Is investors’ enthusiasm for renewable energy justified?
Investors have been pouring money into renewable energy funds. But the sector has had a tricky year so far. Max King looks at the opportunities for investors – and the risks.
Renewable energy funds raised around £2.3bn of new equity the first nine months of 2021, according to Numis, in over 20% of the total for all investment trusts.
This represented an acceleration in terms of money raised in both absolute and relative terms from the 2014-2020 average.
But was it justified by the performance of the sector?
Renewable energy funds have had a tricky time so far in 2021
It seems not. Initially, funds in the renewable energy sector were held back by weak power prices, then by the absence of wind or sun in the summer. They failed to benefit from the surge in prices in September due to their long-term contracts.
Diversification into Europe was no help and the two North American funds in the sector hadn’t yet gained traction. Returns both in terms of share price and underlying performance were mostly negative, even with the inclusion of generous dividend yields.
The two battery storage funds – Gresham House Energy Storage (LSE: GRID) and Gore Street Energy Storage (LSE: GSF) – and SDCL Energy Efficiency Income (LSE: SEIT), by far the largest of the three energy-efficiency companies, performed much better, though prolific equity issuance creates the challenge of ensuring returns on the new projects are as good as on the old ones.
Are investors right to take the long-term view? Analysis by Christopher Brown of JP Morgan Cazenove suggests they are. Not only have spot electricity prices risen, but so have forward prices for the next three years. “Even for those companies which have fixed much of their near term production revenue,” he writes, “there is likely to be a benefit from agreeing new forward contracts at higher prices than for those coming to an end.”
As a result, he has increased his net asset value estimates, on a conservative basis, for the six UK companies by between 1.4% (John Laing Environmental (LSE: JLEN)) and 3.2% (Greencoat UK Wind (LSE: UKW)). Companies with European assets should see a comparable benefit.
In addition, the discount rates used by funds to arrive at net asset values vary from 6% (Bluefield Solar (LSE: BLIF)) to 7.3% (JLEN). The higher these are set, the lower are net asset values and these discount rates look more than enough to take account of the upside to interest rates and bond yields. In other words, net asset values look understated.
Finally, autumn is here and the wind is blowing again, helping electricity generation. Solar energy in the UK may appear to be the triumph of hope over experience of British weather, but significant technological improvements mean that solar generation is more dependent on light than sunshine. Clearly, generators in southern Europe and southern US don’t need to worry.
Investors can afford to relax a little; the sector looks likely to continue to generate high single-digit returns. There could even be some good news if the chancellor is forced to perform a U-turn on higher rates of corporation tax now that the US administration has been forced to stick with the 21% rate rather than increase it to 28%.
The renewables sector has promise but there are plenty of risks
But investors still need to be on their guard. Electricity demand is expected to grow strongly, perhaps doubling by 2050, as the UK decarbonises heating and transport, but that does not necessarily mean higher prices. If the government approves new nuclear power plants, these will eventually supply much of the increased demand at low marginal cost. The supply of sites for wind and solar is far from infinite and the cost of installation and maintenance is likely to rise.
As more and more money is shovelled into renewable energy projects, encouraged by the universal zeitgeist, there is a danger that returns could start to fall. The political and popular drive to replace hydrocarbon generation with renewable energy does not have investor returns as a key objective.
As Richard Crawford, a director of InfraRed, the managers of the Renewables Infrastructure Group (LSE: TRIG), says: “while more and more renewables development may appear to policy makers as low cost and painless progress, without other complementary measures, increased intermittent capacity risks flooding our system with excess electricity at times. This will push down returns, actually discourage investment, and will not on its own achieve the required decarbonisation.”
Too often, environmental and political goals are confused. Reducing the global usage of hydrocarbons is a worthy environmental and economic goal but the commitment to “net zero by 2050 in the UK” is almost irrelevant to that goal and an investment strategy based on it is skating on very thin ice.
There are too many risks for investors to relax. Electricity prices could fall again, reducing returns, either because of over-investment in generation or as wind generation picks up or as the interconnector with France is repaired. Bids from major hydrocarbon companies desperate to diversify into renewable energy are possible but would make no business sense.
Investors should avoid getting carried away by the media and political hype and focus on whether the companies are still generating a satisfactory and sustainable rate of return. They should also remember that the solution to the challenge of decarbonisation lies in new technology. For example, the capacity of battery storage is currently measured in hours but if that could be extended to days or weeks, the intermittency of renewable energy and the inflexibility of nuclear generation would cease to be a problem.
The financial and environmental pay-off would be enormous and explains the high valuation accorded to companies such as Tesla that are investing in this area. By all means invest in renewable energy funds, but find room also for funds focused on innovation.