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Energy Transition Demand Soars, Even as Crowded Market Dents Returns

Capital surging into transitional energy strategies is fracturing returns in some cases, but more managers and investors continue showing up.

Private fund managers continue flooding into energy transition strategies, as does investor capital seeking deals targeting the longer-term shift to more carbon-friendly or renewable energy sources.

But manager crowding in these segments of the private energy infrastructure market may be putting a dent in returns and forcing some players to reshape their strategies.

Over the last few years, managers pursuing exposure to upstream energy deals – especially oil and gas production that extracts or produces raw materials – have flocked to the energy transition market, crowding the segment, according to Christian Busken, director of real assets at the Fund Evaluation Group.

“As with any asset class, when you have more capital coming in, it tends to make things more competitive and ultimately, that will impact returns,” he said. “When you have a lot of capital flowing in, which is exactly what we’ve had… it could drive returns down because of increased competition.”

Investors in energy transition infrastructure strategies in recent years would typically see internal rates of return in the high single digits between 8% and 9%, said Michael Bonsignore, a partner at Clifford Chance. But now, limited partners, or LPs, are comfortable with lower returns between 5% and 7%, because they still offer stable results, he explained.

And there’s still plenty of capital needed in the space, which likely will lessen any significant negative impact on returns.

“There is so much capital required in order to implement the energy transition that the private capital, even as it supplements the public, is not going to be adequate to meet that gap,” said Irene Mavroyannis, a managing partner leading the infrastructure team at Sera Global Advisory.

The International Energy Agency estimated clean energy investment needs to more than triple by 2030 to $4 trillion in order for the industry to reach net zero emissions by 2050. A separate report from the agency published in June determined global energy investment was set to increase by 8% this year, reaching $2.4 trillion in 2022.

“Although encouraging, the growth investment is still far from enough to tackle the multiple dimensions of today’s energy crisis and pave the way towards a cleaner and more secure energy future,” the report stated.

LPs are not leaping into the sector blindly, however, Mavroyannis said, with many being “very judicious” in trying to understand the different energy transition semantics. As LPs become more familiar with these nuances, they are likely to deploy more capital into lesserknown sectors, such as carbon sequestration or geothermal energy.

LPs seeking to avoid investing alongside the masses might settle in with managers pursuing more niche areas of the market, such as battery storage, Bonsignore added.

Some managers are circumventing the crowd in another way, Busken said: pivoting back to traditional upstream energy sources and raising capital for dedicated strategies.

As investors steered away from more traditional energy projects and followed the herd into the energy transition, that component of the market lost traction. But the investmentstarved segment may now look more attractive to some in this environment, he said.

“There are fewer players, there’s less capital chasing deals, there’s more people just on the sidelines not committing. And so that to me adds up to a more favorable competitive environment,” Busken said.

Another way managers are adjusting to the competitive energy transition market is by investing in assets earlier or by acquiring greater control positions.

Infrastructure managers ordinarily seek deals that have energy prices set under a fixed contract for 15 years, meaning their asset will provide a steady cash flow for that duration, Bonsignore said. But to secure their place in the market, some managers are seeking deals to take ownership of a whole pipeline, including future projects not yet built, he shared.

Clifford Chance is also seeing managers invest in projects before a notice to proceed stage to win deals over competitors, he said. Historically, operators selling unbuilt projects would be paid about 20% upfront. However, with today’s competitive rush, they’re holding off to see if they can get more upfront.

Bonsignore said there has been some “push and pull” on that front of deal making in the last year.

Despite tightening economic conditions and continued crowding in the space, energy transition deals are still getting done quite regularly, according to Bonsignore. The segment hasn’t reached capacity yet and new entrants are arriving on the scene all the time, indicating interest is not dissipating.

Managers and LPs aren’t pulling away from the market because there’s too much demand for capital, Mavroyannis said.

“I expect there’s going to continue to be a flood of capital into the space, and that it will find a home because there are so many requirements, so many capital needs to achieve a clean economy and clean energy system around the world that even this amount of capital will not be sufficient,” she said.

Reproduced with permission from FundFire.