Climate change, clean energy infrastructure and strategic asset allocation

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Mercer, the global asset consultant to many ofthe world’s pension funds and institutionalinvestors, published a seminal report in

2011 on the implications of climate change thatcaused many investors to rethink their approach tostrategic asset allocation.

The report also came at a time when asset allocationgenerally was, and continues to be, criticallyreviewed in the wake of the prolonged globalfinancial crisis. Many investors and their advisors aredeeply concerned about the increased correlationof global equities markets and the failure of somealternative assets, such as commercial property, toprovide the expected diversification benefits totheir portfolios. The use of excessive leverage withinvarious ‘real asset’ strategies such as property andcertain types of infrastructure assets, has beenreassessed as the root cause of that failure. Debtcreated an unseen or underestimated correlation ofcertain alternative assets to the sub-prime failurethat undermined the planned for risk diversificationin many pension fund portfolios.

In that context, what might investors take awayfrom some of the critical recommendations in theMercer report regarding the implications of climatechange for strategic asset allocation? To paraphrasesome of Mercer’s key findings:• Climate policy is a significant source of portfolio

risk for institutional investors to manage overthe next 20 years and could contribute as muchas 10% to overall portfolio risk;

• Mitigating climate change risks will require a newapproach for investors with the short-term natureof traditional equity and bond investments making it difficult to price in long-term risksaround climate change;

• Traditional methods of shifting asset allocationinto increased holdings of more conservative,lower risk and lower return asset classes may dolittle to offset climate risks and may evenreduce returns and adversely affecting long-termportfolio performance;

• Under some scenarios, the best way to managethe portfolio risk associated with climate change is to increase allocation to ‘climate sensitive assets’;

• Up to 40% portfolio allocation to ‘climate sensitive assets’ (including infrastructure, realestate, private equity, agricultural land, timberland and sustainable/listed and unlistedassets) could actually reduce portfolio risk interms of climate change impact;

• There are steps that investors can take now toimprove the resilience of their portfolios to climate related risks, including increasing theirasset allocation to climate-sensitive assets as a‘climate hedge’.

Moreover, there is a growing awareness amonginstitutional investors that climate change and in

By David Scaysbrook, Managing Director of Clean Energy and Infrastructure at Capital Dynamics

…climate changeand in particularthe policies of governments inresponse to it, willimpose significantfinancial liabilitiesas well as createthe opportunity fornew asset creation

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particular the policies of governments in responseto it, will impose significant financial liabilities aswell as create the opportunity for new asset creation. It will impact existing asset values yetcreate other long-term investment opportunities,especially in the mitigation of carbon emissionsinvestment in clean energy and necessary adaptationfor the physical consequences to our environment.

One of the more important messages for pension fundinvestors, in particular, was Mercer’s observationthat an increased allocation to ‘climate sensitiveassets’ ‘offers the prospect that institutionalinvestors’ interests can be aligned to both servetheir beneficiaries financial interests as well as tohelp tackle the wider challenge of climate change byincreasing investment in mitigation and adaptationefforts globally’.

Whilst there has been a reasonable degree ofanalysis in the financial literature regarding equitiesstrategies around climate risk, we are focused hereon options for investors within alternative assetsgenerally and, more specifically, with an analysis ofclean energy and infrastructure assets (CEI assets).In Capital Dynamics’ view, CEI assets are climate-sensitive in that they stand to benefit in a positivefinancial way from both current and likely futureclimate policy. This is because our energy industries

are likely to be fundamentally transformed in comingdecades in response to climate policies, energysecurity and the need to replace ageing infrastructure.Clean energy supply projects stand to benefitdirectly from new costs imposed on carbon-intensiveenergy as well as various investment incentives toencourage massive new capacity build in renewableand low-carbon energy supply alternatives.

According to our analysis and client feedback,many pension fund and insurance industryinvestors, whilst not necessarily seeking ‘climatesensitive’ investments currently, are seekingreturns from an allocation to ‘real assets’ withinthe alternative asset class that feature:• Visible and recurring cash yields with 10 year

plus horizons;

• Revenue quality in terms of both high creditbacking and low volatility;

• Capital appreciation to help ensure that totalreturns still exceed those from traditional assets,especially diversified and liquid equities;

• Inflation hedge from revenue escalation tomaintain cash returns in real terms given thetypically long-term nature of these investmentcommitments.

