Investing sustainably
13 June 2022
By Damian Payiatakis, London UK, Head of Sustainable & Impact Investing
Decarbonising the global energy system by 2050 is a mammoth undertaking – and a market opportunity.
For investors with shorter-time horizons, even interim 2030 targets seem equally immense. Recent analysis from the International Renewable Energy Agency estimates that $5.7 trillion of investment in renewables is needed per year until 2030. This would amplify the percentage of renewables to around 40% of energy produced a year from around 14% today1. Through a different lens, to reach the International Panel on Climate Change recommendations on renewable power, global additions of renewable power would need to triple by 20301.
With the rapid rise in fossil fuel prices in advance of, and exacerbated by, the war in Ukraine, the feasibility of this transition has been brought into question.
As reviewed in May’s Market Perspectives, European governments have responded by adapting and accelerating their energy transition plans. At the start of the year, their primary focus had been to reduce their energy sector’s greenhouse gas emissions to meet their Paris Agreement commitments. Now they are seeking to address simultaneous dilemmas of affordability, security, and sustainability.
Even with the current market challenges, renewable energy remains firmly embedded in their thinking. Thus, the conclusion was that while the journey to a decarbonised energy system may be different than before, the destination and ambition remains the same.
But what do the amendments and accelerations mean for specific renewable energy sources, and for investors?
In this article, we review the trajectory of four of the main energy sources referenced in the EU and UK proposals – offshore wind, onshore wind, hydrogen, and nuclear – to assess what opportunities might lie ahead for investors.
To answer the above question, we start by considering the current proportion of renewables, as well as the mix of low carbon energy sources.
Across the EU, renewables averaged 39% of energy produced in 2020, with fossil fuels contributing 36% and nuclear 25%2. Within renewable sources, 14% came from wind, 13% hydropower, 6% biofuels and 5% solar. But these averages hide a wide variation across the 27 countries in both percentages of renewable and the mix of sources.
By comparison, during the fourth-quarter of 2021, about 43% of UK energy generation came from renewables (see chart). The breakdown is roughly 13% bioenergy, 14% offshore wind, 12% onshore wind, 2% solar, and 2% hydro. By adding the 15% from nuclear, we can calculate that “low carbon” sources generated 58% of total energy production3.
Comparing the mix of energy sources, the differences in the approaches and aims of the two governments begin to come into focus. We now review the primary energy sources that were particularly highlighted in the recent UK and EU plans.
Europe is a leader in generating offshore wind energy, as well in the associated industrial sectors. Since building the first offshore windfarm in 1991 in Denmark, the scale and generative capacity have increased, while costs have fallen.
Currently, the EU has 16 gigawatts (GW) of offshore wind capacity4. The EU Green New Deal pushes for installed capacity of at least 60 GW by 2030, and 300 GW by 2050. Additionally, it targets at least 1 GW of ocean or floating wind by 2030, rising to 40 GW by 20505. However, recently offshore installed capacity has been subdued with only approximately 1 GW added in 2021, between Denmark and the Netherlands6.
Until recently, with 10.5 megawatt (MW), the UK had more installed offshore wind capacity than any other nation7. Later this year, Hornsea Phase 2 will open as the largest offshore wind farm in the world, adding another 1.3 GW to UK capacity8 and moving the country towards its target to reach offshore wind energy production of 50 GW by 2030.
For investors, offshore wind is an established, though continually improving, industry. The scale of intended growth across European markets (275% in EU and 380% in UK by 2030) demonstrates its market potential across the lifecycle of construction, manufacturing, and operations, as well as the supply chain. For those looking for earlier stage opportunities, floating wind farms offer the next generation technology to be developed, commercialised, and scaled during this period.
Compared with offshore wind, onshore wind offers lower costs and wider installation, but a more complex and lengthy permitting process. Onshore wind also has a lower capacity factor (so on average it generates less energy per turbine) than offshore counterparts (ranging from 50-300% more MW), due to more variable wind conditions and smaller turbines7.
There are more than 2,500 operational onshore wind farms, with a total capacity of 14.2 GW, in the UK8. However, growth has slowed considerably since 2017 when the government established three-part approval, which effectively stopped most new capacity addition. As a result, the UK only added 0.3 GW of onshore energy in 2021 for example6.
One barrier was removed in 2021 to allow windfarms to bid to supply electricity to the grid again. The others are not addressed by “wholesale changes” in the new strategy. Instead, it only opened the opportunity for consultation with local communities wishing to bring forward new projects9.
The EU added 11 GW of onshore wind capacity to reach 173 GW at the end of last year10. However, as WindEurope has analysed, this is less than half of what is needed to stay on track under its ‘Fit for 55’ package6. So rather than setting new or additional targets, the EU’s REPowerEU strategy added explicit plans to accelerate the permitting process to reduce the cost, complexity, and time to add existing planned capacity.
For investors, onshore wind shares a similar technological foundation to offshore, and the current cost issues around commodity and input prices, and supply-chain disruption. But the permitting process remains a central challenge to expand capacity. However, given installed costs are considerably lower11, if proposed governmental amendments to permitting are successful, industry growth could rapidly accelerate, making it a much more attractive market (see chart).
