The message from the COP26 ‘Finance Day’ was clear: governments will need trillions of dollars of private sector investment to fund the transition to net zero. However, as Europe’s autumn energy crisis has also made clear, the transition is likely to be rocky, raising risks for investors and policymakers alike. Keeping private capital flowing must be a key priority for policymakers, requiring policy consistency alongside a willingness to intervene to avoid contagion.
The UK provides a good example of policy and private investment working well together in its rapid expansion of offshore wind. However, it is also seeing a collapse of energy suppliers in response to soaring wholesale energy prices, showing how unanticipated risk can punish investors.
Net-zero goals have been enshrined in UK law since 2019, and there is a broad political consensus on the need to decarbonise the country’s economy. Yet billions of investments are required to reach these targets and, while considerable progress has been achieved in decarbonising power generation, much more needs to be done. The UK is still at the beginning of decarbonising its heat and mobility sectors, for example.
It has long been clear that the public purse cannot fund those ambitious objectives alone. Therefore, the government has sought to develop a regulatory framework and policy environment that is conducive to investment in the energy transition.
Institutional investors, such as pension funds and insurance companies, are often highly ESG-conscious. As they are targeting long-term returns, they are increasingly aware of the material threats that climate change and environmental degradation pose to our societies and ecosystems, and their investments. Similarly, banks are key stakeholders in supporting the decarbonisation of the economy. Equity investors and debt providers are both looking for stability.
However, the increasing volatility of wholesale electricity prices has triggered havoc in the energy supply market, leading to the failure of several UK retailers. There is a risk this instability could lead investors to adopt a "wait and see" approach, impacting other energy sub-sectors. While the challenges have mostly focused on the supply market, ramifications could threaten contiguous – and interconnected – parts of the value chain. This could diminish investors' confidence in merchant financing, for example, where they fund renewable energy assets without subsidy and rely instead on the revenues those assets can earn in wholesale markets.
We should not be surprised by this potential ripple effect, having seen how the subprime mortgage crisis that started in 2007 quickly escalated into a global financial crisis. The domino effect can sometimes be motivated by tangible economic reasons and sometimes by more irrational waves of panic.
A role for government
Governments can play a significant role in reducing energy investment risk and ensuring that private capital continues to flow into net-zero investment. Contracts for difference have been crucial in de-risking investment in low-carbon generation such as offshore wind, allowing the deployment of cheap and abundant private capital. They guarantee generators (and their investors) a floor price for the power they generate in exchange for a share of profits if energy prices are high. Other mechanisms, such as cap-and-floor contracts, have played a similar role in diminishing the risk of investing in power interconnectors.
Ensuring policy consistency will be crucial, as investors – particularly infrastructure funds and institutional investors looking at energy projects and assets – need stable regulatory frameworks before allocating long-term capital.
Policymakers can play a key role in building firebreaks, preventing the energy crisis from spiralling out of control and extending to other sectors. The first step could be for the UK government to assess the potential impact of the current turmoil on the broader energy value chain, so that suitable risk mitigation actions can be developed.
Such a proactive attitude would help demonstrate that the government supports risk-taking investors that deploy capital in a sector crucial to our present and our future – namely, the energy transition. This vision would be consistent with the UK government's market-based approach to delivering net zero, with policy seen as a key enabler.
Sharing risk and reward
An attitude inspired by sharing risk and reward has, broadly speaking, underpinned the last two decades of UK energy policy, allowing the country to develop a global success story such as the development of offshore wind. It is now crucial to keep sending the right investment signals so that private capital keeps flowing to finance our collective net-zero journey.
Ensuring investor resilience should be a key part of the policy response to the current instability so that energy market participants can be fully confident in the long-term net-zero trajectory.
Home page image by Kanok Sulaiman via Getty Images.