An investor’s perspective on the UK’s Net Zero Strategy

On October 18, the UK government launched the Net Zero Strategy: Build Back Greener¹ document, which sets out its priorities to reduce emissions in power, transport, industry and buildings.

The 368-page document, purposely released just ahead of the COP26 summit in Glasgow, provides much-needed detail and a holistic perspective on the steps required to achieve net zero by 2050. Simultaneously, it makes a compelling case on the benefits this will provide to the economy in terms of green jobs, while acknowledging the challenge of how the associated costs will be socialised to consumers.

In all respects, the document is a big step forward from the government’s previous publications, Ten Point plan for a Green Industrial Revolution² and the Energy White Paper,³ which were big on ambition but lacked detail. The document has even received a positive endorsement from the Climate Change Committee (CCC), the independent statutory body set up to provide advice to the government, which it has frequently criticised for a perceived lack of progress to date.⁴

In its assessment, the CCC described the strategy as “an achievable, affordable plan that will bring jobs, investment and wider benefits to the UK. It is also a strong example to bring to the COP26 summit of how to follow climate change targets with action.”

The CCC’s chairman, Lord Deben, praised the government for its ambition, albeit with a caveat. “Ministers have made the big decisions – to decarbonise the power sector by 2035, to phase out petrol and diesel vehicles, to back heat pumps for homes. And they have proposed policies to do it. I applaud their ambition. Now they must deliver these goals and fill in the remaining gaps in funding and implementation. My Committee will hold their feet to the fire, as we are required to under the Climate Change Act. This is the UK’s climate governance working as it should.”

The importance of private capital

The document is vital for infrastructure investors as they consider the opportunities and challenges from the transition to net zero. Positively, the government has stepped up its engagement with the financial investor community, particularly through the efforts of the Department for Business, Energy and Industrial Strategy (BEIS) and the Department for International Trade.

The strategy is clear on the importance of private capital, anticipating this will provide the bulk of the additional investment needed, which is forecast to increase to £50-60 billion per annum over the next ten years. It is not clear on the baseline assumption used in this calculation, although HM Treasury’s Net Zero Review^5,6 suggests increased net-zero capital expenditure will be around one to three per cent of GDP relative to a recent average total investment of around 17 per cent.

The scale of investment required is already familiar to infrastructure investors. The National Infrastructure Delivery Plan in 2016⁷ set out a plan for the public and private sector to invest £59 billion per annum on average to 2021, which was the target identified in the original UK National Infrastructure Plan in 2010.⁸ Although the priorities for investment have changed over the past decade, most of the overarching themes remain valid.

The UK has made considerable progress over that time and private investment into infrastructure has played a key role. However, we are moving to the next stage of the path to a low-carbon economy.

A big plus for the government is the growing amount of domestic and international capital available to support net-zero initiatives. Assets that have strong environmental, social and governance (ESG) characteristics, particularly those that align to a net-zero pathway, are in high demand. The big question is whether there will be enough quality assets to satisfy demand.

Short-term opportunities, longer-term questions

UK market activity over the past twelve months has been characterised by continued secondary asset acquisition activity and associated debt refinancings, but there has been little primary greenfield investment in assets that align to the government’s net-zero strategy. Core renewable investment remains small in advance of the next Contracts for Difference (CfD) auction, and while there are emerging opportunities in battery storage and early-stage investment into EV charging, the development of carbon capture storage and usage (CCUS) and hydrogen remain at a very early stage. Investors are keen to understand how this will change over the next few years.

The UK has stated a clear aim to be a world-leading net-zero financial system, with climate risk to be embedded into regulatory frameworks. Critically, the strategy acknowledges market failures mean the private sector alone will not deliver at the pace required. With investment required across all stages of commercial development, the government recognises this importance of the right policy signals to mobilise capital, with technologies in early-stage development needing greater government financing.

The Ten Point Plan set out the main sectors the UK wants to develop at scale, including offshore wind, hydrogen, CCUS and nuclear energy. The latest paper sets out a variety of targets and measures to achieve this, with the biggest immediate opportunities for investors in electricity generation. Electricity will play a critical part in achieving net zero and forecasts show a potential doubling of demand and consequently a four-fold increase in low-carbon electricity generation.

While the government’s intention is to decarbonise electricity by 2035 – which it estimates will require £280-400 billion of public and private investment – this is subject to security of supply. Recent events around the availability and price of gas, along with the impact to smaller energy suppliers, serve as a reminder that the energy trilemma has not entirely disappeared from the political lexicon. The biggest energy risk to any government remains the security of electricity supply, although there is increasing concern on the cost to consumers. This perhaps explains why the strategy goes into great detail on the overall positive impact of the net-zero pathway to the economy.

One of the biggest challenges facing the government is forecasting the future energy mix, which could vary from current projections due to economic factors and technological advances in the sources of electricity. While there is a role for a combination of renewables, gas and bioenergy with CCUS, hydrogen, interconnectors, storage and nuclear, there is no “silver bullet”. A range of technologies is needed to meet potential demand.

A sector-by-sector assessment

Here we assess the key sectors that require infrastructure investment, as highlighted in the strategy paper, and our perspective on the opportunities and challenges for investors.

Harmonising public and private needs

As the table highlights, much of the investment required to achieve net zero will be in new or emerging technologies. This presents two major challenges to investors: technology and delivery risk and longer-term revenue and market risk. As a result, financial investors will be looking for a combination of the capability of industrial sponsors to bring forward these technologies alongside government policy incentives or capital.

In the government’s strategy paper, only offshore wind is considered “capital markets” ready, while low-carbon hydrogen, CCUS, advanced nuclear, long-term storage, electrification of transport and energy efficiency are not yet proven commercial propositions.

The strategy sets out how different sources of capital change as sectors mature. The majority of institutional investor capital is seen to be capable of being mobilised as a sector moves to being delivered at scale (and ultimately to a mature state) when the public capital requirement becomes minimal or disappears. The strategy refers to “…providing the investment conditions to mobilise private capital into a portfolio of net-zero financing” but there is no further detail. This recognises there will be no “one-size-fits-all” approach, with each sector needing its own mix of policy intervention and possibly public finance.

In terms of policy incentives, there are multiple options. Increasingly, the government is looking to its two main financing tools – the CfD and RAB models – to attract private capital. This builds on the success of these models in the offshore wind and utilities sectors in attracting significant private capital.

While the strategy highlights the recently established UK Infrastructure Bank as capable of playing a pivotal role in being able to kick start new sectors, details on how it will seek to ‘crowd-in’ private capital will also be eagerly awaited by investors.

Key takeaways

• The strategy sets out in greater detail the scale and pace of investment required in the UK to achieve net zero.
• This will require considerable capital from financial investors. The majority of the estimated £50-60 billion of increased annual investment needed over the next ten years is expected to come from the private sector.
• Much of the additional investment is required in sectors that involve early-stage technology or in markets where there is no defined demand. This will require financial investors to work collectively with industrial sponsors and the government to transform these markets from early-stage to mature technologies.
• While the scale and urgency of the task is significant, change will not happen overnight. Investors need to be patient and spend the necessary time to understand the risk-return dynamics in these new sectors.