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Sovereign wealth funds find opportunity in energy transition

09 February 2022 Kevin Adler

State-owned investors (SOIs) directed $22.7 billion towards green energy investments in 2021—more than triple the amount in 2020, and far outpacing their $6.9 billion in spending on traditional fossil fuels, consulting firm Global SWF said in its annual report.

"2021 will be remembered as the first year in which state-owned investors made more green investments than black investments. This milestone was a few years in the making and has concluded a trend that has been driven by social pressure and financial returns and accelerated by the COVID-19 pandemic," Global SWF said in the report, which was released in January.

Sovereign wealth funds (SWFs) made up $10.8 trillion of an estimated $32.8 trillion managed by SOIs as of the end of 2021, with public pension funds accounting for the remaining balance, SWF Global Managing Director Diego Lopez told Net-Zero Business Daily.

These investors are flocking to green energy because they see growth in demand and proven technologies to serve the market, he said. At the same time, the investors are reflecting the priorities of their funding nations to reduce carbon emissions and mitigate climate risk, especially as more than 120 countries last year updated their emissions targets for 2030.

Increasingly, green energy looks like a safe long-term bet, Eamon Nolan, a New York-based partner at law firm Vinson & Elkins, said. The technologies are proven, the demand is clear, and investors see safe returns from power purchase agreements of 20 years or more. "Nobody expects those projects to fall apart in 12 years," he said.

Late adopters

The risk-averse nature of a SWF can lead it towards certain types of investment and away from others as it moves into the energy transition space.

"Sovereign wealth funds are not going to be the early adopters of new technology," said Danielle Patterson, a Houston-based partner with Vinson & Elkins. "They are to some degree starting to ride a wave, compared to our typical fund investment clients. Now, we're seeing them getting into the game more."

"I don't think we are going to see a sovereign wealth fund at the cutting edge of a green hydrogen play," Nolan added. "But we might see a [small] strategic investment from a national perspective, such as oil and gas state that has a particular interest in hydrogen strategy … and then come in as big player later."

Saudi Arabia's Public Investment Fund (PIF) announced earlier this month a memorandum of understanding on a feasibility study for a green hydrogen plant, in partnership with South Korean technology and engineering companies Posco and Samsung C&T.

Global SWF's data show the trends that Nolan referenced. For example, one of the United Arab Emirates' (UAE) SWFs is the $110 billion ADQ. In 2021, ADQ announced a joint venture with Kazakhstan National Fund to build solar and wind farms in Kazakhstan. To cite another example, Italy's CDP Equity and Italian energy company Eni formed GreenIT in March 2021 to develop 1 GW of wind and solar PV projects by 2025.

As a general rule, SWFs are long-term investors, said Peter Gardett, IHS Markit research and analysis executive director. "We've seen a lot of action in solar and wind last year. These are mature technologies, and there's a highly identifiable market for it [that provides] lower but steady returns," he said.

Mature technologies are perfect for a SWF, which might accept a 4% annual return, rather than a private equity firm that invests earlier in the growth cycle for a return in double digits, or an institutional investor such as a pension fund seeking 8%, Gardett explained.

Because a state-backed investor is using money from government resources, rather than raising from investors who are seeking their own financial return, they incur a lower cost of capital than a hedge fund, Nolan explained. "With a net 5% return … you're not going to get fired in an SWF. But if you do that in a traditional infrastructure fund, you're not able to pay your people and your investors," he added.

Growing need, growing opportunity

With the global need for investment in order to reach net-zero carbon emissions estimated at $100 trillion or more by 2050, according to the International Energy Agency, the opportunities are ample for SOIs across the energy transition.

"I wouldn't be surprised if we see higher investments from state actors going forward," said Rachel Ziemba, founder of Ziemba Insights, an investment research firm, and an adjunct senior fellow at the Center for a New American Security.

"Sovereign wealth funds' interest … is part of the general global investor interest in the alternative energy technology space. In fact, some funds were ahead of the curve, such as Singaporean and Australian funds. Now we're at the point where quite a range of these funds is investing in cleantech," Ziemba said.

State-backed investors "see the writing on the wall that we need more capacity and more infrastructure, including in their own countries," Ziemba continued. "People go around saying there's not enough bankable projects, there's a risk of overpricing. But this is a sector where we need more investment for a long time."

Nolan agreed: "The more money that comes in, the better. There's room for everybody."

Constituency of one

SWFs can be thought of as having "a constituency of one," said Patterson, namely the national interest of the country that provides the funds.

Yet because each country has a unique mix of needs and priorities, how its SWF allocates investment capital can differ dramatically from one country to another.

Using oil revenue, Norway built the largest SWF in the world, The Government Pension Fund Global that's valued at more than $1.3 trillion. In December, the fund issued a statement that it "will work towards a goal of net-zero emissions from the [investments] we own in 2050." In 2019, the fund was required by Norway's parliament to sell its investments in coal companies, reflecting Norway's goal of a 40% reduction in emissions by 2030 from its 1990 baseline.

The fund's new investments in 2021 included the purchase of 50% of two wind farms in Dutch waters last year. The fund also has raised its investment in carbon capture, use, and storage (CCUS).

