Investing in energy and infrastructure: current trends in the US market

May 2023 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

May 2023 Issue

Investors in US energy and infrastructure projects in 2023 face a significantly different market environment than they did just a few years ago. Long-term commercial, technology and public policy factors still make many investments quite attractive, even while geopolitical trends and macroeconomic forecasts are becoming cloudier. Tailwinds remain stronger than headwinds for investments in energy and infrastructure assets. Nonetheless, the flight path ahead may yet be choppy.

Over the last few years, the cost of new energy generation facilities has fallen dramatically, especially for renewable energy. In just one year, from 2020 to 2021, the installed cost of utility-scale solar systems in the US fell by 12.3 percent, according to the National Renewable Energy Laboratory (NREL). The International Renewable Energy Agency (IRENA), an intergovernmental organisation of 165 countries plus the European Union (EU) that supports the transition to sustainable energy, estimates that the global weighted average levelised cost of energy (LCOE) of newly commissioned utility‑scale solar photovoltaic (PV) projects fell by 88 percent between 2010 and 2021, to 4.8 cents per kilowatt-hour (kWh). Similarly, the LCOE of new wind power plants dropped over the same period by 60 percent for offshore and 68 percent for onshore.

The current LCOE of wind energy and utility-scale solar power plants is less than the LCOE for combined-cycle gas power plants and far below the LCOE for peaking gas plants. The levelised cost of energy considers the estimated cost to build and operate a power generation facility over a certain period. Thus, it covers capital costs, which generally are recovered through some combination of capacity or demand charges and energy sales. It also covers the operational cost savings embedded in renewables, which have no fuel procurement costs in contrast to thermal power plants. And it considers availability or capacity factors, intermittency and expected dispatch or usage.

Meanwhile, natural gas commodity prices in the US have been remarkably stable over the past decade, at about the same nominal spot price in early March 2023 as in 2010. That means in real terms that gas has seen a dramatic price drop after adjusting for inflation, despite shorter periods of substantial price volatility. Natural gas prices are, of course, higher in areas where gas supplies or pipeline capacity are constrained, such as New England and Europe, unlike in most of the US.

This picture has changed of late, however. Russia’s invasion of Ukraine significantly disrupted global supply chains and the commodities markets, particularly trade in grains, fertiliser and energy. Natural gas saw extreme price spikes in 2021 and 2022, both in the US and globally. European energy prices shot up last year, though they have since retreated somewhat due to government intervention, a mild winter and replenished storage from alternative sources of supply. Massive exports of liquified natural gas (LNG) from the US and Qatar, continued growth in LNG trade flows in the Asia-Pacific region, new gas import facilities in Germany and Poland, and increased Norwegian gas output to replace natural gas previously imported from Russia have together contributed to a globalisation of natural gas markets and rising gas prices in the US.

Rising energy prices, coupled with monetary easing and fiscal stimulus (which prevented a deep global recession during the height of the coronavirus (COVID-19) pandemic) plus robust consumer demand, concurrent with a shortfall in Chinese manufactured exports to meet that demand, have stimulated global inflation in food and agricultural produce, shipping and transportation, consumer goods, semiconductors and other products where demand growth is outpacing supply. It remains to be seen how rapidly inflation will slow and when the governmental responses to it, including rising interest rates, will end. It is also unknown how the larger geopolitical tensions between the US, Russia, China and the EU will play out, to say nothing of the impacts on investment priorities, risks and returns of climate change, extreme weather events and larger demographic shifts.

To fight inflation, the Federal Reserve in the US, the European Central Bank, and central banks in other Organisation for Economic Co-operation and Development (OECD) countries have increased benchmark interest rates significantly over the past 18 months after years of historically low interest rates, price stability and strong labour markets. When interest rates rise, borrowing costs increase, making capital (specifically, debt) more expensive. Credit spreads have also widened. Higher financing costs can affect the cash flow available to a project or company for servicing debt. Higher debt expense (interest) and increased operating costs (inflation) without correspondingly higher revenues together squeeze forecasted debt service coverage ratios, constraining debt capacity and reducing expected equity returns. Thus, rising interest rates tend to limit the amount of debt that can be used to finance the development, construction or acquisition of projects without helping the supply or relative cost of equity or risk capital.

