Schroders: Private debt faces a three-pronged dilemma

This article is sponsored by Schroders

Why do you believe that private capital has such an important role to play in driving the energy transition?

Investing in private assets is the most effective way to contribute to the environmental and social challenges that we all face today. Private markets can be split into equity and debt, and they can be effective in different ways.

On the equity side, you may take a seat on the board of a portfolio company. A board seat means you have the power to actively formulate or influence a transition plan, ensuring that the business or project contributes favourably to the UN Sustainable Development Goals (SDGs), in partnership with the management team and the co-shareholders.

It is different, of course, when it comes to debt. With debt, your most effective means of supporting the energy transition comes during the asset selection process. At Schroders Capital, we see it as our role as private debt investors to only select those assets that are best placed to help society achieve its net-zero ambitions.

As a capital-intensive industry, sustainable infrastructure requires substantial amounts of debt at competitive terms. This means debt managers can exert significant influence in driving capital into these critical energy transition assets.

Are there levers that lenders can pull beyond the asset selection phase?

Debt providers absolutely have a role to play when it comes to monitoring pre-determined key performance indicators (KPIs) throughout the investment lifecycle. This is most effectively done when loan documentation includes covenants specifically related to sustainability progress. After all, ESG factors can have a material impact on long-term investment outcomes.

As debt holders, it’s true that we have less involvement in the ongoing management and implementation of the borrower’s strategy, including how it relates to net zero. That said, the inclusion of appropriate clauses in finance documentation, alongside active engagement with borrowers on material ESG issues, can encourage greater disclosure and transparency. This mitigates risk for us as lenders and helps support the transition.

Where do you currently see the most interesting deployment opportunities when it comes to the energy transition?

Renewable energy generation is the cornerstone of the net-zero journey. The power sector is a massive contributor of CO2 emissions. By investing in renewables, you are automatically having a positive environmental impact.

Furthermore, renewable generation is amongst the most mature areas of the energy transition landscape. It generally has well-established business models and a well-established value chain, albeit one that has experienced significant turbulence as a result of covid-19 and, more recently, horrific events in Ukraine. But renewables are far from the only game in town. The energy transition is far broader than that.

It is early days but hydrogen, for example, is poised to revolutionise the decarbonisation of transportation and heavy industry. We still need to develop business models and value chains that will enable hydrogen to be deployed commercially at scale, but there is no doubt that it will have a crucial role to play at some point in the future.

Energy efficiency assets, which transform the way that end users consume energy, are also important. Then there is EV charging, of course. After all, while transportation represents almost a quarter of Europe’s greenhouse gas emissions and is one of the main causes of air pollution in cities, it has not seen the same decline in emissions as other industries, most notably the power sector. It is therefore vital that we transition to low carbon mobility.

Carbon capture is another example of a nascent but exciting component of the energy transition ecosystem. In short, whilst renewables are a major part of the story, there are a whole host of other investment opportunities to consider.

As you say, some of these sectors are significantly more mature than others. As a lender, how do you decide when a particular industry is bankable? When is it time to press go?

You have to carefully follow the evolution of business models on a subsector by subsector basis. For example, some areas may require government support. In others, we may see the emergence of long-term contracts with public sector or private sector off-takers (the parties that buy the power).

In this way, what may be deemed a venture capital play today – or at least value-add or core-plus infrastructure – may ultimately become the super-core of tomorrow and I am convinced that this is the case with many of these emerging energy transition industries.

To put it into context, I was structuring debt and equity investments in offshore wind farms over a decade ago, in my previous role. At the time, those deals would not have been considered institutionalised. But we were able to negotiate with the industrial players so that they assumed a certain level of risk in the underlying asset and that meant that as a finance provider we could get comfortable with the risk/return profile. Now, of course, offshore wind is considered to be about as core as it comes.

In terms of timing, therefore, it is all about waiting for those core infrastructure characteristics to become a reality – namely resilient cashflows and business models, monopolistic or other strong market position, and long-term contracts with strong counterparties. Of course, in the meantime, you have to ensure you have all the insight and knowledge to hand so that you are ready to move when the conditions are right.

How competitive is the energy transition space from a private debt perspective and how do you approach origination in order to avoid the most heated areas?

A lot of investors are positioning themselves in the sustainable infrastructure space, particularly focusing on renewables. A great deal of money has flowed into the sector and that is driving a reduction in IRRs. It is fair to say that renewables have become more of a commodity play. But in other areas of the energy transition, it is still possible to create angles in order to distinguish yourself and to identify and secure interesting opportunities. In many ways, that is more true of the energy transition sector than other more traditional areas of infrastructure.

Indeed, having worked in the asset class for more than 20 years, I see that we are at something of an inflection point.

Infrastructure used to be about deploying very large tickets to own mega transportation, communication and power assets. The energy transition, which dominates today, is more about creating new, incremental infrastructure, or refurbishing that which already exists. And it tends to be done on a smaller and more local basis.

That lends itself to a different approach to sourcing. You need boots on the ground. You need to build relationships with all the relevant stakeholders, and you need to carve angles and set yourself apart, in order to secure assets that you can then grow with, and which will become core in time.

Where is your competition coming from?

Trillions and trillions of dollars of private and public sector capital is required if there is any hope of meeting energy transition and net-zero goals. The scale of the opportunity is therefore enormous and that has not gone unnoticed. Interest in the sector has also been intensified as a result of new regulation coming out of the EU, which is forcing investors’ hands when it comes to ESG transparency.

In addition to traditional core infrastructure players, which typically focus on the type of risk/reward profile provided by renewables, meanwhile, we are also seeing new entrants from the private equity side, focusing on some of the more nascent and value-add elements of the energy transition landscape. It is a very natural extension for those private equity firms.

How optimistic are you that we can reach the net-zero goals that have been set, against this challenging backdrop?

Given everything that is currently happening and the extreme energy prices that we are experiencing, I do think it will be a difficult to meet the objectives that have been set by the relevant deadlines. But just because it is challenging, doesn’t mean we can stop trying. It is vital that investors such as our team at Schroders Capital Infrastructure have sustainability in their very DNA and that we integrate the need to address social and environmental goals in everything that they do. These are existential challenges, so really, what choice do we have?

What impact do you think the current geopolitical situation and the focus that it has brought on energy security will have on the broader energy transition agenda?

I think this enhanced emphasis on energy security has added another dimension to the energy transition movement – it has highlighted an additional objective that needs to be achieved. We all know that reaching net zero is essential. There is no compromise to be made there. It is a matter of survival.

We are also grappling with how to meet energy bills in the face of high inflation. How do we manage cost of living issues for the general population? Now we have this additional challenge. How do we secure our energy independence and ensure that we are not subject to the type of geopolitical risk that is playing out so terribly in Ukraine?

Russia currently supplies Europe with between 35 percent and 40 percent of its gas needs, so the scale of the energy security problem is significant, and the energy transition has now become a three-pronged dilemma.