Smart technologies – but can they stand on their own?

Buoyed by growing government support across Asia, private equity interest in renewable energy is strong and getting stronger. But the presence of big-ticket government subsidies in the sector is also a big deterrent, finds Jenny Blinch.

A quick glance through recent headlines on shows the words ‘renewable energy’ cropping up regularly.

Recent mentions include Olympus Capital Holding’s $57 million investment in Zhaoheng Hydropower, a hydropower generator and supplier in China, a deal which marked the firm’s fifth investment in the renewable energy sector; Archer Capital’s failed bid to buy Australian power station operator Energy Developments (had the bid succeeded it would have been the firm’s first foray into renewables); a fresh pursuit of the same target by Archer rival Pacific Equity Partners in October; and coverage of an Ernst & Young report which shows private equity firms invested $301 million in India’s renewable energy sector last year – a dramatic increase from the $30 million annual total invested as recently as 2006.

Though investment in renewable energy, as in everything else, dropped off during the economic downturn, it looks set to rebound strongly – especially when you consider the number of specialist funds being raised for the space (see below). So what is driving the growth of this sector, which, according to Francesco Giuliani, a director at First Reserve Corporation, the US-headquartered energy-focused private equity firm, was “billed as the step-child of the energy sector” until the late 1990s? 

Interest in renewable energy has traditionally ebbed and flowed in line with the price of oil and other fossil fuels: when the price of oil is up, so is the interest in developing other sources of energy. Today, while oil price is still a key factor, renewable energy investors are quick to state that any correlation with oil prices is only one part of a much more complex multi-driver story.

Says Sylvia Chan, managing partner and co-founder at Hong Kong-based Entropy Ventures, which specialises in cleantech investments and recently held a second close at $35 million on its maiden fund: “Renewable energy is no longer a one-legged animal, it’s a five-legged animal in terms of drivers.”

Those drivers are, she says, the price of oil, concerns about climate change, energy security, the rapidly increasing cost-competitiveness of clean technologies, and industry development and job creation. Though they often overlap, Chan says that should one driver – oil price for example – drop out of play for a period, the sector’s growth can still be supported by the remaining four.

Governments in the driving seat

It’s no coincidence that the five key determinants of renewable energy trends are exactly the same considerations that are spurring the governments of many countries around the world to dedicate funding and legislation to the issue of green energy. In developing Asia, energy security in particular plays hard on the minds of governments in the region’s growth economies, and for obvious reasons.

According to statistics from the US government’s Energy Information Administration (EIA) agency, energy use in non-OECD Asia will rise by 104 percent between 2006 and 2030, compared to an average world increase in energy use of 44 percent. Amongst these, China and India stand out as key energy consumers. In 1990 India and China together represented 10 percent of the world’s total energy consumption; by 2006 this combined figure had risen to 19 percent; and by 2030 it is projected to reach 28 percent. 

“All these clean energy and clean investment policies very much align with energy security measures,” says Josh Carmody, senior project specialist in the areas of clean energy and climate change, and manager of the Asia Pacific Carbon Fund, at the Asian Development Bank (ADB). “India is pushing a strong solar mission for the increase in capacity of solar power – that in part is driven by the realisation that they don’t have as much coal as they thought they did.”

“Let’s just assume for the moment that China continues to grow its car ownership and usage levels at the same rate as it’s grown it for the last five years,” says Andrew Pidden, managing director, CRA Management, CLSA Capital Partners, which is in the market for its first clean tech focused private equity fund, Clean Resources Asia Growth Fund. “Then some time around 2030, it would require all the oil that’s produced every day in the entire world, just to run its transportation.”

But governments – and investors – are not just pushing development in renewable energy to plug the yawning gap between future supply and demand, they are also seeking to turn the enforced innovation into long-term opportunity.

Returning to China’s looming car ownership problems, Pidden adds: “One way of getting around the problem is to become the world’s premier producer of electric vehicles, because not only will that actually lower your national requirement to buy oil from the Middle East or Africa, it will also put you in a great position to export high quality goods all over the world, just when demand for them is going through the roof.”

Not to mention the jobs that all the new industry will provide: “They are constantly looking for ways to generate employment in China, and being a major producer of fairly labour-intensive items such as wind turbines for example, or railway components is a great way of doing that. It’s an investment effectively in the future of your country.”

