TODAY’S STUDY: HOW TO GET INSTITUTIONAL MONEY INTO NEW ENERGY

The Challenge of Institutional Investment in Renewable Energy

March 7, 2013 (Climate Policy Initiative)

Executive Summary

With national budgets tight, policymakers look to private capital as a key source for funding energy and climate change related infrastructure. The big prize is institutional investors — pension funds, insurance companies, and other long-term investors — whose $71 trillion in assets form one of the largest pools of private capital in the world, leading policy makers to ask whether institutional investors could help meet the climate change funding challenge. In this paper we explore a particularly interesting component of that challenge, that of institutional investment in renewable energy.

Our analysis shows that given enough attractive investment opportunities and reduced policy barriers, institutional investors could become a significant source of capital for renewable energy. However, our research also suggests that, for the developed world, there is not a shortage of potential investment in renewable energy; rather there may only be a shortage of opportunities at the price — and level of risk — that governments and energy consumers are willing to pay. Institutional investors, with their distinctive risk/return requirements and longer-term objectives, might invest in renewable energy projects at lower returns (and thus prices) than other investors seeking shorter-term gains. Thus, the question becomes whether institutional investors have the potential to bridge the financing gap more cost effectively, and what would be needed to make this happen.

To map this potential and identify the barriers to achieving it, we interviewed more than 25 pension funds and insurance companies across North America, Europe, and Australia, as well as their consultants, bankers, renewable project developers, analysts, and academics. We analyzed their investment portfolios along with global and national data on institutional investors to supplement our interviews. Our analysis compared potential investment from institutions to renewable energy investment needs over the next 25 years, as estimated by the International Energy Agency (IEA).

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These discussions and analyses indicate that the potential impact of institutional investment is highly dependent on how the investment is made. We identify three channels for investment in renewable energy, each of which can come in different forms, such as equity/company shares or loans/bonds:

• Investment in corporations is the easiest investment path for most institutional investors, whether through equity shares or corporate bonds. Our analysis indicates that institutional investors could easily provide corporations with all of the corporate equity and debt that corporations would need to fund their share of renewable energy for the next 25 years. But corporations make investment decisions based on their own strategy and financial considerations. Thus, institutional investment in corporations with renewable energy in their portfolios may not encourage these companies to increase their share of renewable energy, unless the relative attractiveness of these renewable energy projects is superior to other potential investments from a corporation’s point of view. Furthermore, there are relatively few pure-play renewable companies. Therefore, institutional investment in corporations will do very little to change the current renewable energy financing dynamics, and is unlikely to contribute to lower financing costs for renewable energy.

• Direct investment in renewable energy projects is the most difficult for institutional investors. The skills and expense required to make these investments are likely to limit direct investment to the largest 150 or so institutions, while the illiquidity of these investments — the ability to sell the asset at a minimum loss of value if unexpected cash needs arise — limits direct investment, even for those large investors who have developed direct investment capabilities. We estimate that these institutions could provide, at most, roughly one quarter of the renewable energy project equity investment and one half of the related debt required between now and 2035. That having been said, direct investment in renewable energy projects creates an opportunity for institutions to improve their risk-adjusted return, by taking advantage of their size, sophistication, longer-term investment horizon and in some cases an ability to accept some illiquidity, while potentially lowering the cost of capital for renewable energy

. • Pooled investment vehicles or investment funds vary in fit and accessibility for institutional investors. A large, publicly traded pooled investment fund could eliminate both the liquidity and size constraints; however, like corporate investment, it could also reduce the connection to underlying project cash flows and therefore the potential cost of capital advantage for renewable energy. Other fund designs could offer a better connection to the underlying assets — for instance by offering a “buy and hold to maturity” strategy, where the fund agrees to hold an asset for its life in order to deliver predictable cash flows — but in so doing may sacrifice their ability to offer liquidity. So far, the experience with pooled investment vehicles has been mixed, with some institutions concerned about high fees and the uncertain cash flow profiles on offer.

