Would excluding natural gas from the green taxonomy prevent the financing of transition fuels? In anew research note,we look at the (absence of) a good case to support natural gas generation with a ‘green label.’
Natural gas is the transition fuel of choice. Should it be included in the EU Green Taxonomy as a result, since it needs new capital? In a new research note, we show that excluding gas generation from the taxonomy would not increase its cost of capital and thus not create any risk of underinvestment in the `transition fuel’ of choice. Conversely, including gas in the Green Taxonomy creates a genuine price distortion and a perverse incentive to limit future investments in renewable energy technologies.
The role of the Green Taxonomy is to promote investments in certain sectors because capital markets presumably do not have all the necessary information to make investment choices that fully reflect future risks, notably transition risks. If all relevant information about the energy transition was available today, markets could allocate capital to the correct projects without the need for a green taxonomy to signpost the future. By creating excess demand for certain investments, the green taxonomy is expected to drive down the cost of capital of the type of investments it promotes i.e., to create or increase an existing green price premium.
In effect, investors have already started pricing certain investments as greener, especially when it comes to their impact on the climate: they have been willing to pay a green price premium (receive a lower return) to hold greener stocks or unlisted infrastructure equity in sectors such as wind or solar power projects, as recent research has shown.
The EU taxonomy may further amplify this effect on asset prices. Conversely, it could limit the supply of capital to other energy sectors, especially brown ones that rely on fossil fuels such as coal and gas and drive up their cost of capital, that is, create a brown price discount. It is in this context that the inclusion of gas in the green taxonomy of the EU is being considered since it is a useful transition fuel even though it is by no means a zero-emission fuel.
Thus, a seemingly reasonable argument to include gas in the green taxonomy is the following: the taxonomy will cause capital to flow disproportionately to activities labelled as green by the regulator, and the cost of capital of brown energy sources will soar and lead to underinvestment in natural gas, which is the most important transition fuel for Europe. This in turn may lead to a messy energy transition, brown-outs, high energy prices, etc.
This argument is a fallacy: 1/ without coal (which is on its way out everywhere) and with limited and unreliable renewables gas is now the “producer of last resort”: it is a very valuable option and its cost of capital should be low; 2/ in effect, this has already happened: gas (and what is left of coal) are doing perfectly well in terms of profits and dividends. The past 5 years have been bumper years and the cost of capital of these gas producers is already at historical lows.
There is plenty of evidence that, even as renewables have developed, investments in fossil fuel have been doing very well indeed.
Comparing the profitability (Return on Assets) of coal, gas and renewable (wind and solar) projects in Europe over the past five years shows that renewables in Europe are the most profitable (average 18% ROA in 2020 in Europe) but also that gas power projects have enjoyed a significant increase in their profitability (average 14% ROA in 2020 in Europe), as have coal-fired projects.
The level of dividend payouts (as a proportion of revenues) for these three sectors is has also stayed healthy in the gas and coal power sectors, albeit lower than in wind and solar projects. Coal projects continue to pay 8-10% of their revenues as dividends, gas projects 16-18% and renewables 25-30%.
In this light, neither gas nor coal power look like junk. In fact, the costs of capital of gas projects in Europe has been near its record lows in recent years. According to infraMetrics, The average equity risk premium of gas fired power projects in Europe peaked in 2009, since then the attractiveness of gas power projects led to a steady decrease in their costs of capital. Since 2015, it has reached a plateau at around 8% and even fell below that level in 2021.
Hence, there is no reason to argue that gas “needs to be green” so that we have enough investment in “transition fuels”. Everything point to gas being already able to secure all the capital it needs. Conversely, by saying that gas is green, you can slow down investment in renewables, and make gas even more valuable.
Option prices are determined by volatility. The ‘gas option’ is more valuable in a world without enough renewable energy capacity and predictability. `Green gas’ thus creates a genuine misallocation of capital since its very existence contradicts the opportunity to invest in better renewable technologies, especially energy storage.
The gradual privatization of infrastructure assets
I write this watching the news about Sydney Airport’s shareholder vote for a take-private transaction. This is one thing listed infrastructure managers say is a large risk to their businesses. The listed infrastructure managers complain that there has been an increasing trend to privatize listed assets and so the investment opportunity set keeps shrinking. This isn’t something that has occurred in the last 2 years – I remember having a conversation in 2018 in London with listed managers complaining that unlisted managers pay insane multiples to buy unlisted assets.
So what is going on?