Besides the economic and industrial opportunity, there is also the environmental opportunity, as ADB’s Carmody illustrates: “The International Energy Agency predicts that 80 percent of the energy infrastructure India will need to meet its energy demand between now and 2030 isn’t yet installed.

“So you could say that if 80 percent of the anticipated energy infrastructure required isn’t yet installed, then we have a great opportunity to try and encourage an outcome where India's future energy investment choices for power supply are clean electricity generation choices and not high emitting, dirty choices.” 

And the signs are good that many governments themselves agree with this. The Indian government for one proposed the additional generation of 15,000 megawatts of renewable energy in its eleventh five-year plan (2007-2012), amongst other expansion and investment plans in the sector. The Chinese government has been seen to throw its considerable weight behind renewables in the shape of legislation, including 2006’s China Renewable Energy Law, and also capital, including the dedication of $106 billion of the $580 billion stimulus package unveiled in November 2008 to cleantech investment.

It is also clear that governments need help from private investors, like private equity firms, to meet the goals they have set themselves. As an example, a report put out in August by global body The Climate Group highlights the two biggest hurdles standing in the way of China’s continuing development in this area as “technology gaps” and “an external financing deficit”. On the latter, it cited McKinsey research estimating that financing China’s green economy might require RMB40 trillion ($5.8 trillion; €4 trillion) by 2030 – or an annual investment of RMB1.8 trillion.

Standing on shifting sands

Ultimately then, perhaps the biggest driver behind the renewable energy investment thesis is the level of government support it has. But this, paradoxically, can also be the biggest detracting factor for an industry that has yet to become economically viable in its own right.

“The sources of [renewable] energy are more expensive than others – and electrons are electrons,” First Reserve’s Giuliani explains. “If you don’t put climate change in the picture, it could be argued there isn’t the justification for the expense of renewable energy. There is a cost curve. Some types of renewable energy, wind being one of them, will start to match grid prices within two to three years’ time. Others will take longer.”

In the meantime, renewable emergy relies on government subsidies to move forward, which, as Giuliani points out, makes many investors nervous. As he puts is, “subsidies can be here today, gone tomorrow”.

It’s not just the vagaries of governmental funding that are relied on, it’s also the permanency – or not – of the regulatory framework around renewable energy, something which adds another level of complexity and risk to the picture.

“One of the distinguishing features is that investments become more hostage to the regulatory framework and the international framework. You might invest in fast-moving consumer goods in India, but that’s based on the revenue streams for those products. If you’re investing in clean energy, often the entities you’re buying into might be regulated by the state. Or there might be an independent regulator setting the tariffs,” says ADB’s Carmody.

“The equation is local tariff plus carbon price plus a monetisation of the incentives has to equal a certain IRR and that IRR has to balance against the perceived risks,” he adds.

But tariff regimes – like government subsidies – are prone to sudden disappearances. “This creates a challenge in modelling some of these markets in the long run,” says Giuliani. “These are very technical industries, and very different from [other private equity plays like] consumer products or healthcare. The way we do it is to develop an investment thesis based on a detailed macro supply and demand analysis and then deploy capital behind it.”

Of course, there are many different ways to invest in renewable energy; from the companies that manufacture equipment to the operating companies themselves. The sector straddles the private equity and infrastructure asset classes and its perplexities mean many private equity firms are still working out the best way to approach it.

“People are testing the economics,” says David Hudson, senior managing director, Asia and Global Infrastructure, at Darby Private Equity. “Where is the profitability really to be made in these sorts of operations? Some would say you make money in the construction versus the actual operation of a wind farm. The concessions, contractual arrangements and off-takes are in the developmental stage.”

The private equity approach

Nonetheless, private equity interest is already there – and growing. But with so much dependence on others to set the agenda, it is no surprise that most firms in the space are charting a very careful course.

In many cases that means sitting back and watching developments. “We see the scale of wind farm developments and water treatment facilities planned in China and we’re waiting to see how that develops before we go in – it’s a little too early stage for us,” says Darby’s Hudson.

And early stage in renewable energy generally comes with exhaustive funding demands and greater reliance on government support.

“Unlike the internet, these are capital-intensive companies,” says Melissa Guzy, managing director for VantagePoint Asia, the Hong Kong-based Asian arm of US-headquartered VantagePoint Venture Partners. “It’s critical very early on when financing these companies that you make the decision as to whether you just want to develop the company, or whether you’re going to take it all the way through to commercialisation. If you’re going to take it through to commercialisation, there’s no doubt that you’re going to need the support of governmental funding.”

