Why is inflation is generating profits for some energy firms
Rising energy prices are mostly good news for renewable energy funds, but the outlook is complex.
High energy prices benefit oil and gas firms, but they are also benefiting renewable energy funds. Just last week energy-storage fund Harmony Energy Income Trust (LSE: HEIT) announced that its net asset value (NAV) per share increased by 8.8% to 108.9p per share in the quarter to 30 April. Much of the uplift came from higher revenue assumptions, reflecting updates to power price forecasts.
Exactly how the relationship between rising energy prices, and profits and assets works is more complex for renewables than oil and gas. First, wind and solar projects benefit from subsidies which usually have some explicit inflation protection built into them (energy storage firms have very different dynamics).
However, subsidies aren’t the only source of revenue. Many of the funds also benefit from higher wholesale power prices. This doesn’t feed through in a linear fashion to greater profits, because many funds have introduced price fixes and hedges, which dull down some of those price changes for now. But come the end of the year, those hedges will reset.
These are the tailwinds. However, increased inflation also feeds through into higher government bond yields and thus into higher “risk-free” rates in the financial models used to value future income from renewable-energy projects. These models also depend on premiums over risk-free rates, which vary with a long list of factors. Finally, increased inflation might also mean higher operating costs (Harmony mentioned this in its results, for example).
So higher inflation isn’t a simple win for all renewables funds, although on balance it is a big driver of NAV increases. Take Greencoat UK Wind (LSE: UKW). Its NAV at 31 March was 149.3p/share, an increase of 15.8p per share (11.8%) over the quarter. Cash income accounted for 3p per share to NAV, while higher forward energy prices for 2022-2025 added 7p per share and inflation assumptions for 2022 added 6p per share.
These higher NAVs could yet turn out to be an underestimate. Most funds assume inflation reverts to around 3%, but the consensus is now that it will stay above 5% for the next few years. There are contrarians (me included) who have their doubts, but if you believe the consensus, the figures that many of the renewable funds are using look modest.
Then there’s the question of how power prices evolve. The funds base their estimates on research by specialist consultancies such as Aurora Energy, which recently argued that prices will remain elevated for the foreseeable future. But it also introduces a key challenge that isn’t always factored in: the possibility of an energy surplus in the 2030s. Increased investment in renewables might bring higher supply and lower prices. Aurora reckons UK renewables will move from 50% of output now to roughly 75%.
Wind production will increase fourfold and the government’s ambition to increase solar capacity fivefold to 70GW would led to a solar capacity surplus of 18GW during the average summer week by 2035. That could mean lower but more volatile prices.
Finally, there’s government policy. There are rumours an energy windfall tax might be applied to power generators. So where do all these factors leave valuations? The average premium to first-quarter NAV was around 4.5% for the core renewables funds while the average yield is 5.6%, according to Investec.
Analysts there favour Analysts there favour Foresight Solar (LSE: FSFL), Greencoat Renewables (LSE: GRP), JLEN Environmental Assets (LSE: JLEN) and Renewables Infrastructure (LSE: TRIG). Energy storage funds such as Gresham House Energy Storage (LSE: GRID), Gore Street Energy Storage Fund (LSE: GSF) and Harmony might also be well positioned in an inflationary environment with more energy-supply volatility Greencoat Renewables (LSE: GRP), JLEN Environmental Assets (LSE: JLEN) and Renewables Infrastructure (LSE: TRIG). Energy storage funds such as Gresham House Energy Storage (LSE: GRID), Gore Street Energy Storage Fund (LSE: GSF) and Harmony might also be well positioned in an inflationary environment with more energy-supply volatility
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