A record year for climate infrastructure

We are witnessing a dynamic period of transformation in the energy sector known as the “energy transition”, which has established a new asset class: climate infrastructure.

Climate infrastructure is comprised of assets that reduce greenhouse gas emissions, promote the efficient use of natural resources, and/or strengthen climate change resiliency. The energy transition creates opportunities in sectors such as renewable energy, battery storage, vehicle electrification, and energy efficiency.

The increased interest in this asset class reflects the rapid growth of clean energy caused by a decrease in its cost, the emergence of new applications for existing energy technologies, and the actions being taken by governments, corporations, and consumers to mitigate the impacts of climate change.

Together, these dynamics are creating the global energy transition, enabling the decarbonization of the economy by electrifying the transportation, industrial, and buildings sectors and shifting away from fossil fuels towards cost-competitive renewable energy sources at an unprecedented pace.

Climate infrastructure is now the largest infrastructure sector in the US, outpacing all others in total value and number of transactions.^[i] Renewables are projected to nearly quadruple their share of US electricity generation over the next 25 years to more than 50%, after having already made tremendous progress from their 2% market share in 1995.

In addition, for the first time ever, renewables surpassed coal generation in select months in 2019, a trend that we anticipate will become permanent in the years ahead.^[ii]

The energy transition is being driven by the secular tailwinds of what we at Ares refer to in our thesis as the “Three P’s” – price, preference, and policy. Each reinforces the other.

Renewables are now the lowest cost form of power generation, which incentivizes corporate and consumer demand and allows policy goals around decarbonization to be economically viable. All of these contribute to increased deployment, which drives additional cost declines from technological advancement, making the renewables value proposition even more compelling and establishing a self-perpetuating cycle of decarbonization.

As technological advancement continues, renewables increasingly are competing toe-to-toe on economics with fossil fuel generators as costs decline and productivity improves. This is enabling new regions with less robust solar or wind resources to also participate.

Wind and solar, following cost declines of 70% and 85% respectively over the last decade, are now less expensive than combined cycle natural gas even without federal tax subsidies. Furthermore, lithium ion battery storage is now competitive with natural gas peaking generation and continues to rapidly decline in price (down 50% in the last five years), supporting additional renewables penetration by balancing the intermittency of wind and solar resources. ^[iii]

Corporate and consumer preferences are accelerating the energy transition through rapid growth in corporate power purchase agreements (PPAs) for utility-scale opportunities and growth in residential and community distributed generation (situating smaller-scale generation like solar and storage close to customer load).

Today, the most common form of new long-term power purchase agreements for wind and solar projects is not with utilities but with corporations. In 2019, there were nearly 14 GW of new PPAs signed with corporations in the US - up 60% year over year and representing over $14bn of capital expenditures.^[iv] In addition, over 280 influential companies are committing to 100% renewables targets and the energy transition is even impacting major oil companies who are re-orienting their strategy to renewables.^[v]

Individual consumers are also increasingly interested in rooftop solar, home storage, energy efficiency, and electric vehicles, which are some of the most exciting growth areas in the energy transition.

Along the same theme as price drivers, rapid cost declines have supported new applications and unlocked new consumers motivated by decreasing their utility bills and enhancing their resiliency to increasing power outages due to climate events like storms, wildfires, and other service disruptions.

The US federal tax credit programme has been a major success, encouraging the commercialization and growth of the renewables industry, with over 160 GW of wind and solar projects built in the US over the last 10 years. In the US, many states have implemented a program called renewable portfolio standards (RPS), which are deployment thresholds for renewable energy to achieve by certain dates.

There are now 37 states that have an RPS or clean energy target, and there are now 15 states, as well as Puerto Rico and the District of Columbia, that have instituted 100% renewables or clean energy standards.^[vi]

Achieving 100% renewables will not only require continued growth in wind and solar but also requires meaningful storage deployment in order to compensate for renewables’ intermittency. Technology advances and cost declines have put 100% within reach.

We believe the Three P’s are only poised to accelerate in the coming years.

As we begin 2021, we have identified several key themes related to climate infrastructure investment that we believe will characterize the year:

The energy transition involves using technology to create new business models that enable consumers and businesses to directly participate in the broad economy-wide decarbonization. We expect large utility scale renewables deployment to continue, but as we look towards the future, many of the major trends in climate infrastructure we are seeing are tied to distributed generation.

Distributed generation, or (often smaller-scale) electricity generation co-located with demand, capitalizes on the wholesale/retail rate arbitrage to drive its economics and is increasingly preferable for resiliency and reliability reasons, as well as its environmental benefits.

Residential solar has been experiencing annual growth of 20-30% over the last several years in the US, with Q1 2020 hitting an all-time installation record of 810 MW. Installations are still heavily concentrated among a limited number of states, with California, Florida, and Arizona accounting for about 50% of installations.^[vii]

We expect continued expansion and additional institutional investor entry into the space as technology continues to make new geographies with less robust solar resources economically viable.

By 2025, at least one third of new residential solar systems are expected to be paired with energy storage. The residential storage market has experienced record installations, even amidst Covid-lockdowns, and remains the fastest growing segment of the storage market.

Climate events like the recent wildfires in the Western US and widescale pre-emptive blackouts are highlighting the value of resiliency and spurring customer demand for home battery systems.

