Renewables can provide stable long-term cash flows, with a good line of sight.
As long as the sun comes up every day, you’re going to sell power for something. In some senses, investing in renewables is like investing in bonds, except with some sensitivity to the price for generating power.
Renewables can offer strong inflation protection as revenues have direct, contractual inflation obligations.
They also fit in with decarbonisation and ambitions for a 2-degree threshold that scientists regard as the limit of safety before the effects of climate change become irreversible.
The Paris climate conference (COP21) in December 2015 was viewed as hastening the transition away from fossil fuels to a clean energy economy.
In terms of where to find good renewable assets, I tend to favour the UK as it has a ‘sensible’ investor base that understands the asset class and leverage is low, plus there is the strong legal protection afforded by English law.
There is, for instance, much stronger protection around the subsidy regime than is available, for instance, under Italian and Spanish law.
In the US, the investor base tends to be more transient and can include, for instance, hedge funds with much higher levels of coverage.
The US market for renewables is less transparent than the UK’s and with more leverage on assets at the level of the operating company, and that tends to contribute to additional risk.
What we find is tax relief is effectively a subsidy, with the possibility of writing-off assets in order to reduce the tax bill quite quickly.
Additionally, the US structures are much more opaque and there is a substantial number of interparty-related transactions. Although President Donald Trump’s administration has placed an emphasis on renewing US infrastructure, the stance is not as friendly towards renewables as one might have thought.
In Spain and Italy, the subsidies that investors were expecting have changed and this has had an impact on the returns of the assets. This was then compounded by the fact that most of the renewable projects were locked in with quite high levels of leverage.
Sun versus wind
For this asset class, one of the key forecast risks is the short-term variability of the natural resource’s availability. On a year-on-year basis, solar energy is very stable, going up or down by 5 per cent per annum in terms of output.
A clear sunny day like you have in Australia helps, but some 80 per cent of the generation by a solar panel is through the dispersion of the sunlight.
A significant proportion comes from the action of the sun’s rising each day. Wind, on a daily basis, is far more variable, tending to vary by 10 per cent year-to year. On an annual basis, the swing in variability can be as much as 20 per cent.
Investors need to be compensated for the additional risk of the wind’s volatility and as a result there are higher returns from wind assets. Wind turbines – given the number of moving parts – require a lot of maintenance.
Solar panels, although vulnerable to theft, require less maintenance beyond occasional cleaning.
The business plans of both developers and operators of renewable assets include assumptions on the levels of power generation, with these projections used to raise finance in the equity and debt markets.
Assets are valued on probability scenarios, with P50 indicating that there is a 50 per cent probability of the annual production exceeding the forecast and P90, a 90 per cent probability.
In respect of renewable energy funds, I suggest evaluating the yield to maturity and not simply the yield in a specific year.
The internal rate of return calculation takes into account the current stock price, the future dividend streams and the net present value of the portfolio over its lifetime.
Brexit concerns
As the UK embarks in earnest on negotiations to leave the European Union there is the possibility of a resultant recession, and given the UK’s large deficit and uncertainty whether foreign investors will continue to provide capital, sterling could fall further in value.
If inflation picks up because of the cost of importing goods and services into the UK, this is likely to have a positive impact on renewable assets because of their inflation linkage.
Paul Flood is a multi-asset portfolio manager at Newton Investment Management.