Global investment in renewable energy 2004-2011 (US$ billion)

Fig. 1: Global investment inrenewable energy 2004-2011(US$ billion) Source: REN21, 2012

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Arguably these features can be found to a greateror lesser extent in several alternate assets, suchas property and infrastructure. This partiallyexplains why we are seeing more investors makingincreased allocations to alternatives generallywith a primary emphasis on new infrastructure.However, the ‘climate sensitivity’ of assets withinthese two broad categories of alternate assetsdoes vary considerably.

Therefore, with investors seeking more exposure tohigher yielding ‘real assets’, are there strategiesthat can deliver these return features and also actas a climate ‘hedge’ in the sense contemplated byMercer? In our view, clean energy infrastructureassets can fit that bill because of their long-termcash yield profiles and the direct environmentalbenefits that they deliver, especially in the offsetting of carbon emissions from the powergeneration sector. Emissions from electricity generation are the single largest stationary sourcein the world today.

Global investment in clean energy infrastructureInvestment in clean energy globally has increasedsix-fold since 2004. Last year was a record year forglobal investment in clean energy, reachingUS$257bn, up 17% on 2010 and contrasting the

wider global slow-down. Moreover, in 2008, moreinvestment was committed to clean energy assetsin Europe and the US than new conventionalpower capacity (coal, gas, nuclear) for the firsttime ever. The carbon cost implications of coal,the geopolitical issues surrounding gas supply (in Europe at least) and the recent rekindling ofnuclear safety concerns, may ensure that thistrend continues well into the future. These driversand others may do more to attract the interest ofinstitutional investors than ever contemplated.

Growth in investment demand in coming years isalso expected to more than double from the 2011record level just set, reflecting the capital requiredto develop and construct the new clean energycapacity mandated by the various targets set bygovernments in both developed and emergingeconomies in recent years.

The UK is considered one of the more attractiverenewable markets in the developed world and isexpected to require approximately £200bn in newenergy infrastructure investment by 2020.However, the UK lags significantly behind itsrenewable energy targets, some of which are thehighest in the world (Scotland is targeting 100%of renewable electricity by 2020) and ageing

Fig. 2: UK energy investmentrequirements to 2020 (£199bn)Source: E&Y 2012

UK energy investment requirements to 2020 (£199bn)

Investment in cleanenergy globally hasincreased six-foldsince 2004

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infrastructure is leading to a critical demand/supplygap. The UK government continues to supportclean energy investment to address this gap, aimingto provide up to 400,000 new jobs and save theUK an expected £60bn in fossil fuel imports.Significant new equity capital will be required, astraditional debt finance will fall way short of thesecapital needs. This provides an attractive opportunityfor institutional investors. Fig. 2 shows an extractedfrom a recent Ernst & Young report that breaksdown this capital need across various energy infrastructure segments.

Fig. 3 extracted from a Deutsche Bank ClimateChange Advisors (DBCCA) report of the cumulativeregulatory impetus behind clean energy and climatepolicy in recent years. Whilst this has slowed inrecent times due to increasing economic woes inEurope predominantly, the trend is positive.

However, despite this rapid growth, institutionalinvestors have been only modest providers of capital to invest in new clean energy infrastructure.The bulk of capital for new asset finance has beencommitted by banks, industrial corporations, projectdevelopers and energy utilities. With the growingscale of investment demand, as shown in Fig. 3, theincreasing awareness of the attractive investment

features of clean energy infrastructure and newthinking in response to climate change, such as thatby Mercer, allocations from institutional investorsto CEI assets are set to grow.

Investment features of CEI assetsThe investment universe of CEI assets is broad,but has at its core the production and supply ofclean, renewable and low-carbon energy. Examplesinclude electricity, steam and heat supplied fromany one or more of solar and wind energy, combined heat and power using natural gas,power from biomass and organic waste, geothermalenergy and even projects using ‘hard assets’ toincrease energy efficiency.

In terms of more conventional alternative assetcategories, CEI assets can be fairly viewed asexhibiting hybrid characteristics of both privateequity and infrastructure, subject to the particularinvestment strategy being employed. Already builtand operating assets look more like infrastructureassets, especially if they have long-term sales contracts, use well-proven generating technologiesand operate in stable markets. Most investmentrequired in the future, however, will be in new assetcreation, requiring the mass-scale developmentand construction of new capacity to meet ongoing

Fig. 3: Global cumulative binding and accountable climate policies 2008-2010(includes policies from MEFcountries, EU government andmajor US states (CA, NJ, TX)) Source: Deutsche Bank, 2011

Global cumulative binding and accountable climate policies 2008-2010

The UK governmentcontinues to supportclean energy investment toaddress this gap,aiming to provide upto 400,000 new jobsand save the UK an expected £60bnin fossil fuel imports

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demand growth and the need to reduce carbonemissions. Those assets may look more like‘growth infrastructure’ assets to some investors.