Well firstly I would argue that the past performance of unlisted infrastructure has resulted in more investors and managers entering the asset class. This has resulted in record levels of dry powder to allocated for infrastructure assets. This increase in competition has had impacts – firstly, investors are increasingly stretching the definition of infrastructure – the latest example is below:
As someone that thinks 5 degrees minimum is a cold winter day, I don’t understand this investment – nor do I agree that its infrastructure…
Secondly, investors are now large enough to buy assets that they couldn’t previously afford. With Sydney airport, it is the largest airport in Australia and the only one listed on the stock market. It comes as one of the last pure play listed infrastructure asset left. The others slowly being privatized over the years (these are gas pipelines, toll roads, wind energy and even infrastructure funds). In the UK, the water utilities, previously listed are now mostly held privately. This is the same story for ports and airports.
Why would you want to hold things privately? Because it gives you a level of control that you might not be able to get in a public asset. Being able to sit on the board, get information that is not released to stock markets, is very valuable for investors. It would enable them to even lever up the investment to obtain higher returns. This could go some way to explaining why unlisted investors are hunting for listed assets and are willing to pay higher prices than investors in the listed market.
Going forward I would think we would see some further privatization of large listed assets. But this does not mean it’s all one-way traffic. We are seeing the listing of private ‘yield companies’ especially in the UK. These are news companies that invest in a portfolio of infrastructure assets (typically renewables and energy storage). We could see further listing of these assets, well until unlisted managers think that they’re cheap and need assets to burn through their dry powder.
The Companies (Strategic Report) (Climate-related Financial Disclosure) Regulations 2022 (link), published in January 2022 requires companies to include certain climate-related financial disclosures in their strategic reports. These regulations come into force on 6 April 2022. These disclosures are aligned with the requirements of the TCDF and are part of the UK’s roadmap to make reporting of TCDF disclosures mandatory by 2025. The requirement applies to a traded company, a banking company, an authorized insurance company, and a company carrying on insurance business which in each case satisfy various conditions, including that of having more than 500 employees. In addition, these Regulations require two further types of company, with more than 500 employees, to make climate-related financial disclosures. These are a company that has securities admitted to trading on the Alternative Investment Market and a high turnover company which is a company that does not fall within another category, but which has a turnover of more than £500 million.
As per section 4(e), the required disclosures include:
(a) a description of the company’s governance arrangements in relation to assessing and managing climate-related risks and opportunities;
(b) a description of how the company identifies assesses, and manages climate-related risks and opportunities;
(c) a description of how processes for identifying, assessing, and managing climate-related risks are integrated into the company’s overall risk management process;
(d) a description of—
(i) the principal climate-related risks and opportunities arising in connection with the company’s operations, and
(ii) the time periods by reference to which those risks and opportunities are assessed;
(e) a description of the actual and potential impacts of the principal climate-related risks and opportunities on the company’s business model and strategy;
(f) an analysis of the resilience of the company’s business model and strategy, taking into consideration different climate-related scenarios;
(g) a description of the targets used by the company to manage climate-related risks and to realize climate-related opportunities and of performance against those targets; and
(h) a description of the key performance indicators used to assess progress against targets used to manage climate-related risks and realize climate-related opportunities and of the calculations on which those key performance indicators are based.”;
In addition, the Limited Liability Partnerships (Climate-related Financial Disclosure) Regulations 2022—also published this week—will require LLPs with more than 500 employees and over £500 million in annual turnover to make the same disclosures in either their strategic report.
US and Canada:
A group of major American and Canadian banks, including Bank of America, Wells Fargo and Royal Bank of Canada announced the launch of the RMA Climate Risk Consortium, aimed at developing climate risk management standards for banks to integrate throughout their operations. The coalition was established under the Risk Management Association (RMA), a not-for-profit professional association focused on advancing sound risk management principles in the financial services industry. An article with more information can be foundhere.
Dow Jones announced the launch of its sustainability data to help the global financial community understand the performance and impact of a company’s Environmental, Social and Governance (ESG) practices. The initial offering is available for asset managers to make sustainable investment decisions and to better engage the growing audience of purpose-driven investors. The new data set provides sustainability scores and sentiment on more than 6,000 publicly traded companies. The scoring model is aligned with the Sustainability Accounting Standards Board (SASB) Standards, covering five sustainability dimensions and 26 categories. Combining company-disclosed data with news from thousands of global sources, the methodology is uniquely news-driven. Daily news sentiment and scoring updates ensure financial firms are basing sustainable investment decisions on information that is timelier and more transparent than self-reported data alone. Press release can be foundhere.
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