Nuclear power, while not renewable, is a low-carbon solution. It’s also seen as a generator of continuous energy with lower operating costs. On the other hand, it has very high capital costs and long lead times, as well as significant environmental effects and risks of disasters. Whether nuclear should form part of the future energy mix flips by each market, based on dimensions of economic, geopolitical, and familiarity.
Currently, nuclear power provides around 15% of the UK’s electricity supply from 11 operating reactors. As part of the UK’s energy security strategy, the government aims to produce up to 24 GW by 2050. Importantly, the strategy’s wording presents “an ambition” with no overall plans for 2030, or 2050; and no site is prepared to move forward yet.
Consider these ambitions in light of the current, and only, new site under construction in the UK, Hinkley Point C, which has been delayed and is massively over budget. Costs are estimated to be between £25-26 billion, up to £8 billion more than originally estimated when approved in 2016, and completion is not expected until 2027.
In comparison, the EU has 103 nuclear power reactors, across 13 states, producing about one-quarter of the electricity generated (100 GW) in the bloc. France alone produced over half of the area’s nuclear electricity12. Neither the EU Green Deal nor the REPowerEU plans include targets for nuclear energy. However, the proposed Green Taxonomy, controversially, has included nuclear as a sustainable economic activity, splitting views across Europe – most significantly between France and Germany.
The Taxonomy proposes notable restrictions and conditions in order to characterise a nuclear project as sustainable. These, for example, include the use of accident tolerant fuel for all reactors by 2025 and that a high-level waste repository would need to be operational by 2050 (which could be a challenge, as, for example, Spain began its effort in the 1980s and a site is unlikely to open until 2068)13. Whether any nuclear site in practice can be labelled as sustainable remains unclear.
For investors, large-scale nuclear is an uncertain opportunity given long lead times and considerable execution risks. Similar to Hinkley Point, the Flamanville 3 plant in France is more than a decade behind its original schedule and quadruple its original costs14.
Small modular reactors (SMRs) are being proposed to address some of the above issues. However, they remain an emerging technology. The first SMRs will potentially be operational in the next ten years, and seem unlikely to be competitive on cost with large reactors for another 20 years.
Overall, while nuclear has considerable advantages for energy production, it may be difficult for investors to access financially and, perhaps more importantly, environmentally, as its radioactive waste is unsustainable.
Foremost, it’s important to recognise that hydrogen is not a direct source of energy, rather it serves as an energy carrier, feedstock, or means for energy storage. While abundant at an elemental level, hydrogen needs another source of energy to extract it before it can then be used for electricity production (or other applications).
This energy source, and associated process, determines both the economic and environmental value of the gas.
To simplify, different hydrogen processes have been classified into colour categories:
Both the EU and the UK feature low-carbon hydrogen, or blue and/or green, as a central pillar in their energy transition. However, the challenge is to rapidly ramp up production of this energy source, when it isn’t generated at scale at the moment.
The UK first proposed generating 5 GW of low-carbon hydrogen by 2030 in its Ten Point Plan for a Green Industrial Revolution in 202015. In April, the energy security strategy doubled the UK’s target to up to 10 GW by 2030.
The EU has followed a similar path of starting, and then rapidly scaling, its hydrogen plans. In 2020, its strategy set out a target to install at least 6 GW of renewable hydrogen electrolysers by 2024, and 40 GW by 2030.
The EU’s RePowerEU plan now extends the original target to produce 5 million tonnes (mt) of hydrogen by 2030, with an additional 15mt, of which 5mt is to be produced in the EU and 10mt is to be imported. While there is substantial support, the EU has added the requirement that the renewable energy sourced for green hydrogen is additional to existing renewable installations. This means either having specific renewable sites for hydrogen, or excess power from existing renewables that would not have otherwise been used, which could slow adoption.
For investors, hydrogen represents an opportunity to be involved in a next-generation technology with considerable governmental support. While it is an early-stage and rapidly developing field, it also faces technology and execution risks as well as high capital costs to build and scale plants.
Based on the UK and EU governmental ambitions for all four energy sources reviewed, these markets could grow rapidly. And while a gap always exists between government ambitions and real-world activity, there is much scope for the private sector to mobilise its capital and entrepreneurial aspirations.
Beyond the sources highlighted above, solar, hydro, and bioenergy also contribute to energy generation. Also, emerging forms of renewable energy, such as ocean (tidal and wave) and geothermal, are providing innovative options for investors. Moreover, to manage the peaks and troughs of demand, energy storage will be required – through batteries and other large-scale energy storage technologies – opening up opportunities in adjacent industries.
Overall, energy transition provides a wide range of entry points, in both stage and types of investment. To some extent, how to invest will depend on how you believe policymakers will effectively address our energy needs. However, investors should look beyond the current reliance and performance of fossil fuel assets. The world will be increasingly powered by renewables; so long-term investors should consider how they might be incorporated in their portfolio.
This month we take a look at the major trends at play in the financial markets and the implications of surging inflation, central bank rate tightening, and slowing economic growth prospects. We also look at how private markets might be needed to bolster diversification, and what investors can do to limit the effect of what may continue to be a volatile end to the year.
