LONDON - EIG Chairman and CEO R. Blair Thomas sees private equity increasingly trapped in a paradox of exclusions. Some investors, particularly in Europe, shun fossil fuels at all costs. But they’re also turning their noses up at the low-returns offered by energy transition projects.
“The industry's changing quite a bit in terms of what investors are looking for, what they're demanding to invest in the asset class,” Thomas said at the Energy Intelligence Forum 2023. “And so anything that touches the hydrocarbon is challenging.”
Once upon a time, investors were more inclusive, seeking exposure to the energy value chain. Investors “were okay as long as we did that piece they wanted. They were okay that we included other things,” Thomas said.
That dynamic is completely different now, he said.
Today investors approach the sector on an exclusionary basis, “and if you do certain things, they will not invest with you, period.”
Thomas, in a conversation with Bob Maguire, managing director at The Carlyle Group, said that binary mindset has led to a balkanization of asset classes. Private equity has to create different investment vehicles for different parts of the value chain and even different geographies for specific investors.
“If you give them a reason to exclude you, they will exclude,” he said. “Go try marketing a fund in Europe, regardless of what your performance is. If you have hydrocarbons in that portfolio, there's zero percent chance that you'll raise capital.”
Thomas said EIG tries to offer products that suit investor needs, but one of the “big myths out there is there’s an unlimited supply of capital to support the energy transition.”
That’s only half true.
“There's an unlimited supply of capital at a certain rate of return,” Thomas said. “And by and large, the industry has been unsuccessful in consistently delivering that rate of return on low and zero carbon alternatives in the energy value chain.”
While players in the energy industry have an energy transition strategy that might include carbon capture, utilization and storage or hydrogen, without an acceptable rate of return, “again they’re going to exclude you.”
“As an industry, again, it's really hard to do. You hear all the great things about deflation in the renewable space and all of that,” Thomas said. “In Europe today, on an operating renewable project, you're looking at levered equity returns of about 6% or 7%, and no one's going to hire you or me to deliver a 6% return.”
Maguire said the heart of the conundrum facing private equity is how to scale projects fast enough while being responsive to new technologies or standalone projects where the risk profile is simply too great.
“I suspect that's where people are hopeful that private equity, when you have this impossible problem to solve the answer though, private equity will figure that out because they can work through all these different sort of structures,” Maguire said.
Maguire sees that as a big problem: Given a big enough opportunity, could private equity “deploy capital against it? And is there a big enough opportunity to move the needle?”
Thomas said private capital’s competitive edge remains its ability to respond rapidly to prospects.
“The opportunity set's not the challenge. And I do agree that every subset in the market, you need a competitive advantage. Otherwise why do you exist? And so certainly the majors, they have their competitive advantages.
“Where private capital has our advantage is speed and entrepreneurship where we can move quickly.”
In Thomas’ view, for private equity, there's no such thing as a strategic transaction; there are only financial transactions.
“The issue is whether or not the low and zero carbon side of new energy can deliver a rate of return sufficient to attract the quantum of capital that's necessary to unlock the transition,” he said. “Because we're talking about staggering amounts of capital. And, yes, governments are doing their part [through] their subsidies and inducements, but that only gets you so far.”
Ultimately, the energy transition boils down to the electrification of society. Attracting the capital necessary for those investments centers on an inconvenient truth.
“What that means to me is the cost of electricity has to go up to induce people like us to make the investments that enable all that,” he said. “That's not a very popular thing for people to hear.”
‘Starved of capital’
At the same time, traditional energy investments are still needed, but public markets remain inhospitable to the conventional fossil fuel industry.
“We are being starved of capital, and that's a very conscious effort, and it's happening every day,” he said.
In the U.K., banks are exiting the oil and gas industry in an attempt to make oil and gas borrow money through reserve-based lending.
“In the public market side, we're trading at historic lows in terms of multiples. No one wants to give you any value for terminal value. No one believes in growth,” he said. “We've changed from being a growth industry to a yield industry. And so now it's all about dividend yield and share buybacks. We have to do all those things in order to get investors to continue to be interested in the public side of energy. And so that's a pretty big headwind.”
The pushback on fossil fuel investments varies depending on which side of the Atlantic an investor is located. In Europe, investors want zero carbon exposure.
“Low carbon doesn't cut it. LNG doesn't cut it. Gas infrastructure—none of that is acceptable. It's pure renewables,” he said.
In the U.S. and parts of Asia, LNG is more acceptable.
“We've worked very hard to find the universe of investors globally who share our view that LNG is part of the transition, he said. “And for those investors who don't agree with us, well, as I said, they're exclusionary now and they go another direction.”
But there are some more discerning EIG clients. The firm’s largest investor is a European insurance company that Thomas described as a leader in ESG.
“I sat down with the CEO and asked him, why have you invested with us? And he said, ‘well, it's very simple. … If I don't invest with you, you don't care what I think. And if I do invest, you have to care what I think.’
“And so then you enter into a negotiation about what type of monitoring and reporting you're going to enter into and what your targets are. And so it becomes very engaged and we create that alignment, and that's what they're looking for and that's what people should expect from us.”
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