For this reason, CEI assets offer attractive flexibilityin asset allocation terms depending upon whereinvestors are seeking to bolster their portfolios.This can be seen in Fig. 5 (opposite).

What are the features of typical CEI assets that mayinterest investors, especially in terms of portfoliodiversification? Most CEI assets are capital intensive, have long economic lives of 20 years ormore, generate operational income from sellingenergy on a continuous basis and/or earn additionalrevenue from investment incentives offered byclean energy regulation and/or climate policies invarious countries. Therefore, revenue can be eitherregulated over the longer term (with fixed prices,linked to inflation in many cases) or contractedbilaterally to buyers such as energy utilities orenergy consumers.

With proven generating technologies, revenuevolatility stemming from annual production volumescan be predicted with reasonable certainty by theexperienced investor over the long term. Also, assetmaintenance costs can be ascertained and factoredinto the investment evaluation at the outset. Withthe credit of the revenue being either regulated (with

sovereign support in some cases) or contracted toinvestment grade utilities, the implicit ‘quality’ offuture revenue streams can be high.

Fig. 6 (opposite) is a representative example ofan investment in a UK wind farm that was recentlyconstructed with a 15 year sales contract to an A-rated energy utility.

The area shaded in red represents the revenues tobe derived from the sale of Renewable ObligationCertificates and Renewables Levy ExemptionCertificates under the UK Renewables Obligationfor the life of the project. The blue shaded arearepresents the revenue to be derived from the saleof electricity. Both revenues are underpinned bythe energy utility that is the long-term customerof the project’s energy supply.

This return profile ought to attract the attentionof pension funds in particular given the long-termcash generation offered by CEI assets. Solidannual cash yields plus an attractive absolutereturn potential gives this investment strategy its‘hybrid’ character, straddling both private equityand infrastructure.

In Mercer’s analysis, infrastructure assets will be a‘core part’ of the adaptation and mitigation effortsof all governments in responding to climate change.

Fig. 4: CEI asset universeNotes: 1) 2011 new assetinvestment, source: BloombergNew Energy Finance, 2012; 2) includes marine and smallhydro; and 3) includes energy-smart technologiessuch as smart grid, energymanagement, electric vehiclesand power storage, some ofwhich do not fall within thetarget sectors of the fund

CEI asset universe

Clean energy infrastructure isgrowing just asmuch in importancefor strategic assetallocation as it is insheer investmentscale each year

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Existing assets that are carbon-intensive willneed to re-tool and the creation of new assetsthat assist directly in adaptation and mitigation,each have a dominant infrastructure theme.Interestingly, Mercer observed that traditionalinfrastructure portfolios may transition and move towards these new opportunities by allocating more to ‘non-core assets such asdevelopment projects...’.

The greatest opportunities for institutionalinvestors were seen by Mercer to be in energy,transport and water/waste. In energy specifically,there was a strong emphasis on renewable anddecentralised energy, as well as related infrastructuresuch as transmission and distribution networks.Importantly, unlisted renewable energy infrastructure(encompassed within the definition of CEI assets)was considered to have a very high climate sensitivity, exceeding that of ‘core’ infrastructurein all scenarios.

Despite the enthusiasm exhibited by Mercer, whatabout the risks of investing in CEI assets? Like all‘real assets’, appropriate risk management requires

a thorough understanding of the asset class and aclear differentiation between controllable anduncontrollable risks. The key uncontrollable risk isthat of regulatory change. Investing in energymarkets requires a familiarity and comfort withchanging law and regulations given that energy isa heavily regulated sector and not just clean energy.However, the current regulatory momentum isclearly in favour of clean energy, and a quick comparison between the landscape of regulatoryrisk now faced by a fossil fuel supplier relative tothat of a clean energy supplier only serves to highlight that fact.

The key points to take away for institutionalinvestors is that clean energy infrastructure isgrowing just as much in importance for strategicasset allocation as it is in sheer investment scaleeach year. It may be worth becoming more familiar with the risk and return characteristics ofwell-structured investments in CEI assets since itseems that these assets address many of theimperatives driving key decisions for pension fundsas climate risk comes to play a more central role intheir future investment strategies.

