Enthusiasm for investing in the renewable energy sector shows little sign of abating. Unfortunately, it is inevitable that many investors seeking to increase their exposure in the space will end up making poor investments.
The main problem is that the excitement surrounding the sector is generating heat but not much light. Enthusiasm is no substitute for knowledge and experience, which is often lacking. Many investors already find themselves significantly exposed to the risks inherent in a young and little understood sector.
Too often investors are taking big risks by backing large infrastructure projects, which are usually based on applying proven, reliable but not necessarily very efficient technologies.
Ploughing large sums of capital into these sectors on the basis of financial models that assume returns over 15- to 20-year periods is risky without a thorough understanding of the likely advances in sustainable technology over this kind of time scale.
This is the case in both the renewable energy space and the waste sector, where large-scale incinerators and other centralised processing plants are being planned and financed very often with technology which may be obsolete by the time the plant is open and operational.
It's a bit like buying IT hardware for a large organisation based on a ten-year payback period – it just doesn't make sense. Combine this with the accelerated regulatory drivers which are forcing changes across the sector and you have a significant potential risk profile for projects driven by medium-to long-term return on investment (ROI).
This “top down” project-based approach to investing in the sector is risky if you don't understand all the available technologies. Ill-advised investments in the sector are already running into trouble as some ventures begin to fail, such as German bio diesel projects made unviable in just a few months by a sudden and steep rise in the price of feedstock such as rapeseed and soya and a reduction in government subsidy.
We will see more projects such as these in Europe and the US being sold or restructured in distressed situations because they cannot keep up with debt repayments.
WRONG TECH, LOWER PRICE
There is also the very real possibility that those who have backed the wrong or less efficient technology will be bought out at a lower but more realistic price. We're already seeing that happening in the case of wind farm operators.
This is a sector where the UK is well placed to develop a new world-class industry, with its unique engineering heritage which was at the forefront, for example, in the development of the offshore oil industry.
Growth would be assisted if the government engaged in direct procurement of promising technologies as happens in the US. Bodies such as the Environment Agency (EA) are well placed to become sustainable enterprise-friendly.
Aside from lack of state assistance, a further problem new ventures face is the relative lack of technology licensing. We're not seeing larger players on the hunt for partnership or licensing opportunities at the current time
Rather than licensing technology, or forming partnerships with larger players, there is instead a land grab going on in which smaller companies are identifying sites and setting up small-scale power generation projects by whatever means they can.
One of the consequences of this land grab is that renewable energy generation will become much more commoditised and this may be an additional spur to a consolidation of small energy producers in the next three to five years – perhaps sooner.
The winners will be those that have backed the best technology that can as far as possible mitigate exposure to feedstock and other market volatility. Backing the best waste-to-energy projects or highly efficient biofuel production methods will be key, as well as understanding the regulatory subsidies available.
In bio-fuel, for instance, the future lies with businesses which have developed more efficient techniques for producing ethanol or butanol from a wide variety of biomass or biowaste. An example is a technology which enables the production of lignocellulosic ethanol at low cost using a fermentation system based on high temperature microorganisms.
Finding promising technologies and businesses such as these to invest in is best done using a “bottom up” approach. If you have in-depth knowledge of the sector, or are working with specialist investors, it is a good time to be investing at the venture level.
Given the tighter liquidity in the credit markets, larger-scale infrastructure projects will need to demonstrate greater efficiencies to secure funding and therefore will be driven to encourage the adoption of new technologies.
The long- and medium-term regulatory and other macro drivers that will support innovation at the venture stage look likely to remain in place. Factors including high energy prices, greater environmental awareness as well as public policies that drive corporations and consumers to be more efficient and reduce their carbon emissions are not going to disappear.
The trend towards less centralised energy generation is also helping the venture end of the sector, as is the prospect of a gradual break-up of the existing cartel in the waste management sector as the drive to recycle more and make better use of waste gathers momentum and allows smaller companies to enter the sector.
We will see a greater number of smaller-scale power generation facilities, ranging from island communities adopting wind and wave power to waste-to-energy projects that source their energy feedstocks locally.
It is also becoming easier to attract high quality management teams into early-stage businesses in the sustainable sector because of the interest in it, which should mean an ever sharper focus on developing and deploying the right technologies to realise quicker returns on investment.
The movement of talented entrepreneurs into venture-backed businesses in the sector is not matched, however, by a similar migration on the part of venture capital investors. There is a significant shortage of knowledgeable investors in the space and even fewer with a track record of making money. This, more than anything else, may explain the lack of capital reaching sustainable technology companies.
Part of the challenge for investors in finding and backing the best prospects is that this is such a young sector and the majority of companies in it have little trading history to analyse. Undoubtedly there are exciting opportunities to create value in the sustainable sector. The difficulty, as always, is seeing the wood from the trees.