Climate Change investor perspective: Risk and Return around Commercial Breakeven

(Abhishek Uppal, Clean Technology Private Equity 2009; Reference to DB Advisors Investing in Climate Change)

Understanding commercial breakeven
•    For a particular climate change technology to be adopted at scale, it must be commercially viable – breakeven or better against competitive, less environmentally-friendly options. We call this commercial breakeven.
•    Over time, four factors have converged to drive the commercial breakeven of renewables:
o    Traditional and innovation-based incentives have been established.
o    Fossil fuel prices have increased;
o    Carbon prices are being introduced;
o    And the cost of renewables has declined as they have moved down the learning curve.
•    There are different ways of calculating commercial breakeven, which can include or exclude subsidies, incentives and carbon prices. It is important for an investor to be aware of what is and is not included when assessing the economics of renewables;
•    In the long run, the most sustainable breakeven point for renewables is when they are commercially viable without subsidies, but with a carbon price regime as a de-risking backstop.

Using Levelized Cost of Energy (LCOE) as a tool for measuring investor opportunities
•    LCOE is a framework that can be used to assess the economic viability of opportunities in the electricity markets;
•    While the idea of LCOE is attractive at an industry level, adapting the framework to work as a project-level investor model is ultimately more useful. The investor opportunity model should take a number of factors into account;
•    Most importantly, the discount rate should match the individual project risk profile and cost of capital, and local energy market dynamics need to be modelled;
•    Scenario analysis on fuel prices, incentives and subsidies, and carbon pricing needs to be performed;
•    The learning rate and other inputs need to be project-specific.

Using the investor’s model to understand project risk and return
•    As the investor model is developed for individual projects, a set of complex variables come into play at a granular level in a specific region and market context;
•    There is a set of critical risk/return trade-offs investors need to take into account, specifically: operational, financial, regulatory, energy feedstock, learning rate, underlying electricity price and carbon. These risk-return trade-offs will be sources of alpha generation.

The technology development process
•    Each broad technological umbrella (e.g. solar) covers a broad array of sub technologies. Each of these sub technologies is at a different stage of commercialization, presenting different opportunities to investors;
•    The technology development process takes a long time. As technologies move through the pipeline, the nature of the investment opportunity, as well as the risk/return profile, changes;
•    In clean energy, there is significant room for improvements in existing technologies, as well as meaningful opportunities to develop and commercially deploy new, early-stage technologies such as CCS.

Investor implications
•    New clean technologies have emerged over the past decade and technological advances in the clean technology space open up opportunities for investment in a range of new products and ideas;
•    Understanding the characteristics of the sub technologies moving through the pipeline is essential for investors;
•    Deep knowledge of the technology development process, as well as a detailed overview of the technological landscape within each sector, is necessary to generate alpha in the space.