In a global market with plenty of dry powder sitting on the sidelines and uncertainty around investment appetite for the more established financing opportunities such as loans and bonds, will debt providers see an investment opportunity in climate finance? It’s a sector that will be hard for credit investors to avoid for too long. This is partly due to the potential size of the opportunity but also the blurring lines between climate technology and its inter-relationship with increasing ESG responsibilities faced by lenders. For the purposes of this article, climate technology is all encompassing and includes opportunities that directly or indirectly help the climate.
Whichever way debt investors turn, the direct or indirect impact of their investment decisions on climate and society is increasingly coming under the spotlight. In the next few years, it will no longer be sufficient to merely highlight incidental or fringe benefits to the climate from financing a company with stakeholders potentially demanding more measurable and transformative benefits from underlying investment decisions. Financiers will need to evaluate their individual and fiduciary responsibilities to societies and investors, while continuing to make sound investment decisions.
The biggest challenge with addressing the topic of financing the net-zero (or carbon-neutral) economy is how to create a meaningful entry and pivot point for debt financiers. This in some ways requires a complete rewiring – identifying suitable opportunities and creating a conduit for dealflow, presenting climate opportunities to prospective lenders using acceptable metrics as well as pricing risk at a premium to other investments. Advisers and debt arrangers will need to find ways to reach out to disparate pockets of investors locally and globally as well as understand their mandates (and limitations) to make transactions happen while creating liquidity to facilitate wider participation.
One of the clear trends emerging is that climate solutions, while germinating from a technology-based concept, typically require substantial assets or logistics to scale. While this seemingly provides scope for asset-backed lending or special purpose vehicle-based financing structures, there are often limited benchmark metrics such as asset utilisation, cashflow yields or indeed understanding of useful asset life. There is typically a slow but emerging demand for ‘off take’ of the products and services created by climate tech companies, unlike other traditional energy projects where assets are built in direct response to ‘contracted demand’.
Climate companies trying to solve the biggest problems will typically need the most capital. Most of these companies will be unlikely to enjoy the same heady success as certain EV manufacturers or battery storage companies have, instead aiming for returns comparable to utility companies if the concept is successful and widely adopted. If it is too expensive it will hamper customer adoption.
Only a decade ago software- and technology-enabled businesses were seen as high risk (threat of extinction from global majors) by lenders. Fast forward to 2023, that picture could not be starker as some of the world’s most valuable companies are in the technology sector. Debt finance providers have experienced remarkable success in financing private equity-backed companies in the sector. According to Bloomberg in 2021, $146 billion of technology company buyouts were accomplished compared with $42 billion in 2011. Will climate finance follow the same trajectory and do lenders see any parallels?
Will debt providers see the need to finance climate tech projects as a priority to align with high-profile pledges made by various governments? At a time when countries are shoring up their own balance sheets, it seems futile to expect governments to provide subsidised funding to act as a catalyst to the sector. Does this create an opportunity for financiers to set market economics and take the lead?
Three areas of focus in climate finance
Opportunities in the sector can today be classified into three categories
1. Mature renewables: such as solar parks, wind farms and waste recycling supported by banks and asset managers
2. Energy transition: industrial/logistics companies transitioning to a lower carbon footprint, electrification of transport, eco-friendly real estate projects or forestry projects with support from alternative credit and real estate financiers
3. Early stage/scale up: electric vehicle charging or battery technology and circular economy recycling (construction waste and materials, fashion, electronics, etc) concepts which provide some respite to the planet, often supported by venture debt or, increasingly, specialty finance providers.
Right now, climate technology is facing some headwinds in addition to the usual challenges of creating, commercialising and scaling climate technology. It potentially faces a halo effect from softening valuations and risk appetite in the general technology sector, inflationary pressures on operating costs as well as a credit market that is seeking higher returns in response to rising interest rates and an uncertain macro environment. From a customer’s perspective there are also barriers to overcome. For example, SMEs that wish to switch to renewable energy require significant capital investment in assets such as batteries, inverters and solar panels with long payback periods. Citizens who wish to go green also face the challenge of making big-ticket investments in EVs or residential solar panels.
There is a silver lining, with certain climate-related companies successfully raising debt. UK EV subscription service Onto, EV charging infrastructure developers Gridserve & InstaVolt, consumer electronics recycler Raylo and Germany-based e-scooter provider Tier Mobility are just some examples. There is also a precedent for long-dated structures being placed with asset managers by Zenobè, which manages commercial passenger EV charging infrastructure.
Investing in the Green Economy 2022, a report from the London Stock Exchange, suggests market capitalisation of green equities ballooned from under $2 trillion to $7 trillion between 2009 and 2021. Debt financing typically lags equity. Even a tiny fraction of this market would be a draw for lenders.
Away from the banks
Since the global financial crisis, the financing universe has transformed away from traditional banks. Alternative asset managers such as TPG, Blackrock and KKR, as well as wealth funds such as Temasek, GIC, Mubadala and infrastructure funds such as Macquarie and M&G have conducted climate financing transactions. Against this backdrop could the timing for climate financing be more opportune?
Climate financing dealflow is still not strong, most likely due to the difficulty for both sides in finding each other (borrowers seeking financiers and vice versa). Active lenders tend to have ESG- or climate-focused mandates while some generalist lenders approach the sector somewhat haphazardly. There is still some way to go before climate financing becomes a seamless asset. Are credit investors willing to make long-term investments with potentially lower returns? History shows that new asset classes are typically formed in the search for higher yield or to address some form of market dislocation.
Are credit markets at such a juncture right now? Hard to say. Large oil and energy majors, as well as auto manufacturers championing green projects, have a big advantage in terms of accessing credit. Growth equity-backed companies have some advantage too, but companies and spin-offs borne out of a passion for improving the climate with newer concepts will have to continue to look for creative ways to scale and access capital. There remains a big opportunity for lenders to forge a path within the burgeoning climate sector.
Viral Patel is co-founder and managing director at Prime Lead Partners, a UK-based debt advisory and consulting services firm