Institutional investors steward a large fraction of our society’s wealth. In OECD countries, pension funds, insurance companies, endowments, foundations, and sovereign wealth funds collectively manage over $45 trillion in assets ($71 trillion if you add in other investment managers and pension assets outside of pension funds). Needless to say, the financial security of these institutions is a matter of significant public importance.
Many of these institutions have investments in carbon-intensive assets – such as coal, oil, and gas extraction companies – which could have less value in a climate constrained world. Recently, policymakers, the public, and beneficiaries of these institutions have begun to call on institutions to divest from fossil fuels to reduce their exposure to this potential risk.
Another option may be to increase investment in low-carbon assets like renewable energy. To date, however, not much research has addressed the policy constraints on increasing institutional investment in low-carbon assets.
While the long-term needs of many institutions appear to be well-matched by the long-term, stable cash flows from renewable energy projects, a series of barriers prevent institutions from becoming the primary source of low-cost project finance for renewable energy.
CPI recently completed a paper to unpack these issues. We developed The Challenge of Institutional Investment in Renewable Energy with the support of Institutional Investors Group on Climate Change, Ceres/Investor Network on Climate Risk, Investor Group on Climate Change Australia/New Zealand, and United Nations Environment Programme Finance Initiative, who each connected us with their members and provided feedback on the study.
Our analysis shows that certain investor practices, financial security constraints, and policy barriers currently limit institutional investment in renewables. But what are these policy barriers, and what can policymakers do to address them?
Investing in renewable energy projects relies on some degree of policy support. But in some cases, the policies designed to support renewable energy favor other market participants and put institutions at a disadvantage. For instance, tax credits for renewable energy projects in the U.S. are critical for projects to get off the ground. But many large pension funds are tax-exempt, and cannot make use of these tax credits. Project developers often turn to “tax equity investors,” but at a cost: high transaction costs and cost of capital can eat up to a third of the value of the tax benefits. And in our conversations with institutional investors in the U.S., we heard that tax equity often crowds out other types of capital, like project debt or mezzanine finance, that could be attractive to some institutions.
In other cases, policies with objectives outside of supporting renewable energy put institutions at a disadvantage. This occurs in Europe with “unbundling” regulations designed to protect electricity markets from manipulation or other anti-competitive actions by prohibiting controlling ownership of both transmission lines and electricity generators at the same time. But some large institutional investors have transmission assets in their infrastructure portfolios, and under the unbundling rule, cannot invest in renewable electricity generation anywhere in Europe (with a few exceptions). While EU policymakers are taking steps to alleviate this issue by issuing guidance for financial investors and establishing a legal precedent, any uncertainty around whether a particular institutional investment in renewable energy is legal will likely turn some institutions away.
Finally, one policy issue was brought up with almost every investor we spoke with: policy uncertainty. Renewable energy policies differ substantially from country to country, and in the case of the U.S., state to state. And as renewable energy technologies mature, policymakers adapt their policies to changing market conditions. On occasion, policies change in ways that are detrimental for investors. For most institutions, renewable energy will only ever be but one part of a much larger portfolio, and dedicating the time and personnel to understanding and evaluating policy risks may not be worth it. In some cases, investors may never seriously consider renewable energy as an investment because of their perceptions of policy risks. Longer-term, more stable policies would help attract some institutions to renewable energy, although many, particularly the smallest, still may not be able to justify the cost of building in-house expertise on renewable energy policy.
These policy issues (as well as a few others not described here), keep many institutions from investing significant sums in renewable energy – they reduce the potential returns institutional investors could earn in the sector, increase the level of risk that investors perceive, or in some cases keep institutions from investing altogether. Even without these policy barriers, institutional investment may never reach levels that would drive down the cost of capital for renewables; they will likely only cover a fraction of the investment needs for renewable energy. But easing these policy constraints can help institutional investors contribute to the deployment of renewable energy as they look for ways to reduce the financial risks they face in a climate constrained world.