Vauban: Investor focus on energy transition ‘always increasing’

This article is sponsored by Vauban Infrastructure Partners

Last year was a testing 12 months for the infrastructure sector, as interest rates peaked and fundraising fell dramatically. This year the hope from managers and investors alike is that the worst of the economic turmoil is finally over and there is some light at the end of the tunnel.

Infrastructure Investor’s LP Perspectives 2024 Study found investors in bullish mood, particularly for low-carbon energy. Guillaume Faroux, principal at French asset management firm Vauban, breaks down why the energy transition is picking up a head of steam, and examines which subsectors offer the most exciting opportunities to investors.

How has the energy transition sector performed over the past year, and particularly since the energy price crisis in Europe?

The underlying mega-trends supporting the energy transition are still very much alive and encompassing all infrastructure assets classes, such as mobility, social infrastructure (public buildings) and digital infrastructure, besides obvious energy and environmental assets. We need a transition across the production and demand sides, which translates into considerable investment needs and opportunities for the entire infrastructure asset class. Net-zero targets and government backing are also part of the story and a major boost to investment.

If you look at the macroeconomic and political perspective, there has no doubt been a creeping realisation that sovereignty matters for energy production. The immediate consequence of Russia’s invasion of Ukraine has been a state rush for short-term energy supply securitisation, as shown in the gas market. Huge investment to ensure alternative supply and near-term energy supply security at the expense of booming prices were recorded.

That is not to say that there has been a loss of interest in low-carbon energy. In fact, there has been an increased focus on dispatchable ways of generating and transmitting cleaner energy. Volatile prices have provided an even stronger tailwind for the development of renewable energy assets and the underlying trend on both the demand and production side is going strong.

We see vanilla renewable assets such as onshore wind and solar farms as low-hanging fruits in the energy transition. They are vital for decarbonising the global energy mix and have already attracted their fair share of attention and investment in recent years. While potential remains strong for these, there has been an awareness that baseload and dispatchable energy sources are key to transitioning to a more sustainable society, both in terms of energy consumption and energy generation.

How is LP appetite for the energy transition evolving?

Appetite from investors is very healthy as they understand – and have already substantially invested in – energy transition assets based on the long-term decarbonisation mega-trends. They realise that the transition will require substantial macro investment to transform how the global economy is structured.

They have also become a lot more demanding and sophisticated. Many of them have honed their skills and upped their knowledge of the sector through several years of investing through GPs or directly. The upshot is that they are becoming far more selective across a multitude of criteria: everything from geography to technology and demand risk.

Meanwhile, some segments of this sector have also been overpriced for years; the current market evolution is positive, as it ceases to base profitability forecasts on aggressive refinancing or long-term interest rate decreases. We are progressively seeing a more prudent and realistic approach to returns. That might make the investing environment more challenging in the very short term, but it will most likely be beneficial in the long run.

Investors are also becoming more selective to investments and platforms that have gone international very quickly, arguably sometimes too quickly. In the current environment, such companies are required to show more discipline and geographical focus. Investors want to focus on countries where regulation is stable as it provides greater certainty and helps de-risk projects, especially for less established technologies.

The energy transition offers a vast canvas of opportunities for investors and managers. Which segments and subsectors particularly offer the best mix of returns versus risk?

We see a lot of value in energy distribution assets. Urban heating networks are a key sector of focus for us because they are demonstrated assets providing for optimising energy consumption and reducing carbon footprint.

These networks provide heat to consumers through winter and cold throughout summer peaks and are often the lowest-cost heating option. They can be fed by many low-carbon sources, including biomass and geothermal energy.

In many countries, the strong contractual structure and ownership model also makes them particularly resilient, and therefore a great fit for a core infrastructure investment, as is our latest acquisition of Coriance, the leading pure player in urban heating network operation in France. When we think about the long-term nature of the energy transition, this means they are both resilient and provide attractive growth avenues.

