Could an ill wind hit renewable energy funds?

Infrastructure as an asset class is mostly accessed via specialist investment trusts, but as it has (rightly, in my view) grown more popular, we’ve seen the rise of what are in effect infrastructure funds of funds, structured as open-ended vehicles. In other words, these funds grow or shrink as investors buy in or withdraw money, unlike an investment trust which has a fixed number of shares in issue which investors trade with one another. VT Gravis UK Infrastructure and FP Foresight UK Infrastructure Income, the two biggest such funds, have between them more than £1bn in assets under management, and I remain bullish on both.

Big fish, small pond

But some – including a fund manager I talked to recently – have raised concerns, both about these types of funds specifically and infrastructure more generally, which seem worth addressing. First and most obvious is the issue of common shareholdings. Both the aforementioned funds have seven names in common in their top ten holdings list, including HICL, Foresight Solar and Renewables Infrastructure (TRIG). These seven comprise 43% of the Gravis fund’s holdings and 44.4% of Foresight’s (although not in the same mix). This is not unusual or worrying (big US funds often hold the same subset of big tech stocks), except that a) these holdings are investment trusts, which sometimes suffer poor liquidity (ie, they’re hard to buy or sell without moving prices), and b) the funds hold quite a chunk of them.

Broker Numis reckons that the classic infrastructure funds have a combined market capitalisation of around £18bn. There’s roughly another £10bn in medical, student and social property trusts. So that’s around £28bn all told. That means these two funds on their own comprise about 3% to 5% of the total capital invested in listed infrastructure. According to my worried fund manager, the risk is that the Gravis and Foresight funds “are forced buyers of their trusts when they receive subscriptions and they might be setting the price for these trusts”. In other words, the funds (and their investors) are the dominant buyers and sellers of these trusts.

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To be clear, these worries are not entirely echoed by market makers and analysts who cover this sector. Most reckon the ownership of big trusts such as HICL and TRIG is fairly well diversified. As one put it to me: “It’s not like Woodford/Invesco in P2P lending where they were half the registers in a lot of cases.” Simon Elliott, who heads funds research at Winterflood, also isn’t too fazed. The six big infrastructure funds “have an average market cap of more than £2bn, while seven of the 13 renewable funds have market caps greater than £500m”.

What if?

William MacLeod, managing director at Gravis Advisory, adds that 11 of the trusts held in his Gravis UK fund (about 63% of its total listed investment trust exposure) are FTSE 250 members, with natural daily traded volumes in the millions. Thus the fund’s share dealings in the likes of HICL and TRIG are “rather insignificant” compared to wider market activity. Meanwhile, Mark Brennan, lead fund manager for FP Foresight UK Infrastructure Income notes that the fund owns “less than 5% of the issued share capital of all our holdings”, with an average ownership level of 2%.

However, I’m not entirely convinced these diversification strategies will stand up in a worst-case scenario. Infrastructure has held up well in tough market conditions. But, say, an external factor knocked the whole sector for six. If that happened, we could see selling across the sector. In turn, these funds of funds, with their big holdings, might be forced to sell into this volatility if unit holders also decided to run for the exit.

Such a rush is hardly far-fetched. It seems like ages ago now, but just last year we saw market jitters over Labour’s proposals to curb private sector infrastructure investment. But I would be most cautious around renewables. Again, my fund manager contact has a specific fear: “Why would you invest in anything where the marginal cost of production is zero, as pressure on pricing will always be downwards? Dividend cover is very skinny with these trusts … income will come under pressure as power prices inevitably come down.”

Now, I think the idea that marginal costs will head to zero is a tad alarmist (see below for more on power pricing) but concern about the valuations of renewables more generally is widespread. Note that the Foresight fund has been cutting its exposure to UK renewables since the second half of 2019 “in reaction to pricing and valuation”, according to Brennan.

The risk to me is that if there is a sudden rush for the exit within infrastructure over the next few years, it might happen in the renewables space where premiums are still high. If that worst-case scenario did occur, we might see investors flee both the trusts and the funds of funds holding them, fuelling a downwards spiral. As I said, I’m still bullish on them – but investors should remain alert for signs of strain in the underlying trusts.

Renewables, power pricing and valuation risk

Renewables are flooding the UK power market at an increasing rate. Wholesale prices are determined by the marginal cost of generation, which – as renewables typically have very low marginal costs – is pushing wholesale prices down. JPMorgan analysts recently warned that renewables were “cannibalising” revenues, noting that data from Bloomberg New Energy Finance suggests that UK baseload electricity prices will fall in real terms (ie, after inflation) by 4% a year to £19 per megawatt hour (Mwh) by 2040.

The danger is that many UK renewable funds expect prices to rise by 0.6% a year over that time, to £52/Mwh. JPM reckons this mismatch could see the share price of such funds fall by a third on average. Moreover, many renewable funds’ direct exposure to power prices has been rising, because subsidy flows have fallen. JPM may be wrong – as Winterflood’s Simon Elliott warns, “any number of experts have struggled to consistently forecast prices”. However, he also acknowledges that sector’s “risk/return characteristics ... [are] undoubtedly changing”.