The transition to a low-carbon economy is producing myriad productive ways to put capital to work. Considerable capital will be needed to fund the massive investment required over coming decades. Investors looking to maximize impact should invest in strategies that lean into recent policy initiatives (e.g., the Inflation Reduction Act) and specialized climate tech funds seeking to solve difficult challenges. Those looking for more stable returns will find an abundance of opportunity in infrastructure funds.
Even with some near-term headwinds, we see opportunities in private equity and venture capital (PE/VC). As with broad markets, climate tech PE/VC is facing slowing deal activity and exits in a higher rates environment. Higher financing costs and elevated valuations may weigh on future round financings and exits in the near term, particularly for earlier-stage hardware climate-tech companies that have a longer runway to profitability. However, overall investment activity should gradually recover as climate-tech PE/VC funds look to deploy a significant amount of dry powder, and recent policy developments support the opportunity set. Climate-tech VC funds target mid/high-double-digit returns by focusing on early-stage companies in areas such as software, battery/storage technology, commercial transportation, renewable fuels and solutions for complex industrial challenges (e.g., cement and steel production). Less crowded areas, such as hardware climate technologies, offer higher scalability and potential payoffs, but require dedicated expertise in the fields of technology, engineering, manufacturing, and project finance.
Private infrastructure funds focused on the energy transition provide the largest opportunity set. Smaller infra funds will invest in areas that overlap with PE, like scaling solar developers and electric vehicle infrastructure, given double-digit return targets, while larger funds with lower, more predictable, return targets may focus on acquiring power assets with long-term revenue contracts in place (and related storage plays). Infrastructure funds benefit from the investment scale needed to meet net-zero goals, but face headwinds, including rising competition for assets, higher financing costs, and difficulties with everything from supply chains (e.g., Inflation Reduction Act requirements) to delays in grid connections. One result is that even some large infrastructure funds have broadened their focus from renewable power projects to utility-scale storage and renewable energy installation and financing for the residential sector. Investors looking at managers allocating in these markets should consider skill sets (including technical, regulatory and financial), sourcing abilities and public market trends, as some energy transition plays have struggled to perform (in part due to initial public offerings executed at high valuations).
Like PE, performance in public equities addressing the energy transition has been volatile and valuations for renewables, and especially tech-oriented energy transition plays, are elevated. However, public equity managers focused on the energy transition typically cover a broad array of securities in businesses ranging from renewable utilities and renewable equipment to energy efficiency, advanced materials, software, agriculture and the circular economy. The companies themselves may participate in a mix of activities but tend to meet some threshold of green revenues. A key consideration when investing in public securities is that much of the industrial sector will need to adapt their business models over time to a low-carbon future. Managers that engage with portfolio companies to understand, support and hold them accountable for realistic climate reduction strategies should unlock value in portfolio holdings over time.
There are also investment opportunities related to green metals (e.g., copper, cobalt, lithium) via commodity futures or mining stocks. However, there are near-term risks to consider. Many of these metals are highly sensitive to the global business cycle; demand for industrial metals may soften if China sees a secular shift from an industrial-led to a services-driven economy; secondary supplies may increase with further investments into metals and battery recycling; and higher prices may drive development and use of alternative battery technologies to reduce critical mineral dependency. As such, another way to address this idea is with investments in battery recycling, as well as alternative battery and mineral extraction technologies.
The investment opportunities and the disruptive forces the energy transition brings will create plenty of winners and losers that require investor focus. We expect investors with a deliberate and thoughtful plan to invest in the transition across the risk/reward spectrum will be rewarded.
Celia Dallas (CIO), Wade O’Brien (managing director, capital markets research) and Vivian Gan (associate investment director, capital markets research) authored this article for Cambridge Associates. The original version of the article appears on the firm’s website here.