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Emerging market clean power offers investment option

Capital is being attracted to emerging market renewables and gas-fired power projects to profitably and effectively mitigate climate change

Institutional investors inclined—or under pressure—to reduce the carbon footprint of their portfolios may be tempted to consider funding the energy transition in emerging markets. Under certain circumstances, the investment strategy can offer a cost-effective means of reducing emissions as well as competitive profit potential.

Many European countries are both signatories to the COP21 Paris Agreement and have substantial assets in public and private pension schemes—and governments are increasingly connecting the dots.

Some have even gone further; the UK in 2019 legislated to commitment the economy to net zero emissions by 2050. The UK's Pensions Regulator (TPR) updated its guidance for defined contribution (DC) pension schemes trustees last month with an obligation, from October 2019, to publish consideration of climate change in a statement of investment principles (SIP). They will also have to report implementation progress from October 2020.

Consideration of environmental, social and governance (ESG) factors should allow investors to evaluate the short and long-term financial risks and opportunities of investments by looking at the current practices of the firms in which they invest, the new guideline state. Investors are asked to consider the implications of the systemic risk of climate change on investment decisions when developing their SIPs. Discharging this responsibility while maintaining a fiduciary duty to maximise returns is not a trivial task.

Powerful argument

At its 2019 AGM, Shell forecasted that rising demand for electrification will be driven by emerging markets—a prediction in line with many other forecasts.

"We do not need new electricity in Europe or the US. In many respects we have excess supply," says Scott Mackin, managing partner and head of the international power team at private equity firm Denham Capital, adding that demand is 5-11MWh per person per year in developed markets and sub-1MWh in many emerging markets.

Mackin urges institutional investors to consider funding the energy transition in emerging markets (EMs) as an effective route to reducing carbon emissions and meeting regulatory requirements. While Denham's international power division had its roots in investing conventional power it "has changed in the same ways that the world has changed—now we would not do coal".

There is an opportunity, also identified by certain majors including BP and Shell, in renewables generation as far as they are financially viable supplemented by gas-fired power to plug the intermittency gap. "The question for countries without [domestic] gas is: will it be coal, or will it be LNG?," says Mackin.

“If you want to do something for greenhouse gas emissions right now… shut down all the Chinese coal and change it over to gas.” Mackin, Denham Capital

Institutional investors can provide the answer to this question while complying with their ESG responsibilities. Sabine Chalopin, Denham's ESG manager, power deal team, is charged with "making sure we develop projects to the highest standards" demanded by institutional investors and development finance institutions (DFIs).

Denham's international power division makes up just over 25pc of the company's total business, which also includes oil and gas as well as mining. Denham produces impact reports only for its power business, reflecting the demands the type of investors attracted to the funds.

"That [demand for reports] is being driven by the limited partner (LP) base," says Chalopin. "Our ESG policy means we cannot invest in coal and we focus on renewables and gas. We calculate the CO2 savings from all our projects, which is of interest to all asset buyers in terms of climate change mitigation. DFIs, which have very high standards in how they look at ESG, are also investors in our funds.

"We look at the resilience of our assets in terms of climate change—if conditions change, how does it impact the assets? We do that through impact, or ESG, assessments. More and more it is becoming one of the items that is looked at in detail by third-party people doing assessments."

Emerging opportunities

Emerging market power generation is low-hanging-fruit among CO2-mitigating investments. According to Mackin, the typical energy mix is "a lot of old, beaten down hydro built in the '70s or '80s" that is state-owned and "never enough" due to population expansion. This means that polluting quick-fixes are common.

"Energy generation always precedes GDP growth—so emerging countries quickly go to diesel, heavy fuel oil (HFO) or something similar," he says. "Diesel and HFO is expensive and dirty—and that is setting the marginal price. Replacing it with small hydro, gas-fired generation, wind or solar is a good thing."

COP21 caused immediate financing pressure on coal projects in Africa and Latin America. "DFIs cannot touch coal and commercial banks are increasingly saying they will not touch it. It has become very, very tough to get coal done," he adds. The Paris Agreement had its intended effect and improved the relative viability and attractiveness of gas.

Mackin says that Africa, Asia and Latin America—where, for example, it has two renewables teams and one gas-fired team—all provide opportunities. "It's good to see Asia starting to finally pay attention to it," he says.

Indonesia is a telling example. "They certainly have the coal," he says. "Arguments go back and forth—four years ago they were going to build lots of coal. But I have not seen it happen yet," suggesting the government may be amenable to gas-fired development.

Likewise, the Philippines has traditionally been a coal-dominated market, due to its geography not being suitable for hydro-electricity. "That is not going to change anytime soon. But the question is—will LNG start eroding new coal in the Philippines? That is the battle."

Globally, China presents the biggest potential benefit from a transition from coal to gas. Although it is a world leader in renewables "coal is massive", says Mackin. "At one point they were building a 300MW coal-fired project a week. If you want to do something for greenhouse gas emissions right now, to have an impact, shut down all the Chinese coal and change it over to gas."

While China presents the largest potential opportunity, unfortunately it is not realistically investible. "Some people try to do it. But for most people like us—what value do we add? The Chinese have the skillset, the people and the money so we do not have an edge. We provide an edge in markets where they do not already have these things, such as Brazil. It would be hard to differentiate ourselves in China."

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