Navigating a new wave of energy investment in 2025

The energy transition is increasingly driving investment in the energy sector. Investment in the energy transition is forecast to double that of fossil fuels in 2024. For several reasons, this trajectory is expected to continue in 2025.

Firstly, the macro-economic challenges which the sector faced over recent years, such as geopolitical uncertainty, supply chain constraints and the rise in the cost of finance, are now largely accounted for in valuations and return expectations. Businesses focused on the energy transition are particularly impacted by these conditions due to difficulties in passing increased costs on via higher prices have (for the most part) shored up their finances by implementing strategies such as strategic disposals or partnerships.

Secondly, having spent the first half of this decade revising regulatory frameworks, governments, particularly in OECD countries, are now proactively implementing measures to steer capital towards energy transition opportunities. The EU’s Green Deal is an example of this. Initiated in 2019, the EU institutions have now undertaken a significant programme to align EU laws with the climate neutrality goal. In November 2024, Ursula von der Leyen announced her new Commission will continue to pursue its goals but with a focus on competitiveness in key areas such as innovation, manufacturing and industry.

The picture is nuanced, particularly in countries where new administrations are set to take office following recent elections. The US is an obvious example of a likely retrenchment from energy transition policies, however it is unclear the extent to which this rhetoric will be borne out. However, in other markets incoming governments may seek to deepen energy transition policy. Such as in the UK where the government’s Clean Power Mission is seeking to accelerate decarbonisation of the electricity system by 2030.

In the private sector, the adoption of climate risk management strategies and greater levels of sustainability reporting by businesses and investors, whether voluntary or mandatory, are also driving investment in energy transition-related assets.

Investor requirements must be appropriately accounted for

However, to mobilise private capital requires a range of policy interventions. The type of intervention varies and depends on a range on factors:

1. Technology maturity – investment appetite and return expectations vary depending on the maturity of the technology. Pre-commercial technologies require a higher risk / reward due to their novelty and uncertain returns. As a result, they are typically incubated using R&D budgets within large corporates or funded by venture capital investment. An example of the latter is Tokamak Energy, which recently raised a $125 million of further funding for its fusion energy solution.

2. Financing approach – where corporate finance is being used, debt and equity funders will look to the corporation’s balance sheet to recoup their investment plus returns. However, where non- or limited-recourse finance is sought, investors will need to satisfy themselves that risks are appropriately mitigated or allocated, and that forecast revenues are reasonably likely to be achieved.

3. Investor hold period – some investors will have mandates that require a sale within a given period. For example, hold periods are typically 4-7 years for private equity, but perhaps up to 10 years for infrastructure funds, and much longer for patient pools of capital with long-dated liability such as pension funds or insurers. This in turn drives investment pay-back periods.

4. Investor risk appetite – certain types of capital prefer low risk, regulated returns, whilst others will accept greater levels of risk, commensurate with rewards.

It is not appropriate for governments to intervene in relation to every risk, however. Some risks such as technology, construction and operating risks are commonly managed by the private sector.

Thoughtful policy design is critical

It is crucial that these factors are considered in the design of policy interventions. However, the extent to which they can be accounted for will depend on local circumstances. In some jurisdictions, central vs local government jurisdiction may limit the country-wide actions the central government can deploy. In others, constitutional or public law checks and balances or value for money duties may also need to be accounted for. For example, in the UK and EU, State aid or subsidy control rules will need to be respected. As a result, approaches to stimulating energy transition investment can vary significantly.

For pre-commercial technology, interventions focus on grants or tax incentives for R&D which tend to be relatively blunt tools, providing little insight into the actual expenditure required which can raise value-for-money concerns. Investors may also be reluctant to rely on tax incentives for multi-year projects due to actual or perceived change in law risks. The incoming Trump Administration will likely remove or curtail incentives introduced only around 2.5 years ago in the Inflation Reduction Act. And the UK government’s promise of stability in a “Corporate Tax Roadmap” has done little to boost business confidence which in November 2024, was reported to be near the record low recorded at the start of the Covid-19 pandemic (with business tax among the top three concerns). So, what other tools are governments using to incentivise significant capital expenditure?

Early investments into many renewable technologies such as onshore and offshore wind or solar in the UK and EU were historically supported via fixed feed-in tariff or a feed-in premium schemes. However, many markets are now implementing a contracts for difference (CfD) mechanism. A two-way CfD scheme for renewable power generation, introduced in Britain in 2014, is widely seen as successful to incentivise development of high capex, low opex renewable assets (see box for details). The CfD mechanism is now also being rolled out for newer technologies in the UK such as electrolytic and carbon capture and storage (CCS) enabled hydrogen production. It is also now expected to be used more widely in EU member states for new renewable and nuclear projects following adoption of proposals to reform electricity market design in 2024.

Where policy seeks to stimulate demand for a higher cost low carbon fuels, market mandates have been used to incentivise the supply by avoiding non-compliance penalties. This has helped to encourage investment in renewable transport fuels in the UK and is the approach that both the EU and UK have introduced to develop the market for sustainable aviation fuels (SAF) under their respective ReFuelEU and SAF mandate policies. Whilst it is still too early to judge the success of these policies in the context of the international aviation market, there is a risk if the penalty is not sufficient to drive investment in local production, particularly where lower cost, international supply is available. This may result in fuel suppliers preferring to pay the penalty and pricing this into supply via increased charges, effectively shifting the responsibility for investment to their customers.

To mobilise institutional investment in monopolistic infrastructure, the UK is increasingly considering structures geared towards investors seeking long-dated, regulated returns. Regulated asset base models or licence-based cap and floor regimes which provide revenue certainty over the long-term are increasingly implemented. We are seeing these being deployed for new nuclear power projects and networks such as carbon dioxide transportation and storage and hydrogen transportation. For first-of-a-kind projects, this is being supplemented by a government support package to address key risks and ensure bankability. However, because periodic price controls mean that expenditure and returns will be subject to regular review, a key element in the success of these regimes is confidence in the regulator. This will vary according to the market and can be sensitive to wider market sentiment.

Other indirect interventions are also important. These include concessionary finance (debt or equity) from publicly owned institutions where liquidity is lacking in the commercial markets. For example, the UK’s National Wealth Fund will have a total capitalisation of £27.8 billion and an expanded mandate to support delivery of the UK’s industrial strategy in areas where there is an undersupply in private finance.

Conclusion

Increasingly government interventions underpin investment models for energy transition assets. To ensure their success, it is important for investor requirements to be borne in mind in their design. Consequently, debt and equity investors will need to model and stress test the regulatory regime to appropriately assess and structure their investment.