Earth, wind and fire: there’s reliable income in renewable energy

Solar and wind energy are often overlooked by investors, but these sources of power generation offer investors opportunity.

To date, renewable energy has largely been the focus of environmentally conscious investors. However, these emerging sources of power generation are overlooked by investors as a reliable source of income.

Traditionally, investors saving for retirement have relied on established utility companies. However, since the 2008 financial crisis, shareholder returns for the six major firms dominating the UK energy market have been poor and, in some cases, dire.

Most recently, Centrica announced a dividend cut of almost 60% and an asset disposal plan, after a near 50% fall in first half operating profits. Its share price has fallen more than three-quarters since 2014.

Conventional sources of power in the UK face a raft of challenges, with UK coal-fired plants due to close by 2025, while nuclear plants remain very expensive to build and are subject to a vast number of risks.

This is where renewable energy offers real opportunity. While it has been heavily promoted by the UK government and environmental lobby, the case for investing in renewables is driven by falling production costs and backed by long-term contracts delivering solid returns. These far outweigh concerns about costs, subsidies, and intermittency.

Solar: a place in the sun

There are seven generally accepted forms of renewable generation: wind, solar, hydro, marine, biomass, geothermal, and fuel cells.

To date, onshore wind has been the key renewable source in the UK, with total wind capacity now exceeding 12GW. However, given the closure of the Renewables Obligation subsidy regime to new capacity in 2017, this figure is unlikely to grow as fast as previously.

Nevertheless, sharp cost reductions in the offshore wind sector should see the government focus on developing offshore wind power generation. Anticipating this policy, National Grid predicts that offshore wind power capacity will take off in the coming decades.

Despite the UK’s temperate climate, solar power – at least in southern England – is now also making a meaningful contribution. Solar investment in the UK has risen sharply over the past decade – with total capacity now exceeding 12GW. In recent summer months, solar power has, at times, been able to meet 20% of total UK electricity demand.

While heavy investment was undertaken prior to 2017, when renewable energy subsidy regimes were particularly enticing, cost reductions will play an increasingly prominent role in new solar-build.

A government report shows that by 2020, the Levelised Cost of Energy for solar power is expected to be £67 per MWh, compared with the £92 per MWh anticipated seven years previously.

In its Future Energy Strategy 2018, National Grid set out high projections for solar power, echoing the prediction from Shell CEO Ben van Beurden that solar “will be the dominant backbone of our energy system”.

A key attraction of solar power investment is high predictability during the estimated 25-year life of solar park components. Solar energy is converted into revenue, based partly on subsidies and partly on prices negotiated well in advance within power purchase agreements (PPAs).

Both wind and solar power are intermittent, depending on weather and light conditions. In time, however, the ability to store more renewable power – and release it into the grid when demand and prices are high – will boost returns from renewable energy investments.

Gresham House Energy Storage Fund plc (GRID) is one such energy storage business, the largest of its kind listed on the London Stock Exchange, with a capacity of 70MW that it is seeking to expand.

Aside from providing frequency balancing services, GRID expects to benefit from the many arbitrage opportunities arising from the increase in UK renewable generation output.

All-weather returns

Renewable Energy Infrastructure Funds (REIFs) – which have a combined market capitalisation of approximately £7 billion – offer an attractive means of securing exposure to the benefit of rising UK investment in these sectors.

The largest listed renewable energy funds are Greencoat UK Wind at £2.1 billion and The Renewables Infrastructure Group at £1.8 billion.

Since 2014, total REIF returns have been solid, approaching 10% per year. Targeted real dividend increases underpin the attraction, and major earnings shortfalls are low-risk, with little likelihood of a dividend cut. Prospective dividend yields for most REIFs are now 5% to 6%. As a result, the sector premia over net asset valuations for most REIFs now lie in the 9% to 19% range.

REIFs offer a defensive allocation for investors seeking consistent returns throughout the cycle. Share price ratings are boosted by the relative security of earnings. In most cases, wind and solar generators are largely protected via PPAs. Moreover, solar irradiation figures and wind speeds have historically been quite predictable.

Undoubtedly, REIFs, with a focus on a single technology or market, are more vulnerable to adverse regulatory decisions on subsidies. However, the wind and solar sectors are far less exposed to major political shifts than the broader utilities sector – given the Labour Party’s re-nationalisation commitments.

Moreover, holding a portfolio of diverse REIFs reduces the risk of exposure to a single fund or technology, and offsets the political risk of holding traditional utility stocks.

Nigel Hawkins is renewable sector analyst at Hardman & Co.

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