Thursday, 20 September 2018

Sustainable investing

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Investor enthusiasm for carbon exposure has ensured a rush of funds to the sector, looking to invest in all parts of the alternative energy industry, be it solar or wind projects, energy efficiency technology or carbon trading. Solomon Teague reports.

Increasing interest in the carbon market is unlikely to come at the expense of the equity or fixed income markets, according to Martin Schulte, director carbon investment advisory at First Climate, a carbon asset manager. Institutional investors have entered the market as an asset allocation decision, in recognition of the growing importance of the market, while private investors see it as an alternative investment, and come looking for high returns. For both sets of investors it is still seen as a niche investment.

Carbon investment vehicles can be crudely divided into hedge funds – though many are long-only – and private equity funds. The former have lockups of one or two years, and tend to be more active in the secondary market, trading carbon credits, where the liquidity on offer enables them to offer investors redemptions at shorter notice. Private equity funds have longer tie-ins of up to 10 years and tend to operate in the primary market: the illiquidity associated with environmental infrastructure investments means assets need to be locked in for longer periods.

David Love, managing director at placement agent C.P. Eaton Partners in La Jolla, California, likens the current clean energy market to technology in the late 1990s. Just as with the technology bubble, he cautions that there are plenty of opportunities but also dangers. Fund managers have a large and rapidly expanding investment universe from which to pick, with many duds among the real diamonds.

Of the private equity funds on offer, venture capital funds offer investors with a higher risk appetite exposure to the sector through carbon efficiency technologies. As with VCs generally, the chance of a “home run” investment is offset to a certain extent by the probability of a relatively high proportion of non-performing investments.

C.P. Eaton works primarily with later stage funds, with US$500m–$3bn in assets. Investing in technologies that have cleared the first hurdle offers reduced risk, although sometimes at the expense of upside potential. Its clean energy division has a bias towards funds dedicated wind and solar power, currently the most developed sectors. The best add value by helping create a strong management structure; early stage businesses are often run by entrepreneurs and ideas people, not necessarily those with strong operational backgrounds.

C.P. Eaton’s target funds look to exit their investment by selling a strong and fully functioning business, sometimes to one of the energy majors. It is striking that although these companies were originally among the strongest opponents of carbon trading and moves to stimulate the growth of alternative energies, many now show signs of embracing it, according to Love. Masdar, the carbon neutral city being proposed in Abu Dhabi, is a good example of the change of approach: the emirate hopes that it will provide a hedge to its reliance on the oil market.

Carbon is a good hedge, displaying very little correlation with other asset classes – although Love admitted that a global recession would be likely to have an adverse impact on the sector. It “would slow down the rate of change by reducing the upward pressure on the price of oil,” Love explained. “But this would just be a hiccough – a temporary slowdown in a longer term trend.”

The best fund managers recognise that there are significant differences – regulatory, scientific and financial – between the various sub-sectors of the alternative energy universe, and are dividing them into different silos. Some are putting teams in place with expertise in various fields, even in those in which they are not currently active, anticipating new sectors being opened up by innovative technologies.

Things can change very quickly: there is currently little momentum behind biofuels, for example, but a simple change of policy in the US to reduce tariffs on Brazilian ethanol imports might be enough to transform the economics of such technologies overnight.

Fortis recently launched the Fortis Clean Energy Fund (CEF), a private equity fund investing in wind, small hydro, solar photovoltaic and biomass projects – high quality assets with a track record of delivering yield – with around 70% its investments in Europe and the remainder in selected emerging markets.

The fund targets returns of 12%–15%, which it will achieve by selling the electricity generated by its alternative energy investments. While some still have reservations about the viability of these methods for energy production, particularly the reliability and consistency of their output, Peter Dickson, technical director for the CEF, said that the risk to the fund is offset by the subsidies available to many such projects throughout Europe. And while these subsidies are falling over time, this reflects the increasing viability of alternative energy as technologies improve and the price of fossil fuels make alternatives look better value.

CEF has already raised €50m, and hopes to have around €150m by early next year, with a target to ultimately reach €400m. Interest has come from across Europe and Asia. This reflects peoples’ increasing awareness of environmental concerns and energy security, as well as the stability that is the hallmark of infrastructure funds, said Dickson.

Why hedge?

“If the carbon market is to become more efficient and fulfil its aims, carbon must become much more expensive,” said John Baillie, a hedge fund analyst at Systematic Absolute Return’s SAR Environmental Fund is a fund of hedge funds, investing in a range of funds, including carbon funds. Of the 10 carbon funds in its portfolio, seven are in asset-backed lending and three in arbitrage and trading strategies.

In a market with so many bulls, many will opt for long-only funds, ETFs or direct investments in carbon, but hedge funds hope to deliver better risk-adjusted returns, usually by offering most of the upside with reduced volatility – potentially a significant factor in such a young and illiquid market.

First Climate advises two investment funds, Climate Change Investment I and II, which invest in Clean Development Mechanism (CDM) projects, earning Certified Emissions Reductions (CER) that can be imported into the EU Emissions Trading Scheme (ETS). The strategy exploits the arbitrage opportunity between CERs and EU Allowances (EUA) – two carbon currencies that exist simultaneously in the EU ETS but do not move in tandem.

There are risks to the strategy. The first is volume risk – the risk associated with how productive the CDM project will be, and, indeed, whether the registration of a project will even be completed in a manner that allows CERs to be imported into the EU ETS. Then there is market risk, although this has hitherto displayed less volatility than investors experience in the equity markets. Finally there is liquidity risk, which makes hedging particularly difficult. With Phase II of the EU ETS being so young (see separate story on the ETS), it is difficult to predict future returns, said Schulte, but the funds are expected to achieve yields above 10%.

Fund manager and broker Carbon Capital Markets has a similar strategy, investing in mid-size projects in emerging markets that would be below the radar for the larger investment banks, from which CERs are created. It is inherently long carbon, because its investment is repaid with the carbon generated by projects, which it then trades on the carbon markets.

The market for financing such projects is competitive, so Carbon Capital Markets has to be proactive in securing mandates, competing with other investors, funds and smaller banks. “In investment banking terms it is origination, though from our perspective the business has more in common with infrastructure finance,” said Lionel Fretz, CEO at Carbon Capital Markets.

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