Fig. 5: CEI assets – flexible asset allocationSource: Capital Dynamics

Fig. 6: UK wind farm revenuecontribution and cumulativeIRR (2009-2028F)Source: Capital Dynamics,company reports

CEI assets – flexible asset allocationCEI assets – flexible asset allocation

UK wind farm revenue contribution and cumulative IRR (2009-2028F)

References

Bloomberg New Energy Finance,

extracted January 2012

Deutsche Bank Climate Change

Advisors, February 2011, ‘Investing in

Climate Change 2011: the Mega-Trend

Continues: Exploring Risk and Return’

Ernst & Young, March 2012, The Future

of Clean Energy in 2012 and Beyond’

Mercer, February 2011, ‘Climate

Change Scenarios – Implications for

Strategic Asset Allocation’, Public

report, Mercer LLC, www.mercer.com/

articles/1406410

Ren21 and United Nations

Environment Programme (UNEP),

January 2012, ‘Renewables 2012

Global Status Report’

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On the subject of the UK economy there areseldom areas of universal agreement amongstthe politicians of different parties, academics

and interest groups, or even civil servants from themultiple strata of the state. Nevertheless, a rare andalmost unanimous consensus of opinion exists inthe UK on our infrastructure: it is under strain, andsomething needs to be done about it. Despite havingthe world’s seventh largest economy, the WorldEconomic Forum ranks the UK as only 28th in theworld on the quality of its infrastructure. Perhapseven more alarmingly, only 26% of businessesthat took part in a recent survey saw the UK as afavourable destination for infrastructure investment.1

Clearly the conservative level of development andrenewal of infrastructure is a potential Achilles’heel in the pursuit of economic growth, and whilethat growth is clearly coveted by the current government, for the first half of its tenure that hasproved elusive.

There are two main obstacles in the way of large-scale investment in infrastructure. The firstis political. At least one part of the Coalition hasideological problems with a Keynesian-style publicinvestment in infrastructure schemes – the meresuggestion flies in the face of the Friedman-inspiredliberalisation mantra espoused so effectively by theConservatives' celebrated matriarch. Moreover, bothpartners signed up to a frugal financial policy basedon eliminating the structural deficit within a term.Combined, these standpoints make public investmentvia traditional forms of debt politically dicey forministers. Instead they would prefer the privatefinancing of projects, albeit funded from pensionpots and sovereign wealth funds, rather thaninvestment banks. Therein lies the second majorobstacle; the main vehicle for delivering privateinvestment within infrastructure schemes over the

past two decades, the Private Finance Initiative (PFI)has been roundly lambasted by parliamentariansfrom all sides. So intense was the barrage of criticism of the model that George Osborneannounced that PFI would be subject to a ‘review’,which would scrap it in its current format. Howthen can pension holders’ and foreign governments’money be ploughed into infrastructure while delivering value for taxpayers and remaining aworthwhile investment?

The man charged with finding a solution to thisconundrum is Infrastructure UK (IUK) ChiefExecutive Geoffrey Spence. After a career workingmainly in the world of private finance with DeutscheBank and HSBC, Spence should be well placed tounderstand the needs of the organisations thatgovernment is wooing to invest in infrastructureprojects. He should also be sensitive to therequirements of the Treasury, with a decade ofcorporate memory accumulated heading up thePFI unit at 1 Horse Guards Road and later as anadvisor to Alistair Darling in his tenure asChancellor. Now leading the 60 strong IUK team,Spence has been fairly coy to date about hisorganisation’s work to lever the private investmentneeded to deliver two-thirds of the NationalInfrastructure Plan.

In an interview earlier this year, Spence wasguarded about the dialogue going on between IUKand pensions investors, which was, in his words, aconversation about “opening up a long-term sourceof capital for everyone; not just the public sector– not even mainly the public sector”.2 Two ofthose discussions, with the National Associationof Pension Funds and Pension Protection Fund,received some negative press in a national newspaper – coverage Spence was quick to rebuff.

Putting strength into structureWith large-scale investment in infrastructure increasinglyrequired to enable growth, and traditional private financeout of favour, a new ‘PFI 2.0’ will require expedient politicalbacking, writes Public Service Review

Despite having theworld’s seventhlargest economy,the World EconomicForum ranks the UKas only 28th in theworld on the qualityof its infrastructure

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“We’re not going to them and saying: ‘We’re gonnaraid your piggy banks to spend all this money’.For very good reasons, they all want to spend moremoney in terms of investing in infrastructure, andthey want us to help them overcome some of theobstacles they face.”

