How renewable energy can help manage risks facing DC members
Heightened uncertainty and market volatility has highlighted key risks for defined contribution pensions (DC), which could be partly addressed by a broader investment approach that incorporates renewable energy investments. We explain how.
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2025 has been a year of volatility – and prevailing uncertainty.
Seismic changes to US trade and foreign policy – and rapid sentiment shifts on markets about their impacts – have led to whipsawing on global equities markets. US stocks, for example, endured the worst first 100 days of any presidency, but at the time of writing are sitting on modest gains for the year to date on the back of positive trading in recent weeks.
Bond markets, too, have exhibited greater volatility. Government bonds in particular have been rocked by doubts over (re)inflation and interest rate policy, as well as, critically, widespread concerns on debt sustainability.
This matters for pension savers, particularly those in defined contribution (DC) pension schemes who ultimately bear the investment risk in terms of retirement outcomes. These schemes have also generally not been able to access the potential return and diversification benefits of private markets, leaving investors, especially those many years from retirement, with high exposure to public markets.
New investment horizons
We believe that for investors with a long-term investment horizon - such as DC members – investing into a broader range of assets could help improve expected risk-adjusted returns. Specifically, we believe that most DC members would benefit from a meaningful allocation to a broad range of private assets that mirrors what we see from other large institutional investors (in the region of 15-20%).
Historic barriers to investing in these asset classes, including relating to liquidity considerations and capital lock ups, have been addressed by product innovation, including the UK’s Long-Term Asset Funds (LTAFs). Alongside this, successive governments have sought to incentivise more capital to be invested by workplace pension schemes into the real UK economy, including through the recent Mansion House Accord.
With this in mind, we believe renewable energy and energy transition-aligned private infrastructure should be high on the list of asset classes DC decision makers consider adding to their portfolios. Here’s why.
Why is renewable energy a good fit for DC members?
The move to net zero and the global transition to low carbon energy production requires significant investment. The International Energy Agency (IEA) estimates that around $4.5 trillion per year needs to be invested into the energy transition from the early 2030s, an almost three-fold increase from 2023, itself a record year.
This provides an opportunity set arguably not seen since the industrial revolution.
Further, powerful tail winds for these investment opportunities are provided by the increasing cost-effectiveness of renewables versus other sources of energy generation, as well as an increased focus on energy security.This latter has come to the fore since the Russian invasion of Ukraine in 2022 and the resulting spike in energy prices, which had profound impacts across global economies. For investors, this also indirectly led to sharp falls on both global equities and bond markets for the first time in half a century, while energy transition strategies outperformed (see table).
Annual returns across asset classes in 2022
Equities | Fixed income | Private equity | Real estate | Private debt | Diversified infrastructure | Energy transition infrastructure | |
|---|---|---|---|---|---|---|---|
2022 returns | -17.7% | -17.0% | -1.6% | 7.1% | 5.4% | 9.1% | 22.6% |
Source: Schroders Capital, 2024. For illustrative purposes only. There can be no assurance that any objective or intended outcome will be achieved. No strategy can guarantee future results. The views shared are those of Schroders Capital and may not be verified. Based on simulated performance. Simulated performance is no guarantee of future returns. Returns are based off quarterly prices, covering the period from 31 December 2021 – 31 December 2022. Simulated energy transition returns are constructed using a combined Net Asset Value (including dividend) performance of Schroders Greencoat listed vehicles. All other private asset classes are sourced from pitchbook benchmarks for private assets. Public assets are sourced from Refinitiv, September 2024. Global equities returns is calculated from MSCI World Gross USD prices. Fixed income returns are calculated from Bloomberg Global Aggregate Credit Total Return Index.
Moreover, we believe it is the ability of energy transition and renewable infrastructure investments to address key considerations of return, risk and impact that make renewables well-suited to a DC portfolio.
Returns
Proper incentive is required to attract the level of investment detailed above. This can, we believe, be demonstrated by renewables.
Equities are currently the predominant growth investment for DC schemes, which means this is the benchmark that any new investment should be held against. Schroders’ research suggests equities, subject to market cap and geographical focus, are forecast to deliver a range of approximately 6% to 8% gross returns per annum over the next 30 years.
A typical, operational renewable energy investment in the developed world, run by our team, is expected to deliver returns of 8-10% per annum on a buy and hold basis1. This is in line with – or at a premium to – listed equities.
Risk management
While the returns from renewable energy are attractive, it is the way that these returns are generated that makes it so well-aligned to DC members.
Like all assets, investing into renewable energy exposes DC members to risks. Returns are effectively the payment for taking these risks. Renewable energy infrastructure exposes members to risks they otherwise would not have in their portfolio – and these different risk ‘premia’ deliver diversification.
Below we detail what some of those risks are and how they impact portfolio behaviour:
- Inflation: Renewable energy returns are often explicitly linked to inflation via payment streams (often government backed or supported). They are also implicitly linked to inflation exposure via power prices. Being positively exposed to inflation is a critical benefit for DC members investing into renewables, as it helps to maintain the real purchasing power of their investments.
- Positive power price risk: Listed equities and corporate bonds are typically negatively impacted by power price rises. This was demonstrated throughout 2022, where high energy prices didn’t just impact the “cost-of-living crisis”, but also negatively impacted businesses. In contrast, renewable energy portfolios benefit from rising power prices through the energy it generates and distributes.
- Resource/weather risk: Wind and solar radiation are diversifying to other risks in an investor’s portfolio. While predicting the weather today or tomorrow is challenging, over a 30-year asset life this is much more predictable. Our data shows wind to exhibit a 2% standard deviation of outcomes over a 10-year period. Solar’s standard deviation is even lower.
- Technology: These risks are specific to the energy transition technology and deliver another source of risk premium to investors. For example, the operational considerations of a biomass plant vary significantly to a wind farm or hydrogen plant. Again, the key benefit to DC members of this risk premia is the diversification to a wider portfolio.
- Geography/policy: Energy security concerns globally are driving policy and regulation to support an accelerated energy transition, resulting in a green subsidy race. Even where political push back is creating headwinds for new renewables build out, such as in the US, the inherent cost competitiveness of renewables today should continue to support new development.
Conceptually, these return drivers and risk premia should deliver robust diversification, particularly for listed equity-heavy investors like DC. As noted above, renewable energy certainly provided much needed diversification in 2022 for those institutional investors who have already made investments in this area.
Meeting the need for positive impact in investment
DC members are growing more aware of the impact their portfolios have on the world and increasingly expect their investments to contribute to solutions rather than just avoiding harm.
Renewable energy and energy transition-aligned infrastructure can tangibly be measured in green electrons produced and homes and/or electric vehicles powered. This makes the contribution of these assets towards a net zero economy clear. It is also clear that investing in this sustainable asset class goes beyond the structural environmental benefits of clean energy generation and requires a sustainable approach to the community and local biodiversity.
Events over recent years have brought all three of these points into clear focus for investors and DC schemes specifically; public markets provided limited shelter from the market volatility as both inflation and energy prices spiked. There is today, however, thanks in part to long-term asset funds (LTAFs), a broader choice of investment solutions available which can help the member journey and deliver better outcomes while addressing the impacts of climate change.
1Source: Schroders Greencoat forecast. There is no guarantee that forecasted figures will be achieved. Buy and hold IRRs assume no exit and zero terminal value for investments over the expected life of the asset (which is generally between 25-40 years).
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