In the face of these ongoing headwinds to new investment, why do investment activity and the deployment of both debt and equity capital to finance new energy and infrastructure capacity remain so strong? In short, there are three main tailwinds driving new investment, which together more than offset these challenges.

First, from a commercial perspective, the huge drop in equipment costs and the relative stability of energy and infrastructure project operating cash flows make these assets very attractive to investors and lenders, especially in times of heightened economic volatility. These assets are traditionally resistant to inflationary pressures. Because power and, to a lesser extent, transportation, water and other infrastructure sectors, are usually highly regulated, returns tend to be fairly predictable and barriers to entry (depending on location) are high. Project revenues are often supported by long-term contracts with creditworthy off-takers, or by regulated tariffs, or by the availability of hedges and derivative securities in deep and liquid markets with meaningful price discovery. And long-term demand growth remains strong. However, other energy investments, such as coal or other fossil fuels and conventional thermal power plants, may be more exposed to boom-and-bust commodity price cycles. They also confront potential obsolescence and stranded costs in the face of poor economics, new or proposed decarbonisation rules, and environmental, social and governance (ESG) goals or similar stewardship policies for fund managers, pensions and other institutional investors that can affect the availability and cost of capital.

Second, new technologies attract billions of dollars in risk capital and are already (or are expected soon to be) deployed at scale. Energy storage, distributed generation, offshore wind, sustainable aviation fuel, other advanced biofuels, and electric vehicles and charging networks are already attracting massive new investment. Data centres and newer digital infrastructure facilities are being developed and financed across the country, often alongside updated existing power generation facilities or new solar power plants or wind farms. Other earlier-stage technologies, such as advanced nuclear power, carbon capture and sequestration, clean hydrogen and next-generation batteries, collectively have raised billions of dollars in venture capital and new equity in both public and private markets, sometimes long before full commercialisation.

Third, government policies strongly support investment in all these energy and infrastructure sectors and technologies. One of the most significant developments in the US energy and infrastructure market in the past year was the enactment of the Inflation Reduction Act (IRA) in 2022, following on 2021’s Bipartisan Infrastructure Law. The IRA, championed by President Biden as a part of his commitments to mitigate climate change and spur domestic investment, serves multiple goals: reducing greenhouse gas emissions, fostering innovation and workforce development, and bolstering domestic supply chains. Already, the IRA has provided a major boost to deal activity. Tax credits for renewable energy, plus new credits for advanced manufacturing, clean hydrogen and other technologies, have been extended for at least 10 years and are now available to a wider array of innovative energy technologies. The tax credits for carbon capture and sequestration have been raised while the thresholds to qualify have been eased. New credits also support the continued operation of existing nuclear power plants, easing the impact of the retirement of older, unviable coal fired power plants. The production tax credit – now extended to solar power plants, not just wind farms – and the expanded investment tax credit and other regulatory initiatives are stimulating investment, as intended, in a wide range of climate-friendly technology and energy projects.

The US energy and infrastructure market is expected to remain an attractive investment destination for institutional investors in 2023, despite the challenges posed by rising interest rates and inflation. The IRA has unlocked a new wave of deals. The ongoing focus on renewable energy and sustainable infrastructure presents promising opportunities for institutional investors. To be sure, navigating the complexities of the energy and infrastructure markets requires careful analysis, due diligence and thoughtful risk management. As such, developers, investors and lenders will need to stay nimble and alert to changing market conditions in order to maximise returns and manage risks in this dynamic and evolving landscape.

Allan Marks is a partner at Milbank LLP. He can be contacted on +1 (424) 386 4376 or by email: atmarks@milbank.com.

Allan Marks

Milbank LLP