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Barriers to achieving investment potential

While direct investing has the greatest potential to lower financing costs, even the one-quarter to one-half potential will be very difficult to achieve. The reality is that a series of barriers, including energy policy, financial regulation, and investment practices within the institutional investors constrain their ability to invest in renewable energy, and may keep the investment potential from being reached.

The investment case for renewable energy almost always has a significant policy element, while the institutions are themselves subject to their own set of regulations. Three types of policy discourage institutional investors:

1. Policies that encourage renewable energy, but in ways which discourage institutional investors; for example, the use of tax credits as an incentive mechanism in the U.S. discourages investors like pension funds that are tax exempt and for whom the credits may have less value.

2. Policies addressing unrelated policy objectives which unintentionally impede institutional investors from renewable energy investment; for example, in Europe, policies intended to ensure the functioning of energy markets make investors choose between renewable energy generation and the transmission assets they may already own.

3. Energy policy and renewable energy specific policy that is lukewarm, or inconsistent and creates perceived policy risk; for example, retroactive tariff cuts in Spain or start-stop expiration of incentives in the U.S. create an aura of uncertainty that makes institutions ponder whether building a team to invest directly in renewable energy will make economic sense in the long-term.

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Maintaining secure pension funds and insurance policies is an important limitation on direct investment. The primary objective of institutional investors is to provide services such as pensions and life insurance at reasonable costs, with a very high degree of certainty. These investors must maintain appropriate levels of liquidity, transparency, diversification, and risk to maintain this certainty.

Financial regulation codifies these requirements, and in so doing may limit direct investment or in other ways impact the attractiveness of direct renewable energy investment. Investment practices of all but a few of the institutional investors are only beginning to catch up with the opportunities available. Many pension funds will not invest directly in any illiquid assets, while many others have not built the specialist investment expertise to invest directly in renewable energy.

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National pension policy varies widely between countries, so the funds available to invest in renewable energy are unevenly distributed. Ninety percent of the pension assets in the OECD are concentrated in just six countries, and even within these countries the size and style of the funds vary, leading to different investment potentials. Insurance assets are more evenly distributed across countries.

To provide one quarter to one half of required renewable energy project investment, institutional investors would need to rapidly expand the role of direct investment, build out direct investment teams (in large institutions), and be willing to allocate more of their capacity to accept illiquid investments — in exchange for higher returns — to renewable energy projects.

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Five steps could help reach institutional investment potential:

Based on our analysis, we identify five steps that could help to overcome these barriers and enable institutional investors to meet their potential to invest in renewable energy projects.

1. Fix policy barriers that discourage institutional investors or investment funds. However, many of the policy barriers exist to achieve important policy objectives outside of encouraging institutional investment. Thus fixes need to consider the value of increasing institutional investment versus the cost of implementing fixes. In some cases, appropriate exemptions or specific policies may encourage institutional investors.

2. Improve institutional investor practices. However, changing some practices, like increasing the tolerance for illiquidity and building direct investment teams, could impact both the risk profile of the institutions and the culture of their organization, which also requires careful consideration. We find that building this capacity may be difficult for institutions with less than $50 billion under management.

It is unclear whether these two steps would encourage enough institutional investment to lower renewable energy costs significantly. Thus, several additional actions could be taken to encourage renewable energy investment from institutions:

3. Identify whether any regulatory constraints to renewable energy investment by institutional investors can be modified without negatively impacting investors’ financial security, solvency or operating costs. In some cases, the regulation of pension funds or insurance companies themselves constrains investment in renewable energy projects.

Generally, this regulation is structured to ensure the solvency and security of the pension funds and insurance companies; therefore we see little room for major improvements. Any modification of these policies to encourage renewable energy investing must be carefully weighed against impacts they might have on the financial health of institutional investors.

4. Develop better pooled investment vehicles that create liquidity, increase diversification, and reduce transaction costs while maintaining the link to underlying cash flows from renewable energy projects; however the structuring and fee levels of such vehicles to date have limited the impact, so careful fund design will be essential.

