Energy transition becoming larger part of portfolios

Energy transition away from fossil fuels is catching on with investors, six years after the shale boom displaced clean technology as the hot, new investment theme.

A recent Preqin report predicted that unlisted natural resources assets under management, which includes investments related to energy transition, will hit $271 billion in 2025, up 28% from $211 billion in 2020 as industries act to decarbonize.

Investments in energy transition can include everything from renewable energy such as solar and wind to battery storage, hydrogen-powered electric vehicles and charging stations. These investments are being sprinkled across alternative investment asset classes, including venture capital, growth equity and infrastructure. While parts of the strategy are new, some managers are targeting high single-digit returns.

Institutional investors have recently had success in pushing companies in their public equity portfolios to prepare for the transition.

On May 26, Exxon Mobil Corp. shareholders, backed by the three largest U.S. pension funds, voted to replace at least two board directors with activist investor nominees. Hedge fund firm Engine No. 1 promoted a slate of four candidates with experience in energy transitions to turn the company's aspirations of addressing "the risks of climate change into a long-term business plan, not talking points," a news release from the firm said.

Among the investors siding with Engine No. 1 were the $458.9 billion California Public Employees' Retirement System, Sacramento, the $299.8 billion California State Teachers' Retirement System, West Sacramento, and the $254.8 billion New York State Common Retirement Fund, Albany.

Regarding the vote, CalSTRS CIO Christopher Ailman tweeted that it was a "watershed moment" and "a bold step to prepare the company for the global energy transition."

On the same day, 48% of shareholders supported a resolution asking Chevron to report an assessment of how a dramatic reduction in fossil-fuel demand will effect its financial position.

Separately, a Dutch court ruled against Royal Dutch Shell PLC, ordering the oil company to reduce carbon emissions by a net 45% by the end of 2030.

Global reliance on fossil fuels also appears to be waning. BP PLC's Energy Outlook 2020 said that it expects demand for fossil fuels could fall by as much as 50% over the next 20 years.

"I've witnessed an unbelievable shift in players investing in the energy transition," said Kirsty Jenkinson, investment director for sustainable investment and stewardship strategies at CalSTRS.

The investment opportunity in the U.S. is becoming clearer, making it possible for investors to build portfolios that can earn meaningful returns while tackling climate change, Ms. Jenkinson said. That opportunity is not only attracting renewable energy managers but those with broader energy or infrastructure mandates, including managers that also invest in fossil fuels and hydraulic fracturing.

The pandemic hit fossil fuels hard with oil and gas prices cratering in early 2020, accelerating investors' movement into energy transition investments. In March, the CalSTRS board approved a 5% allocation maximum to public as well as private sustainable investments and stewardship strategies. CalSTRS is targeting $1 billion to $2 billion in commitments to its new private sustainable portfolio over the next couple of years, Ms. Jenkinson said.

What's changed in the past few years is that the sustainable investment ecosystem has broadened to other technologies or solutions that dramatically expanded the risk-return of what energy transition means, said Brandon A. Freiman, Menlo Park, Calif.-based partner and head of North American infrastructure at KKR & Co. Inc.

Five or 10 years ago, when investors and managers talked about the energy transition, they were really talking about wind and solar power plants, Mr. Freiman said.

Wind and solar have a long investment history, and those assets, especially if they are stable investments with 10- to 20-year power contracts, have evolved into core assets, he said.

"People are looking at them as a bond replacement," Mr. Freiman said."That's a fairly mature ecosystem. There's a lot of deal flow there."

Energy transition strategies also can include investments in technological innovations such as around electric vehicles, not only in manufacturing but the infrastructure such as charging stations and storage, Mr. Freiman said.

"There's a lot of strategies you can pursue in energy transition," he said.

Returns for investments in the energy transition vary by the type of investment.

For example, renewable energy investments in Europe, which is about a decade ahead of the U.S., have come down, said Chris Post, Denver-based senior managing director, renewables at FTI Consulting Inc.

Five years ago, a wind-project investment might have produced a low double-digit or high single-digit rate of return, he said. Now a wind project is very competitive if it is in the mid-single digits, Mr. Post said.