We are also very interested in waste-to-energy assets, in particular refuse-derived fuel incineration units dedicated to combustion of non-recyclable waste and biogas-generating plants that can efficiently valorise organic waste and provide a green share of much-needed gas to our economies.

Alongside recycling, which is key to lead us towards a more circular economy, they offer a strong solution for how society can make better use of the non-recyclable fraction of waste, which would otherwise end up in landfills. Waste-to-energy units, when connected to urban heating networks, can positively contribute to a more efficient energy mix, as they could curb the peak requirement for electricity.

In some European countries, waste-to-energy assets are already experiencing overcapacity and we expect waste to progressively become a valuable resource, and stop being transported over long distances based on the development of local end-treatment assets, established closer to waste production and heating networks.

The pace of growth for such investment can be further accelerated by authorities developing favourable regulatory environments and incentive schemes that will encourage stakeholders to improve their behaviours.

What are other key energy transition challenges that need to be weighed? 

Infrastructure project acceptance is a topic that needs to be addressed. Energy transition entails a larger, more decentralised and visible array of energy producing and distributing assets from wind and solar farms to waste-to-energy plants across all regions and landscapes. The footprints of those are not always popular, especially in rural areas where views and greenbelt land can be impacted.

All these assets need to earn their essential infrastructure asset status in the opinion of all stakeholders. That is, they must obtain a “licence to operate” to be sustainable in the long term.

From a European perspective, it is interesting to note that all countries face specific challenges resulting from their legacy energy mix and portfolio of assets, and political arbitrage. Germany’s mix was heavily tilted towards gas, often imported from Russia, while in France, nuclear energy plants have been providing low-carbon and affordable electricity, yet these plants will near their useful lifetime in 15-20 years. This is triggering, in both cases, massive investment requirements.

As for nuclear energy, this may remain one of the potential solutions for the transition, but the picture is complex. A strong proportion of investors are against using the technology, while many hold the view that such investment can constitute a “white elephant” – a large project whose capital expenditure is excruciatingly difficult to secure. In such a situation, it is hard to envisage how it can be compatible with private investment.

Given the sheer amount of energy that will be needed – not limited to electricity – all investment will need to be efficient in output prices, yet there will be a premium attached for states and users to contend with. Policies like carbon taxation will also add extra cost and weight on companies and voters in the medium to long term.

How do you see the sector evolving through 2024 and beyond?

Investor appetite for the asset class will clearly remain strong this year and beyond because of the positive macro trend that we see supporting the energy transition. The increasing level of LP sophistication will also continue with investors building and using specific knowledge about geographical markets and technologies.

This will reciprocally make them more demanding and selective of GP experience and expertise in specific subsectors or geographies and ability to manage the different stages of development, in particular capital expenditure risk management. Increasing specialisation is most likely where the sector is heading.

Of course, political risk will remain: there are always going to be bumps in the road. Each country is moving from a different starting point, whether that means consumption, generation or interconnections. Each country also has its own political agenda and there will be local as well as national differences. This might affect the journey to net zero, but we are still confident in the long-term trajectory and value in energy transition assets over the long term.

There will also be a growing emphasis on waste management. We have been living for decades in a global economy where waste was something to be disposed of rather than valued. I think we will transition into a world where waste will be both reduced and an important resource.

In the long run, it will be needed as a feedstock to generate gas and electricity, or as a material to be recycled. This will make it very valuable.

How should managers go about offsetting development and technology risk?

We have been in this space for 20 years, so have gained plenty of experience of investing in greenfield investments, both large and small. Adopting a disciplined approach towards management of capital expenditure, authorisations, resources and revenue, among many other factors, can greatly reduce development risk.

From a technology standpoint, it all depends on the process and its associated track record. Infrastructure provides essential services, so reliability is paramount. As an example, what was mostly missing in many hydrogen projects and companies that we passed on was not technology track record, but rather a lack of competitive offtake, exposing those assets heavily to market risk.