The significant state incentives available in certain markets are further aiding the rapid declines in battery costs from technological advancement driven by both storage and electrical vehicle applications.

In addition, multiple technologies like solar and storage are being paired together in larger microgrid applications for corporations and multifamily housing communities, enabling them to interface with the grid in new ways as a dispatchable virtual power plant.

Annual US deployments totalled about 600 MW in 2019, up almost two times from two years prior, with approximately 70% of US commercial buildings being potential targets for solar.^[viii] Microgrid configurations may very well be one of the next big growth areas driving the energy transition.

Renewable energy benefits from bipartisan support in the US, with broad federal renewable tax credit extensions signed into law in December 2020 as part of the Covid-19 stimulus package. Nonetheless, we believe that the recent US elections will only accelerate the clean energy transition already taking place, with a Democrat-controlled Congress serving to accelerate President Biden’s ambitious climate programmes.

In the executive branch, President Biden supports climate infrastructure as a pathway to achieving two key objectives of his administration - economic recovery and action on climate change. Announced policy initiatives that are supportive of additional clean energy deployment include:

• Rejoining the Paris Climate Agreement

• Utilizing the Federal government’s procurement power to accelerate deployment of renewable energy and energy efficiency

• Building 500,000 electric vehicle charging stations by 2030

• Requiring public companies to disclose climate-related risks

• Establishing a 100% national clean energy standard by 2035 and targeting economy-wide net zero emissions by 2050

• Increasing R&D funding for renewables^[ix]

While state governments have held a recent leadership role in supporting climate infrastructure development, we expect a more proactive federal government response to create additional momentum for the asset class.

In response to the aforementioned trends, we believe insurance companies in particular are increasing exposure to climate infrastructure for the following reasons:

Insurers are distinctively attuned to climate risks through their exposure to natural catastrophes in their core business and the associated data collection and risk model development, causing them to emphasize the integration of environmental, social, and governance (ESG) factors in their investment underwriting process. We believe that Covid-19 will only accelerate the emphasis on ESG investing and the focus on tail risks like climate change.

Many insurers already understand and are comfortable with climate infrastructure assets through insurance underwriting in property and casualty portfolios. Further, we believe the experience with Covid-19 has reconfigured risk perceptions for all asset classes – at the height of the crisis the scarce liquidity environment caused certain assets generally regarded as safe to not provide the level of downside protection that was expected.

Even within the broader infrastructure asset class, we believe climate infrastructure distinguished itself in terms of both asset utilization and valuations relative to other sectors such as airports, ports, toll roads, and midstream/downstream energy assets.

Climate infrastructure can represent an attractive investment alternative for insurers which are disproportionately exposed to fixed income and therefore have their income under pressure from low interest rates. About 57% of the $1.9tn in property and casualty assets and 71% of the $4.3tn in life and annuity assets are invested in bonds.^[x]

However, with the 10-year US Treasury note yielding close to 1% and investment grade corporate bonds yielding sub-2%, insurers risk being unable to generate sufficient income to match their liabilities (which may be growing rapidly due to climate risks).^[xi]

Climate infrastructure assets, which have historically offered multi-year contracted cashflows with creditworthy counterparties, have the potential to generate low volatility returns five to ten times the yields available on current 10-year US Treasury notes and three to five times the yields on current investment grade corporate bonds with limited correlation to most public markets – thereby providing a potential diversification benefit to investor portfolios.

Investments in climate infrastructure assets also have the potential to generate cash yield, provide inflation-protection, and serve as a hedge against dislocations and stranded assets caused by the global energy transition away from fossil fuels.

The scale of the energy transition is immense and its scope is potentially all-encompassing. It is being driven by price and economics as much as it is by durable trends of preference and policy.

Climate infrastructure assets have recently demonstrated a resiliency and downside protection not observed in other infrastructure asset classes. We believe this may drive increased interest in the sector, including amongst insurers, as secular trends related to cost declines, ESG-driven consumer/corporate preferences, and government policy continue to expand the market.

For investors seeking a diverse portfolio of asset types, the energy transition presents a myriad of investment opportunities in a sector that is fundamentally changing our energy landscape for decades to come. We believe this is an exciting time to be participating in the industry’s continued growth and innovation into new deployments that improve society at large.

[i] Source: IJ Global. Includes asset acquisitions, primary financings, and portfolio financings. Excludes corporate acquisitions.

[ii] Sources: BNEF for projections, EIA for historicals.

[iii] Source: Lazard, Levelized Cost of Energy Analysis: Version 14.0 and 10.0, October 2020 vs. June 2010.

[iv] Source: BNEF Corporate PPA Deal Tracker, April 2020.

[v] Source: RE100, December 2020.

[vi] Source: National Conference of State Legislatures, December 2020.

[vii] Source: Wood Mackenzie, November 2020.

[viii] Source: Greentech Media, “Abstracting the Complexity of Microgrids,” November 2020.

[ix] Source: Biden Climate Plan, January 2021.

[x] Source: Insurance Information Institute, “Facts + Statistics: Industry overview,” 2020.

[xi] Sources: U.S. Department of the Treasury for 10-year Treasury Note and S&P 500 Investment Grade Corporate Bond Index for investment grade bond yield. As of January 13, 2021.