An example given by Spence is the need for thepublic sector to change its attitude to risk onunusually difficult construction projects; however,Spence added the cautious rider that it’s not “ablank cheque for people to get a guarantee fromgovernment at any point in time; it is for government to be more realistic about what risks itcan take and what still is the private sector’s role”.If Spence’s comments on risk were vague, hisremarks on reforming the PFI model were opaque.He preferred to defer any indications of what apost-review financing model might look like untilthe close of the consultation now being analysed byofficials. He did, however, mount a retrospectivedefence of PFI, and argued that a phased changeof approach should have been adopted. “A betterway of taking a policy forward is always to lookat where it could be improved and to try and achieve a process of incremental change,” he said,going on to put the model into context withother procurements: “We’re far more transparentabout PFI than we are about anything else in theprocurement space.”

So perhaps PFI is not completely dead? Regardless,solid details of a functional finance mechanismare a prerequisite if the Chancellor is to achievehis aspiration of harnessing pensions to invest ininfrastructure. Spence’s refusal to give any hints toindustry on the likely outcome of the PFI reviewcame after what many view as procrastination bythe government on project finance. IUK was without permanent leadership for over six monthsafter the departure of former CEO James Stewartbecause of perpetual delays in recruiting Spenceto the position.

Since then, the Treasury agency has repeatedlypostponed its review findings – the call for evidenceclosing over five months ago. A June article inThe Independent has, however, indicated thatthere is light at the end of the tunnel, reportingthat Spence is set to unveil ‘PFI 2.0’ at a summitin September.3

UK infrastructure is understrain, and faces both politicaland financial obstacles

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The conservative level of developmentand renewal of infrastructure is apotential Achilles’ heel in the pursuitof economic growth

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The new model is likely to allow pension funds toinject debt as well as equity into projects, reducing the investment risk. Shortly followingthat press report, Spence delivered the keynoteaddress at Public Service Event’s ‘Pensions:Infrastructure Investment’ conference. He tolddelegates how government is approaching theagenda. “We recognise for all classes of investor weneed to improve the attractiveness of the UK andits infrastructure,” said Spence. “The way we lookat pension funds is as new investors. For themajority of pension funds, and even those thathave participated recently in this market, infrastructure is a new asset class. From thatpoint of view, the government wants to removethe barriers to investment for pension funds.”

Spence specified these obstructions: “One of thebarriers that we have seen is a problem of collectiveaction. For some there is an issue about constructionand there are also some problems around access.Even if you want to invest during the constructionperiod, actually you can’t do that by investing atfinancial close – you have to go to a fund in thecity and hope they win a number of different projects. You take bid risk, development risk forthe early stages and then at financial close themoney is invested. There is no way at the momentfor pensions to invest directly.”

He went on to explain how IUK proposed to breakdown the obstacles. “The first key development isto have the right interlocutor for the pension fundindustry. As a first development, it’s right that weshould put in place that skill base, industry-led andcapable of making safe and good investments. Weare putting in place risk mitigation options, andaddressing access issues such as the model. Let’smove away from the 90/10 model to an un-gearedor partially geared model. That changes the way weprocure things and financially structure projects.”

In summary, the consensus remains that thereneeds to be large-scale investment in infrastructureto enable growth. It’s reasonable to assume thatthe environment in Westminster does not allow forinvestment funded by an increase in the nationaldebt, and that private finance through pension fundsand other sources is preferred. With traditional PFIout of favour, a new or adapted model ‘PFI 2.0’requires expedient political backing. If ministerswant to make their rhetoric about utilising pensionand sovereign wealth funds a reality, then the timeto stop navel-gazing in Whitehall is now. GeoffreySpence’s most recent comments give some causefor optimism.

1 www.kpmg.com/uk/en/issuesand

insights/articlespublications/news

releases/pages/investment-in-

infrastructure-would-kick-start-uk-

growth-new-cbi-kpmg-survey.aspx2 http://network.civilservicelive.com/

interviews/csw/read/633819/

interview-geoffrey-spence3 www.independent.co.uk/news/

business/news/billions-to-flow-from-

pfi-reform-7856339.html

…the consensusremains that thereneeds to be large-scale investment ininfrastructure toenable growth