractive investment proposition. But some opportunities are better than others, writes Maha Khan Phillips
This August, BlackRock Real Assets raised €650m for its Renewable Income Europe fund from 25 European and Asian institutional investors who backed the strategy. It had initially targeted €500m. The fund, which invests in wind and solar projects in western Europe, was oversubscribed because investors are focusing on increasing their real assets exposure. In a difficult market, investors want income-producing assets that provide diversification, and income protection.
It is no surprise that a May 2016 report from BNY Mellon predicts that investor demand for real assets will surge by the year 2020. Some 60% of infrastructure managers expect their assets to at least double.
According to Preqin, 15 unlisted natural resources funds reached closure in the third quarter of 2016, securing $25bn (€23.3bn) in commitments. This figure was dominated by Brookfield Infrastructure III, which closed on $14bn in July. Although the fund is not solely focused on natural resources, it is expected to commit capital to energy-related investments.
Energy strategies are popular, with 86% of natural-resource investors targeting the sector over the next 12 months, according to Preqin. Three quarters of active energy investors are focusing on renewable assets, but investors are also seeking exposure to oil, natural gas, and coal-related assets and processes. Investors are also diversifying their exposure. The majority (82%) of investors have a strong preference for gaining exposure via unlisted funds over the next 12 months, while 31% will target direct investments and 19% expect to make investments in listed funds.
“Clients are focused on energy within a wider real asset strategy,” says Toby Buscombe, global head of infrastructure at Mercer. “They are very much focused on unlocking the benefits that real assets can deliver. Real assets can provide diversification via different sources of risk and returns from equities and bonds, storage of value, and the potential to build in some inflation hedging and income protection.”
Buscombe says the assets Mercer favours have limited exposure to direct energy price risk – and tending to have a long-term power purchase agreement in place – or benefit from government tariff or subsidy, or other regulatory regime. “We are also seeing a lot of money going into the grid, in distribution and transmission assets. They can be quite attractive assets, though in some cases, competition can be quite high.”
Robert Smith, CIO and deputy state investment officer at the New Mexico State Investment Council, says that energy looks attractively priced. “We are invested across the energy spectrum, and across risk and return profiles, as well as specific sectors within the industry. We have taken a deep and broad view of the sector. It provides a good opportunity to diversify across risk and return, and in general, private energy investment is an area where we are seeing better returns, given that public markets seem so expensive.”
The fund has about $600m committed to the private energy sector, of which $408m has not been called. Smith says New Mexico SIC committed capital during 2014 and 2015 when prices were falling, but it perceived that future return potential would rise. However, he says that opportunities do exist.
Some of its investments include commitments to First Reserve Energy Infrastructure II Fund, Carlyle Power Partners II, and Blackstone Energy Partners II. It also has allocations with EIG Energy Fund XV, and EIG Energy Fund XVI, as well as Natural Resources X and XI, and EnCAP Energy Capital Fund IX and EnCAP Flatrock Midstream Fund III.
Smith says interest in the sector has been rising. “We are seeing a lot more investors interested in the energy sector, not only the private investments, but also the publically traded ones, like the MLPs [master limited partnerships]. When we commit to these funds, we run into many of our peers.”
While the unlisted market is offering opportunities, listed managers believe they can offer diversification and accessibility. “The listed market is somewhere where investors, who want to diversify their exposure across different types of energy, and across multiple assets, can do so,” says Jeremy Anagnos, senior global portfolio manager at CBRE Clarion Securities. “They can diversify risk and invest in public companies which are large and have tremendous operational structure.”
The firm manages listed portfolios of investments that trade on global exchanges, through a broad infrastructure strategy that includes energy, as well as utilities. It also has a focused energy infrastructure strategy, primarily targeting North American listed markets, and has $250m allocated to infrastructure and energy strategies.
“We have individual companies that own many different types of production, from coal, to natural gas, to renewables, and even nuclear energy within their structures,” Anagnos says. “There are opportunities for investors, in the context of diversity, to invest across multiple jurisdictions from a regulatory perspective.”
All pointing to renewables
Investors are focusing on renewables. According to the International Energy Agency, the share of global energy provision from renewables – including wind, solar and hydro – will increase from 21% in 2010 to 25% in 2020. In markets ranging from Germany and the US to India and Brazil, wind and solar power have reached cost parity with new fossil fuelled power generation, says MSCI Research’s report, 2015 ESG Trends to Watch.
