Quinbrook Infrastructure Partners: Are eyes wide shut to renewables risks?

Renewables have attracted a lot of capital, but Quinbrook's David Scaysbrook and Rory Quinlan question whether investors are taking full account of the increasing risks.

This article is sponsored by Quinbrook Infrastructure Partners

As the energy transition picks up further steam, power markets are changing beyond recognition. Annual investment into renewable power has increased from less than $50 billion in 2004 to around $300 billion over recent years, according to the International Renewable Energy Agency.

These figures will only keep rising, but the risk-return characteristics of renewables are shifting. We spoke to Quinbrook Infrastructure Partners co-founders, David Scaysbrook and Rory Quinlan, to get their take on the key risks in today’s renewables market.

Investor interest in renewables is higher than ever as the energy transition picks up pace. How is the renewables landscape changing?

David Scaysbrook: Renewables is a relatively new asset class for many investors and we see an optimism bias in the market with a rush to get asset exposure. There is a flood of new entrants that don’t have long-term power sector experience and aren’t seeing the warning signs. Even experienced industry players are being impacted. We are now witnessing a separation of the ‘wheat from the chaff’ in the relative performance of GPs who have invested in renewables.

Back in 2010, renewables as a standalone strategy was a really tough sell to investors. That’s all changed but institutions are starting to see value impairments they didn’t think were possible. Investors are being presented with the ‘glass half-full’ picture when a fund is sold to them, but there are emerging risks they need to be very conscious of. Like most things, it comes down to manager selection, the fundamental features of the investment strategy and downside risk protection.

There are material shifts happening in the world that should give investors pause for thought. Take the Texas freeze event earlier this year, which decimated asset values for many renewable projects in that state. Elsewhere, we are seeing power prices go negative and the production of wind and solar projects substantially constrained at certain times.

None of those events were foreseen when the investments were committed by their sponsors. For a host of reasons, I think this is the riskiest time for investing in the power sector that I’ve seen in the past 30 years.

What will be the key developments over the coming years?

DS: There are several mega-trends we see. Solar and battery storage will be teamed together more often and this will be very potent in reducing power prices – that will be the ‘engine’ of the energy transition. Renewables will also be increasingly valued for their carbon abatement impact above any other factor. We are already seeing this with the Locational Marginal Emissions project we are working on with ReSurety.

Pricing and value will coalesce around carbon impact more than being a product of pure MW generated. Full 24/7 carbon accounting and tracing will also become critical as Scope 3 emissions become possible to track and measure with improvements in compliance, data collection and processing.

Technology for the management and trading of power supply and the interface with customers will strip away unnecessary cost in the administration of delivery and consumption of power. We will definitely see more choice and innovation, as well as the application of artificial intelligence and machine learning right across the energy system and the management of distributed energy assets, especially the optimisation of battery storage. That technology will help manage the demand side more, lower costs further and increase overall system efficiency.

Is the current phase of the energy transition too risky?

DS: Yes and no. It really comes down to how you are managing ‘uncontrollable risk’ in an era of increasing disruption. There are a lot of aspects at play in power and energy markets. One of these is around fundamental price formation because what set the price of electricity historically won’t set it in the future. The factors governing power markets included centralised system planning – the static nature of the technology deployed and the fact that power was often generated and distributed by utilities – meant nothing was very dynamic and prices were stable and predictable.

Renewables technology advancement and cost has changed this entirely. You have solar and wind generation at a fraction of the cost it once was and most often way cheaper than conventional power sources. And you have a splintering of the incumbents sitting on legacy assets versus competitive new entrants deploying the latest and cheapest.

Rory Quinlan: Previously, you could think decades ahead and not worry about technology obsolescence. You could look at a gas-fired power station and agree 25- to 30-year revenue contracts. Risks were largely allocated to the utilities, that were best placed to bear those risks due to their monopoly power and they could pass on increased costs to customers, who were captive.

The world today is very different. Everything is more fragmented, customers can generate their own power using cheap and user-friendly technology and power is being priced every five minutes. The 30-year timeframe has shrunk to just 10 years or less. The scale and speed of the contraction in the risk/return horizon has been extraordinary.

How is this rate of change affecting markets and regulation?

DS: Power markets in the US, UK and Australia, where we invest, were not designed for the influx of lots of intermittent renewables with zero marginal cost of production. We’ve seen solar power in particular cause huge price drops and system disruption.

But we are just getting started with battery storage now set to proliferate around the world, making power storable for the first time in history. This enables power to take on a commodity-like character and the implications of that are just starting to become apparent.

Even the cost of hydrogen electrolysers is coming down fast – for certain applications they’re half the price they were 18 months ago and no-one predicted that. History has shown us that LCOE forecasts in renewables are usually quite conservative and so if we know these forecasts are wrong, the question is by how much.

RQ: Unsurprisingly, power buyers expect prices to keep falling so contracts are shortening in duration. That’s rational behaviour by buyers because of the rate of change we’ve seen over recent years. But it means that the contract duration is often materially shorter than the life of the investment – sometimes half or even less. That’s a massive risk exposure.

How is this affecting returns?

RQ: This may erode expected returns on many assets that are already built and operating, especially where they have been too optimistic about future power prices. These are ‘uncontrollable risks’. The level of uncontrollable risk in many renewables investments has increased materially, yet those risks are not being factored into a lot of asset pricing.

DS: You are effectively exposed to what drives electricity price and value 15-20 years from now and that’s a long time when you might be facing technology obsolescence because things are changing so rapidly. Despite all this, renewable energy has been so successful over recent years that in some markets it is starting to ‘cannibalise’ itself.

What do you mean by that? How is renewable energy cannibalising itself?

DS: There is increasing saturation risk in certain markets and we expect this to continue as new capacity is built. Wind gets built where it’s windy and solar where there is high solar irradiance.

That’s perfectly logical as historically that has generated the best returns. However, at higher levels of capacity build, you can get saturation and curtailment of production because too much capacity is operating in the same location. When the wind blows, for example, all the wind farms are at full output and power prices plummet. Texas and Oklahoma are but two examples of this challenge.

You also see this with solar in California, with the now famous “duck curve” where prices fall in the middle of sunny days. We see frequent periods of zero or even negative power prices when there is too much solar generating within the same region. This is what we mean when we say cannibalisation.

RQ: There is a range of risks coming onto the radar that are each material – technology obsolescence, power price formation, saturation and cannibalisation, regulatory change, shorter term contracts and so on. The overall impact of any one or more of these risks if left unmitigated, is a serious threat to equity.

This gets worse when investments are heavily levered. In our experience, some investors focus their attention on development or construction risk which is actually ‘controllable’ and therefore manageable. This focus is therefore misguided if you then sleepwalk into these other risks that are far more impactful to invested capital on the downside.

How can investors mitigate these risks?

RQ: Project development needs to be a lot smarter and investors should be more discriminating in selecting the projects they commit to. Not all projects are created equal. Location and siting are more critical than ever and you need a project to have an enduring competitive advantage.

DS: There are ways to effectively mitigate these risks to a meaningful degree. You can create meaningful partnerships with corporates to agree long-term supply arrangements and engage in risk sharing.

It’s possible to structure investments so that you can get corporates over their concerns around potential price reductions in the cost of renewables and obsolescence. One of the most important features of this approach is having unique project locations – the closer you can be to the end-customer demand, the more scope you have to build protection into the offtake agreements.

Future developments need to be smarter, better structured and tailored to helping customers meet their decarbonisation aims. It’s a B2B market that bypasses the utility intermediaries. One thing is for sure, the market doesn’t need another plain vanilla wind and solar fund!