Future Capital Partners - vision & creativity

17 February 2010

Article about Future Fuels and Renewable Energy investments in Citywire

Future Fuels news Why Grimsby is at the centre of the energy revolution

By Trevor Castledine

The renewable energy sector is an obvious candidate to outperform the market over the coming years; but what will drive this outperformance and what are the best strategies for making sure that you exploit the opportunities in that sector?

Everyone is aware that climate change is a major concern and that this has resulted in CO2 emission reduction targets which are being strongly supported (in the EU at least) by a regulatory environment which favours the use of renewable energy sources.

The key to investing in the sector at present is to avoid technology risk, identify situations where legislative incentives (or penalties) will create the biggest economic discontinuities and to identify fundamental attributes of any opportunity which underpin the investment returns available.

Investing in early-stage R&D or unproven technology is a risky business. Such is the sex-appeal of the mission to save the planet, there is a bewildering array of new technology ideas, all of which have committed and passionate backers. Government incentives which provide economic support to R&D will be as good as useless on a case-by-case basis if the technology itself does not become commercialized and profitable.

While there will be amazing financial success stories arising from the current stock of renewable energy R&D projects, much money will disappear into research black holes and it will be a lucky investor, rather than a skillful one, who hits the jackpot. Investing in the next-generation of renewable energy technology, therefore, is probably best done through an expert-led fund which diversifies risk and if well structured may provide a degree of downside protection.

So where are the biggest incentives to be found without taking on technology risk? In terms of changing the world, 10 years is not a long period of time; in order to meet binding emissions reduction targets therefore, legislative policy is focused on available, proven technology which is capable of making a major and reliable impact quickly.

There are some very obvious existing technologies which will certainly see an upsurge in interest – wind and solar seem obvious – but these are expensive, relatively inefficient and unreliable technologies at present and the ability to scale either is reliant on a combination of technological advances and availability of huge amounts of land. So legislators are looking for something which will have more impact.

The EU Renewable Energy Directive (RED) includes a binding minimum target for renewable fuels to have a 10% energy-share (13% by volume) of the transport fuels market by 2020. There will be severe penalties applied to fuel retailers for failing to meet these blending benchmarks.

This sector has been targeted because globally, transportation contributes one-quarter of all greenhouse gas emissions, with 80% of that coming from road transport and half of that from cars. Furthermore, total CO2 emissions from cars will double by 2050 unless alternatives to fossil fuels are developed. Liquid renewable transport fuels (RTFs) in the form of ethanol and biodiesel are the only current low-carbon alternatives to fossil fuels and the liquid fuel infrastructure already exists, meaning that the transportation and distribution logistics are already in place.

The EU RED will create a huge market for RTFs (6.5 billion litres UK, 49.5 billion litres EU by 2020), equating to a new market in Europe the size of the global market for RTFs in 2006. Given current blending at around 8-10 billion litres, this means a 5-6 fold uplift in just 10 years (it took Brazil 30 years to develop a market for 20 billion litres).

First generation technology for producing RTFs is proven on a commercial scale (Brazil been making bioethanol from sugar cane for nearly 40 years and a well established corn to ethanol industry sector exists in the US). There is a degree of technological protection too in that many first generation technologies can be modified to accommodate second generation technological advances as and when they become commercially viable (and arguably second generation technology will only become commercially viable if it can utilize existing infrastructure).

Other global producers will not have sufficient capacity to meet EU needs and are also unlikely to comply with the stringent sustainability criteria now introduced into the EU RED (there is significant carbon footprint associated with transporting the fuel across the Atlantic).

So investing in RTFs seems to offer a particular opportunity to invest in renewable energy in order to capture the value of what are enormous legislative incentives, where the infrastructure is in place and with limited technology risk.

Getting access to such investments is not easy. Most publicly quoted companies with RTFs in their portfolios have many other products and business interests which could act as a drag to performance. If one believes in the investment story, seeking out opportunities which isolate the production of RTFs is the way forward. This might be through companies which exclusively own and operate RTF facilities or through an investment directly in the building and commissioning of an RFT facility such as Future Fuels, a recently announced opportunity to invest in a 200 million litre per annum facility to be built in Grimsby.

Two other factors bring added interest to such an opportunity. Firstly, current market conditions mean that the availability of project finance is limited and financing spreads are relatively high, especially during the construction phase. That means that equity investors should benefit from windfall gains on refinancing post-construction or as and when liquidity returns to the financial markets. Secondly, with oil majors having significantly under-invested in this technology over the past few years, vertical integration is likely in the future with a trade sale offering a likely exit strategy at a healthy profit for prospective investors in an individual facility.

Although the lure of spectacular returns from getting lucky in the R&D field is tempting, the reality is that investment returns in RTFs can be exceptional from what is essentially proven technology in an artificially stimulated market with little obsolescence risk.