5. Encourage utilities and other corporate investors. If the concern is raising enough finance rather than its cost, policy may need to be reoriented away from project finance toward corporate finance. Institutional investors are adept at investing in corporate securities, although funding renewable energy through corporate finance could limit the advantage that institutional investors may have in lowering the cost of finance for renewable energy.

This paper has highlighted concerns around each of these paths, but further research is necessary. Over the coming months and years CPI will continue to delve into each of these areas.

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Introduction

Pension funds and insurance companies invest money today to provide products like pensions and life insurance that help us protect our tomorrow; but providing pensions and insurance may not be the only way that these players help protect our future. Institutional investors, a group that includes pension funds and insurance companies, may also help avoid and adapt to future climate change by investing some of that money into long-term, low-carbon assets like renewable energy. They may even be able to improve their investment performance by doing so. Or so the theory goes.

This theory has grabbed the attention of policy makers, as they cannot miss the scale of assets managed by institutional investors when they face the daunting investment requirements associated with climate change. Policy makers observe that institutional investors look for longterm trends, like the global response to climate change, that can help their portfolios outperform in the long term.

At the same time, many of the investment opportunities associated with climate change are precisely the longterm infrastructure assets that should appeal to institutional investors seeking attractive, low-risk, long-term investment performance. Thus, the relationship between institutional investors and climate change could be very important.

In this paper, we estimate the scale of potential institutional investment in one subset of climate change related investments — renewable energy — and identify both barriers and potential solutions for reaching this potential. But before we can adequately address the potential, barriers and solutions, we must clarify the scope along a number of dimensions:

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• Who are these “institutional investors” and do differences within this group matter with respect to renewable energy?

• What types of renewable energy financial assets do we expect institutions to invest in and does the choice of asset matter to renewable energy goals?

• Does it matter how institutions invest, for instance whether they invest directly into projects or invest indirectly through intermediaries?

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There are a range of possible answers for these questions…

To explore these questions, we have interviewed over 25 institutional investors across Europe, Australia, and North America. We have also interviewed several of their investment consultants and advisors, bankers and investment managers, academics, analysts and ratings agencies.

In addition to these interviews, we have mined relevant investment data and analyzed some of the policies and investment barriers to gain further insight. In section 2 we define the set of institutional investors that could have an impact on renewable energy. In section 3, we scope the potential for their investment in renewable energy. As it turns out, the types of assets institutions invest in and the channels they use matter a great deal (see appendix 1), particularly if the primary objective is to reduce the cost of renewable energy while enhancing returns, rather than merely finding the required capital at any cost (see discussion in boxes 1 and 2). Meanwhile, the ability to use different channels and invest in different types of assets varies significantly between investors.

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In our scoping exercise we highlight differences between investors and the impact that these differences have on that they invest in and how. In particular, we focus on the distinction between direct investment in projects and investment in corporations (either directly or through intermediaries). In section 4 we contrast this potential, segmented by direct versus corporate investment, against forecasts for renewable energy capital needs.

Regardless of how institutional investors or investment assets and channels are defined, few policy makers or institutions would argue that the potential is being met.

More controversial is the question of what is actually limiting institutional investment in renewables. Many institutions we spoke to cite a lack of good investment opportunities and unsupportive, unclear, or volatile policy. Some policy makers and industry observers suggest that it may just be the investment practices of the institutions themselves that prevent them from realizing the potential value. Still others ponder whether this may just be a temporary phenomenon, due to the immaturity of the renewable energy market, that will sort itself out once institutional investors become more comfortable with renewable energy. The remainder of this paper will investigate the limiting factors and develop a framework for developing solutions.

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There are significant national differences between institutional investors, their regulations, objectives, and investment practices. Thus, in section 5 we highlight some key differences of these constraints by country and region. In section 6 we investigate the constraints faced by institutional investors. First, as institutions manage these assets to meet obligations or future objectives of the institution, the risk of not meeting those obligations due to poor investment performance is a very important constraint. The difficulty and complexity of managing large investment portfolios adds further constraints. Policy — both energy policy and regulation of the institutions themselves — creates additional constraints which we discuss in this section.