Instead, many private equity firms looking at renewable energy prefer to seek out those companies where they see – in Guzy’s words – “the momentum for commercialisation”.

“We always look for industry segments that are big opportunities. What we want to make sure is that the company we’re choosing should generally be a leader in their category,” she says, adding that it is no easy task in a market as fragmented as China’s.

“The commercialisation opportunities are often in efficiency stories; companies that create the same products we all want at a much lower environmental cost, because that environmental cost is a monetary cost as well finally,” says CRA Management’s Pidden. “The balance is how much extra does it cost to create a process that uses far less wasteful by-products, and the answer is that the smart investments have really short payback times and are therefore very easy to spot.”

The economic downturn, though detrimental to some of the more early stage funding sources for companies, such as large listed companies, has, Pidden says, helped weed out some of the weaker companies in the industry, leaving a “pretty decent pipeline” for private equity firms.

“You’ve got much more chance with people who’ve brought companies to market before, who’ve been through the issues before of raising money, securing management, meeting investors’ expectations, whilst not raising those expectations to silly levels,” he states.

But though careful assessment of the opportunities and energy sector knowledge is a prerequisite, there is can be no doubt private equity interest and investment in the renewable energy sector will continue to grow. After all, as Giuliani puts it: “Everyone ultimately believes that renewable energy is the way forward for energy.”

With that common sense belief behind it, the sector will no doubt be spotted on the investment remits of more and more private equity firms in the next few years.

Spurring private sector investment

Josh Carmody, senior project specialist: clean energy & climate change, and fund manager: Asia Pacific Carbon Fund, at the Asian Development Bank, talks about the ADB’s role in renewable energy private equity in developing Asia.

What is the Asian Development Bank’s goal in promoting private capital investment in renewable energy?

What we’re trying to do is get private capital into some of these markets that may not be first choice jurisdictions for private equity. We invested $100 million last year in five clean energy private equity funds that were focusing on Asia. That’s expected to galvanise about $1.3 billion; so that’s leveraging $100 million off our balance sheet to over a billion dollars of investment going into the region. I think the investment of someone like us or the International Finance Corporation is perceived to be important for the implicit comfort of the relationships we have with the governments in the markets we work in and the understanding we have of the risks in the markets we’re dealing with. There’s also hopefully some implied comfort that a counter-party would be more reluctant to default against an investment in which we’re a member. It’s not an express guarantee, but the private equity participants and investor community seem to take a lot of comfort from our presence.

But there already seems to be a lot of private sector money moving into the sector…
There’s a boom in clean energy and there’s a lot of money flowing into the sector, but it’s predominately flowing into North America and Europe. That’s responding to the perception of risk in those developed country markets relative to anticipated returns. And that’s driven by both the European emissions trading scheme, and then various regulations supporting clean energy in those jurisdictions. Investors like putting money into technologies like solar or wind in countries such as Germany or Spain because there are strong tariffs supporting those technologies in those markets and low perception of country risk. Clean energy investment in these developed markets is obviously a positive thing. However, in my view, the key markets for creating the deep, profound change in greenhouse emissions growth that we urgently need are the large developing countries like China, India and Indonesia. This is where most of the growth in global energy demand is going to occur in the next 30 years and it is this predicted emisions growth that we need urgently to address.

One of the perverse outcomes of all the great regulatory incentives in the OECD markets is it can have the effect of making it more difficult for investment capital that has an appetite for clean energy investment to migrate to clean energy investments in these key emerging markets where the perception of country risk may be higher. Developing market economies can rarely match the generation based ‘feed in’ tariffs provided in countries like Spain and Germany.  In most cases, the developing market governments cannot afford to absorb these high tariffs and the developing market consumer doesn't have the ability to pay. However, the thing that makes a huge difference and has the potential to equalise this difference in energy tariffs between developed markets and developing markets is the extra value earned via carbon credits in developing markets, the cost of which is paid by purchasers in developed countries. When carbon credit prices are added to local incentives then the value proposition becomes real and fwe get that value proposition right then we will get investment flows into clean energy into emerging markets at the required scale.  The second feature that’s really important is local domestic regulatory support in range of tax relief, tax holidays and excise relief on imported equipment & products. Only by virtue of the combination of some smart regulation locally plus a strong carbon price will you really move the needle so to speak.
And is that local domestic regulatory support forthcoming?
My view is that the key places are switched on to the fact that they have to get this right and they have to provide incentives. The message that hopefully public and private sectors are telling these countries is that if you don’t honour your regulatory and policy frameworks and you don’t get this investment, you will suffer. I think they get that loud and clear and they’re trying to bring in a suite of programmes and incentives to encourage that investment.