Indeed, returns for renewable energy funds have been falling each vintage year since 2015, when renewable energy funds earned an internal rate of return of 49%, according to PitchBook Data Inc. Vintage year 2019 funds earned an IRR of 1.1%, while vintage year 2018 funds earned an IRR of 2.3%.

KKR is building a business around renewable investing that will stretch across many of the various investments the alternative investment manager runs, he said. Like technology, the energy transition affects most investments, Mr. Freiman said.

In March, KKR hired three investment executives experienced in investing for the energy transition from Capital Dynamics.

KKR is also including investing in energy transition infrastructure as one of the strategies of its first open-end core infrastructure fund, according to a May 25 presentation to the $33 billion New Mexico State Investment Council, Santa Fe. The council committed up to $100 million to KKR Diversified Core Infrastructure Fund. In addition to energy transition sectors, the fund is expected to invest in utilities, power and renewables, telecommunications, transportation and social infrastructure. The fund expects to invest in North America, Western Europe,and developed Asia.

In April, the $17.2 billion The Ohio Police & Fire Pension Fund, Columbus, made an up to $125 million commitment to KKR's open-end core infrastructure fund.

New Mexico State Investment Council's Paul Chapman, the endowments' director of real estate and real assets, told the council that its real estate consultant, Townsend Group, had raised about $1 billion among its clients to commit to the fund, negotiating fees for the investors as a block.

KKR's concentration in energy transition does not signal a speedy switch away from its oil and gas investments.

"There's a reason we call it an energy transition. It's not an abrupt switch," Mr. Freiman said. "It would be impossible to do that transition immediately without a tremendous amount of human suffering due to how much humanity relies on energy in all forms."

At the same time as KKR is investing in wind and solar energy plants, it is also investing in natural gas as a replacement fuel for coal-fired power plants.

"We don't think that coal has a role to play in the energy transition" and so KKR does not invest in coal, Mr. Freiman said.

Other large players investing for the transition away from fossil fuels include TPG, Brookfield Asset Management and Macquarie Asset Management, CalSTRS' Ms. Jenkinson said.

TPG executives decline to discuss its new private equity strategy, TPG Rise Climate, other than to say that it is being headed by Jim Coulter, TPG co-founder and executive chairman. In January, TPG's The Rise Fund, its $5 billion impact investing business, invested in Element Markets LLC, a North American marketer of renewable natural gas and environmental commodities, its second investment in the climate and renewable energy sector in six months, a news release said.

There are several funds aiming to invest in the energy transition in the market or soon to be in the market, said Jeffrey J. Eaton, Houston-based partner at placement agent Eaton Partners, in an emailed response to questions.

"There is no doubt that there is movement away from traditional oil and gas-focused energy funds and towards energy transition and decarbonization," Mr. Eaton said.

However, these tailwinds are not enough to ensure that these funds will all successfully close, he said.

"A robust deal pipeline, a team that's done it before, and an attributable track record in the space is imperative," Mr. Eaton said.

One energy transition fund that closed May 4 was energy manager EnCap Investments LP's $1.2 billion EnCap Energy Transition Fund I, raised mostly during the pandemic. EnCap executives started raising the fund in October 2019.

EnCap executives view the energy transition sector as including investments associated with the transition to a low-carbon-intensive economy.

EnCap's focus includes reducing energy usage by the industrial power sector and carbon mitigation by the oil and gas sector, said Jim Hughes, Houston-based managing partner of EnCap's energy transition business.

The first fund is focused exclusively on the decarbonization of the U.S. power sector, he said.

"This is where all the progress has been occurring over the past decade," Mr. Hughes said.

The cost structure of solar businesses, for example, has changed significantly so that a once government-subsidized sector now no longer requires that support, he said.

EnCap has already invested 45% to 50% of the fund's capital, Mr. Hughes said. EnCap's strategy is to back management teams that are starting to build companies largely from scratch.

"To earn private equity-level returns, you need to be involved in the enterprise from the very start," he said.