In section 7 we outline options for increasing institutional investor involvement including: removing energy and renewable energy policy barriers; improving investment practices at the institutional investors; identifying potential improvements to financial regulation and national pension policy; developing third party pooled investment vehicles for renewable energy projects; and, strengthening the role of potential corporate investors in renewable energy. While the path forward for any of these options is not entirely clear, our discussion and analysis aims to provide a starting point for pursuing and selecting amongst these options.

Note that the issues associated with institutional investing in the developing world, including macro country risk, exchange rate risk, and policy risk, are significant, and merit their own, specific analysis. In order not to confuse the discussion here, in this report we focus on investments by developed world investors in developed world energy projects. Other CPI papers and analysis focus on developing world investment issues.

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Conclusions and next steps

Institutional investors have the potential to play a significant role in providing capital for renewable energy. The match between renewable energy investments and the long-term investment needs of many institutions further offers the possibility that, by making these investments, institutions could enhance their own risk adjusted returns, lower the cost of financing renewable energy, or both.

However, institutional investors are heterogeneous and their impact cannot be assessed as a group. Differences between pension funds and insurance companies, large companies and small, and a host of other distinctions determine what is possible. Furthermore, differences between debt markets and equity markets, direct investments, investment through project or infrastructure funds, or investment through stocks and bonds all have a profound effect on the potential impact of institutional investors.

Our research suggests that while there are many paths through which institutions can invest in renewable energy, only for a limited set of these paths will institutional investors differ markedly from the financial markets in general and so contribute to lowering the cost of renewable energy financing. These paths are different for different investors. The largest 150 or so institutional investors have the biggest opportunity to affect the cost of financing renewable energy by directly investing in project equity or debt.

Accounting for portfolio and risk management constraints, these investors could provide up to one quarter of the project equity and half of the project debt required to meet the developed world’s renewable energy goals.

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Pension funds have greater potential for investment in project equity, while life insurance companies’ potential is more focused on project debt. In fact, many insurance companies are active providers of renewable energy project debt. While these institutions can help meet renewable energy investment needs, they are unlikely to become the dominant source of project finance. They may have some impact on the cost of capital for renewable energy, but the institutions themselves will likely capture additional value in the form of better risk adjusted returns.. Policy barriers and a slow uptake of these opportunities by institutional investors further limits the extent to which institutional investment in renewable energy projects could be game changing with respect to financing costs for the sector as a whole.

Infrastructure funds or other pooled investment vehicles provide an avenue to increase the flow of institutional money into renewable energy projects. Depending on their structure, these funds could increase the number of institutional investors with access to renewable energy projects and also increase their allocations. However, the costs of managing these funds, fees charged and the structure of the fund investments could erode a substantial portion of the potential benefit to reducing renewable energy financing costs. From both the perspective of the economics of the investment funds themselves and the demand from institutional investors, we believe that there is greater potential on the equity or mixed equity/debt funds than on the pure debt funds side. But in any case, careful structuring of these funds will be required to achieve any financial benefit for renewable energy.

Perhaps most importantly, our research suggests that policymakers need to consider the specific role of different types of institutional investors in designing their policies. Institutional investors have a great capacity for investment in liquid investments in corporate equity and debt, and if policymakers are primarily concerned about achieving enough investment, rather than lower the financing costs of that investment, they might consider policies that encourage utilities and other companies to finance renewable energy on their balance sheets, rather than relying on project finance to meet investment needs.

The challenges in encouraging corporate investment, as well as the implications and tradeoffs of changing market structures, encouraging innovation, and improving regulation are certainly a topic deserving of further study.

Institutional investors alone will not solve the challenge of renewable energy investment, and scaling up investment from institutional investors will be a difficult task. The ways forward — from improving policy and regulation, to creating effective pooled investment vehicles and encouraging corporate investors — each deserve the attention of policymakers. However, the prize is substantial. Any comprehensive solution that reduces the financing costs of renewable energy or bridges the financing gap will require consideration and engagement of institutional investors.

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