Cleantech movers and shakers

Renewable energy is only a part of the broader cleantech spectrum – a sector which is receiving increasing attention from the private equity industry.

“Anecdotal evidence from our conversations with other private equity firms tells us that people are cutting back on some sectors, but nobody’s really letting go in the cleantech space,” says Sylvia Chan, managing partner and co-founder at Entropy Ventures. “Most firms in fact seem to be trying to do more in the space.”

Her comment is echoed by that of Melissa Guzy, managing director for VantagePoint Asia, who says: “I think people who were dabbling are now beginning to think about hiring people and putting in place the infrastructure necessary for the sector, especially [in Asia]. People always go where the activity is and there are a lot of people who think that cleantech is one of the most interesting areas for investment right now.”

Those ‘dabblers’ now looking to make cleantech and renewables more of a permanent feature in their investment remit will follow on the heels of an increasing number of Asia-focused firms who have made it their core – or a primary – focus. Below is a snapshot of these firms and funds:

Specialist firms:

• Hong Kong-based Entropy Ventures, which recently held a second close on $35 million for its maiden fund, Asia Pacific-focused Amadeus Asian Clean Energy Fund. The firm is targeting a final close between $75 million and $100 million by the end of the year and will make growth and expansion stage investments.
• Mumbai-based Global Environment Fund, which is currently targeting commitments of $200 million for its South Asia Clean Energy Fund. The fund will invest in India, Sri Lanka, Bangladesh and Nepal and will make growth and expansion stage investments.
• Singapore-based Middle East & Asia Capital Partners, which is raising $400 million for the MAP Clean Energy Fund and will focus on clean energy investments in Indonesia, India and Pakistan.
• Singapore-based CRA Management, a division of CLSA Capital Partners, which recently launched its first private equity fund, Clean Resources Asia Growth Fund, with a target of $200 million. CRA Management already has four cleantech-focused listed equity funds.

Specialist funds:

• Hong Kong-based firm First Vanguard this year launched the First Vanguard Water Fund, which is reportedly targeting $500 million. The fund is focused on direct investment in water projects or water treatment-related projects, with its key geographical focus being on the Greater China region.
• Hong Kong-headquartered Olympus Capital’s Asia Environmental Partners, which was launched in 2008 with a $250 million target. The fund will be invested across Asia, but its primary focus is on China and India. In April, the fund received $25 million from the International Finance Corporation.
• Selangor-based Abundance Venture Capital’s Abundance Cleantech Energy Fund, which is reportedly targeting $250 million for investment across Australasia.
• Korea’s Green Growth Fund, managed by private equity firms Korea Technology Investment Corporation, Benex Investment and Japanese investment firm SBI Holdings. The fund, which is targeting $80 million, has a $15 million commitment from Korea’s Ministry of Knowledge and Economy, and will invest 70 percent of its capital in Korea, with the remainder to be invested elsewhere.
• The Robeco TEDA Sustainable Private Equity Fund, an RMB-denominated fund formed out of a joint venture between Robeco and TEDA International, is a subsidiary of Tianjin Investment Holding. The fund, which was launched earlier this year, aims to raise between $200 million and $500 million from Chinese institutional investors for investment in companies that develop technologies which increase the productive use of energy, water and other resources, and technologies which reduce waste and emissions.

Sector specialists:

• VantagePoint Venture Partners, which has its Asian base in Hong Kong. Cleantech is one of the firm’s three sector specializations, with the others being healthcare and information technology. Since the UB-headquartered firm’s inception in 1996, it has invested over $100 billion in cleantech.
•  US-based First Reserve Corporation, which specializes in investments across the energy sector and closed its most recent fund, Fund XII, on $9 billion in April. The firm currently dedicates 10 percent to 15 percent of its funds to investments in renewable energy. In April 2008 the firm invested with India’s Kalyani Group to establish Kenersys, a wind energy-focused company headquartered in Pune, India and Munster, Germany.