Oil-rich countries such as Qatar, the UAE, and Saudi Arabia are directing state funds towards renewable energy and CCUS. Ziemba said they are "hedging their bets" as fossil fuels become a smaller part of the energy mix.

The Middle East SOIs also are reflecting an awareness that their bonds are facing additional risk premiums because the countries' economies are reliant on fossil fuel exports. "They have a desire to 'green' their balance sheets, to some extent," Ziemba explained.

Their actions illustrate the new level of attention that "environmental stress testing" of investment portfolios is receiving, and why green energy is now at least part of the discussion for most institutional investors.

A prime example of the benefit of greening a portfolio occurred in February, when Saudi Arabia's PIF received an A1 credit rating from Moody's, the fifth-highest level. Last year the leadership of the $500-billion fund said it intends to offer a green bond for the first time in 2022.

Moody's called the fund's portfolio "quite diversified" and said that "many of the sectors where PIF invests have low exposure to environmental and social risks."

"This is an example of what we are seeing—interest from sovereigns both in investing in green technology but also interest in taking advantage of opportunities for capital raising in both green and traditional financing," Ziemba said.

"Saudi Arabia is interested in a wide range of energy activities, and is aiming to raise capital both for cleantech and fossil fuels for the energy and economic transition. PIF is one of the most prominent sovereign development funds, which invests at home and abroad and is looking to leverage its historical fossil fuel assets into a range of more sustainable development areas," she continued.

Institutional investor model

Some SWFs approach their investments "closer to an institutional investor model" of seeking higher returns and accepting riskier plays, Gardett said. He cited investments by Temasek, a Singapore fund, and Mubadala Investment Co., funded by the UAE, in hydrogen production and battery storage.

Temasek also has invested in climate-focused private funds such as Blackrock Decarbonization Partners and Brookfield Global Transition Fund. Because those funds make their own investment decisions across the energy transition, Temasek is indirectly buying into a range of options from the less to the more established.

Finding those emerging opportunities can be driven by many desires—from higher financial returns, to covering for resources that a country lacks, to taking advantage of resources that a country has in abundance. "Look at Germany—it's not a petrostate, and it doesn't have strong solar or wind. It's focusing on hydrogen," said Patterson. "Chile is going aggressively in hydrogen too, but it's because it has the energy resources for green hydrogen."

One way that SWFs can both minimize risk and find an attractive upside is to invest in an established technology in a fast-growing country. "Solar power in India would be an example—and so it's no surprise that state investors have flocked to that market," Gardett said.

The GIC Wealth Fund of Singapore and UAE's funds have invested in solar power projects in India in the last two years.

Nolan said that the electric vehicle (EV) supply chain and charging equipment are fast-growth, relatively established sectors that could be attractive to state investors. "There was a school of thought that EVs were a Tesla play, but as you look around and see all the car companies manufacturing EVs, you see the infrastructure is not there to support the industry's growth," he said.

IHS Markit sees replacing outdated, inefficient energy infrastructure as another area with strong growth potential and comparatively safe returns. India or Brazil are among the promising markets.

SWF managers may have been "kicking the tires" in those regions and industries for the past several years by making small investments and using them to learn about the opportunities and risks, Ziemba said.

One area to which SWFs have not yet migrated heavily is venture capital funds that invest in companies with high growth potential that have yet to offer investment to the general public.

SWF Global called venture capital "the asset class of the year" for 2021, as new state-owned investments grew by 81% to $18.2 billion. "The majority of VC investments pursued by SOIs in the past year or two have been in technology, retail, and healthcare," said Lopez.

But a few energy transition projects can be identified as well, such as Canada's Public Pension Plan taking a stake in CCUS firm Carbon America and Kuwait Investment Authority's investment in TAE Technologies, a fusion power firm.

Strategic decisions

While SWFs are reaching more deeply into the energy transition, analysts said it's important to remember that many of them answer to national priorities beyond investment returns and carbon emissions.

In some cases, SOIs use their money to leverage economic development that responds to social needs such as energy production and employment, said Ziemba, often as co-investors. Nigeria and Egypt are examples of nations that are providing some capital with which they try to attract partners for fossil fuel and renewable power projects. These are similar to big telecommunications investments made by SOIs a decade or more ago and continuing today.

Occasionally, national needs lead to decisions that do not make sense purely on financial or environmental grounds. Never were the competing factors that a SWF has to balance more in evidence than during the worst of the global recession caused by COVID-19, said SWF Global. "Some funds were asked for capital (withdrawals) or invited to invest in struggling domestic businesses (bailouts), while others could afford to seek investment opportunities abroad (shopping)," Lopez said.

Global politics can come into play as well. With COP27 due to take place this year in Egypt and COP28 in 2023 in the UAE, Ziemba said it would not be surprising if Middle East countries step up their green energy investments heading into those global events.

The bottom line is that the issues driving SWFs are as diverse as the nations that created and manage them. "When looking at these investments, you have to [remember] governments try to harness markets, using their financial power for national interest," Ziemba said.

Posted 09 February 2022 by Kevin Adler, Chief Editor


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