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New generation: harnessing natural power

As long as the sun comes up every day, you’re going to sell power for something,” says Paul Flood, a fund manager and strategist at Newton, on why he believes renewable-energy assets can provide stable long-term cash flows.

If everyday prices continue to go up because the cost of importing goods and services into the UK rises due to the fall in the value of sterling, this is likely to have a positive impact on renewable assets because of their relationship to inflation. (Historically, the UK has been prone to high inflation, notably in the 1970s and the early 1980s.) As the UK embarks in earnest on negotiations to leave the EU, there is the possibility that the UK economy might contract. Given the UK’s large deficit (it spends more than the money it receives through taxes) and uncertainty whether foreign investors will continue to fund the deficit, sterling is likely to be vulnerable to further falls.

Renewables also fit in with decarbonisation and ambitions for a 2ºC threshold that scientists regard as the limit of safety before the effects of climate change become irreversible. http://phys.org/news/2016-09-global-2c-threshold.html as at 13 June 2017 ">1 The Paris climate conference (COP21) in December 2015 was viewed as hastening the transition away from fossil fuels towards a clean energy economy.

Sun versus wind

For renewable-energy assets, one of the key forecast risks is the variability over the short term of the availability of the natural resource. However, on a year-on-year basis, solar energy is very stable, going up or down by around 5% per annum in terms of output. A clear sunny day helps but some 80% of the generation of energy by a solar panel is through the dispersion of the sunlight. A significant proportion comes from the sun’s rising each day.

Wind, on a daily basis, is far more changeable, tending to vary by 10% year to year. On an annual basis, the swing in variability can be as much as 20%. Investors need to be compensated for the additional risk of the volatility of the wind and as a result there can be higher returns out of wind assets. Wind turbines – given the number of moving parts – require 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. These projections are used to raise finance in the markets for stocks and shares and debt. Assets are valued on probability scenarios, P50 indicating that there is a 50% probability of the annual production exceeding the forecast and P90 a 90% probability.

In terms of renewables, UK investors are familiar with the asset class and the companies behind renewable-energy assets in the country are less inclined to take on too much debt. Plus, there is the strong legal protection afforded by English law. There is much stronger protection around the subsidy regime than is available, for instance, under Italian and Spanish law. In the US, investors tend to come and go and can include, for example, hedge funds.

The US market for renewables is arguably less transparent than the UK’s and the operating companies of renewable-energy assets tend to take on more debt. This can contribute to additional risk, combined with the fact that the structures are much more opaque. However, with tax relief, there is the possibility of writing off assets in order to reduce the tax bill quite quickly. Although President Donald Trump has placed an emphasis on renewing US infrastructure, the administration’s stance is not regarded as friendly towards renewables.

Subsidy regimes

In Spain and Italy, the subsidies that investors were expecting have changed and this has had an impact on returns. This was then compounded by the fact that most of the renewable projects were locked in with quite high levels of leverage.

When the financial crisis occurred in 2008 and was followed by recession, demand for power dropped dramatically. Spain had earned a reputation for leadership in the development of wind and solar-powered electricity and the subsidy regime for renewables came from a contribution from electricity bills. When electricity usage went lower (because of reduced economic activity), there was less money to go towards renewables and the subsidies went by the wayside. This is now the subject of a legal challenge in Spain and a similar pattern has been observed in Italy.

Changing the historic subsidy regime can make it difficult to entice capital to infrastructure spending in the future. However, there is an argument for bringing down subsidies as the cost of constructing solar and wind plants, as well as the provision of equipment, has gone down dramatically. It also reduces the burden on the tax payer. But this is unlikely to affect existing projects.

While this is an asset class that may get overlooked, it has been less affected, compared to other financial assets, by the distortions resulting from quantitative easing and zero interest-rate policies.

Emphasising Environmental, Social and Corporate Governance (ESG)

Solar can play a part in many countries in Africa as sunlight is abundant and there is a growing demand for power. Faced with a lack of connectivity to the electricity grid, building out renewable energy power sources can provide lighting to farms, villages and small towns. It can also enable the use of mobile phones and computers, which are much needed to access banking facilities and agricultural trading. In such a context, the security of the assets is paramount for an investor.

Where professionals, say from the UK, provide the ‘know how’ to develop such facilities, governance would generally be high as UK listing rules require strong governance. Having support from a regulator provides reassurance for investors.

A failure to meet recognised standards of good governance and to operate sustainably represents threats to financial performance that are not adequately compensated by the expected returns. A way of assessing the overall quality of company management is looking at how effectively environmental and social aspects of the business are handled. This means meeting with the management of a company to raise points of concern and to discuss why the company should be concerned as well. This is a very active process that can happen over many years and involves holding a company to account if necessary. By the same token, if the company is acting in a way that leads its sector, this can be acknowledged.


Important information

The value of investments can fall. Investors may not get back the amount invested. 

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