“One of the things about renewables is that there’s a really easy route to market,” says Duncan Hale, head of infrastructure research at Willis Towers Watson. “Building it doesn’t take particularly long, and you get your money in the ground in a couple of years. Once you’ve built it, it is operationally very simple. Also, how you get paid is reasonably well understood.”
Hale says investors who build solar assets would probably see a 7% return on a completely unlevered basis. If they are buying brownfield assets that figure would be 6%. Onshore wind is producing returns of 9% from new builds, and 7% otherwise. Offshore wind in the development stage is about an 8% return.
Amber Infrastructure manages International Public Partnerships (INPP), a London-listed fund that focuses on energy transmission. Giles Frost, founding director of Amber Infrastructure, says investor appetite is increasing for offshore wind. INPP focuses on offshore connectors that link wind farms with the grid. “It is interesting to see how many more institutional investors are now coming to offshore wind, whereas a year ago, it was an unproven technology,” Frost says.
He believes the market will become more expensive to access, however. “Most of these investments in the newer technologies will likely become commoditised. But when that happens, there will be a higher price to pay for the assets.”
Managers say trends of markets shunning fossil fuel means it is a good time to build capabilities in renewables. “We like renewables,” says Ben Morton, senior vice-president at Cohen & Steers, which has a dedicated listed infrastructure strategy that includes investing in MLPs and midstream energy. “The cost of solar and wind has gotten to a place where it is cost competitive with environmentally adjusted fossil fuels in some cases, and you’ve seen a real proliferation of solar and wind installations around the world.”
The firm sees energy opportunities in new markets. “If you think about the investment opportunity, a lot has to do with new securities and new structures that are evolving and coming to market,” says Tyler Rosenlicht, vice-president, midstream energy and MLPs portfolio. “Mexican infrastructure, for example, is expected to see a continued wave of privatisation.”
Changes in the US energy sector are having an impact on natural gas, says Antonio Barbera, portfolio manager in global listed infrastructure at AMP Capital. He points out that in 2006 just under 50% of electricity in the US was generated by burning coal, while under 10% of electricity generation came from renewable sources. Ten years later, coal has fallen to 30%, while renewables have grown to 15%, with wind making up 5%, the largest increase.
“The big winner has been natural gas. There has been a big shift in the resource mix, with fracking making natural gas extremely cheap and abundant,” he says. Gas has risen from 20% in 2006 to 34% in 2016.
Cleaner gas has replaced dirty coal in the generation mix, and this has resulted in environmental benefits. This ‘coal to gas switching’ has had consumer benefits, in terms of cheaper electricity, as well as environmentally.
“This means that coal cannot compete with low-cost natural gas or renewables in the long run,” says Barbera. “With or without environmental regulations, gradual additional retirements of the coal fleet will occur worldwide as the plants approach the end of their useful life.”
He says a safe way to play the uncertainty of this shift of the generation mix is through transmission companies. “Old electricity grids simply can’t cope with the fluctuations of production that renewable resources provide.”
It is one reason why battery storage is becoming more popular amid investment managers. “The big future revolves around batteries, and storage, and the load shifting of power,” says Oliver Hughes, head of renewables at Oxford Capital, the distributed energy asset manager. “As more renewables and wind comes online, there’s less fundamental base load in the market, and a much greater balancing of power production and power consumption. The natural base for that will always be battery storage.”
With some estimates putting performance of nuclear assets at 10% per annum, it would be understandable if investors were flocking to the asset class. Unfortunately, nuclear liabilities have shot up over the past 18 months, according to S&P Global Ratings.
It warns that these long-term liabilities are becoming more short term, and sometimes carry immediate funding needs. Performance of dedicated assets may falter, because of low economic growth and the low interest-rate environment.
“Nuclear isn’t a typical investment for an institutional investor,” says Giles Frost, founding director of Amber Infrastructure. “Institutional investors don’t feel that they really understand the risk in novel and unproven asset classes, and they tend to trail commercial investors in that sense. They want assets that are straightforward to understand.”
Jeremy Anagnos, senior global portfolio manager at CBRE Clarion Securities agrees. “It is difficult to see how nuclear would be a major energy replacement,” he says. “Nuclear power faces significant challenges, since the unfortunate disaster in Fukushima in Japan, which led to increased scrutiny over nuclear as a power source, and scrutiny of existing assets. The development of new nuclear sources faces tremendous hurdles.”
Consultants say that they rarely come across nuclear opportunities, and investors agree. Robert Smith, CIO and deputy state investment officer at the New Mexico State Investment Council, says the New Mexico Investment Council has not “seen any opportunities”.