Renewable energy generation will undoubtedly play a leading role helping countries meet their net-zero emissions targets, but each source ultimately depends on variable weather conditions.
“Overall, we believe the build-out of solar and wind capacity will mitigate the effect of decreasing hydropower output”
Swiss Life Asset Managers
Hydropower developers evaluate decades of weather data to assess the viability of projects and their expected yields, and to provide institutional investors with a sense of whether they are an attractive prospect. Reliable cashflows and positive carbon footprints have made hydro projects a sought-after asset class, but the data may now be working against them.
The northern hemisphere experienced its second-hottest meteorological summer on record, according to the US National Oceanic and Atmospheric Administration (NOAA). Across Europe and North America, a summer of droughts has substantially depleted assets’ capacity to generate due to ‘evaporative demand’, which quantifies the loss of water due to atmospheric conditions.
“The persistent excessive heat increased evaporative demand which, when combined with below-normal precipitation, made drought conditions worse from Spain to Germany and from the British Isles to the Balkans,” the NOAA noted in its August report, adding that much of the US also experienced droughts during August.
Last year, the Intergovernmental Panel on Climate Change warned in its Sixth Annual Report that larger areas would suffer droughts as global temperatures rise. This has obvious implications for society in general, but also for investors.
Long-term drought conditions could have a considerable impact on hydropower production and the viability of plants, according to Rune Jensen, senior partner of global energy technology investor EV Private Equity.
“In the regions suffering more long-term droughts over the last several years, for example in the western part of the US, droughts have impacted both production capacity and production efficiency,” Jensen says. “Therefore, the economics of these power plants may have been significantly hit.
“In addition, when suffering severe droughts over the longer term, these players also risk hurting their traditionally strong reputation of being a stable and reliable supplier of electricity in their local regions. This is particularly important in countries and regions where hydropower plays a large role in the energy mix.”
He also notes that the impact of droughts on hydropower plants has added to the global energy crisis, particularly as nuclear and coal power plants are being shut down and fewer investments are made in oil and gas.
“This helps us understand the importance of energy security, with increased electricity production from a portfolio of renewables, combined with improved grid and energy storage solutions,” says Jensen.
However, not all parts of the continent, or the world, have been equally affected. Indeed, shifting weather patterns mean that the generation potential has increased in some regions. While some of these unmovable assets could become obsolete, new opportunities could emerge in other areas.
Scandinavia has been experiencing wetter-than-usual conditions during the summer months. This is part of a longer-term trend, says Marc Schürch, head of renewable energy at Swiss Life Asset Managers.
“This year’s hydrological situation is in line with our long-term expectation: more precipitation in the north and less in the south compared to the long-term averages,” he says.
“This could reduce returns for investors, especially if lower-than-expected power production is not compensated by higher power prices and if such weather conditions are not taken into account during the acquisition of assets.”
Swiss Life Asset Managers is focusing its hydropower activity in northern Europe and its other types of renewable energy in the regions where it anticipates lower rainfall.
“More hydropower production this summer could have had a dampening effect on the high power prices in Europe,” which followed Russia’s invasion of Ukraine, Schürch says. “Overall, we believe the build-out of solar and wind capacity will mitigate the effect of decreasing hydropower output in the countries where lower output is observed and expected.”
In the UK, where hydropower accounted for just 2.1 percent of the renewables mix in Q4 2021, according to National Grid, the challenges posed by one of the hottest summers on record and widespread drought had largely been planned for, says Simon Hamlyn, chief executive of the British Hydropower Association.
“When developers consider developing hydropower schemes in the UK, they don’t just raise the funds and build it – they do a significant amount of pre-construction work, which can include assessing the forecast for rain over a period of time, historically and looking ahead,” he says.
“As with all forms of renewable generation, such as solar and wind, data sometimes includes best guesses. In many cases, you can’t be any more precise than that. Some months are completely at odds with the forecast and others are identical. There’s often no precision, rather it provides indicative guidelines.”
Beyond Europe and the US
Brazil is the second-largest hydropower producer in the world after China, making up two-thirds of its electricity generation, according to the International Energy Agency, and is a country that has drawn much interest from investors in recent years.
“In the case of Brazil, hydro is the cheapest source of energy and it’s very reliable. But when there’s a drought, the energy prices spike,” says Eduardo Monteiro, co-chief investment officer at Victory Hill Capital Advisors, which manages the London-listed VH Global Sustainable Energy Opportunities fund. “You have less production, but on the other hand, you [typically] get better energy prices [as an investor] because the system in Brazil is so dependent on hydro.”
Brazil has been investing heavily in other renewable sources, such as wind and solar, says Monteiro, which reduces pressure on hydropower during times of drought. However, due to Brazil’s long-term experience in hydropower, there is a lot of data on rainfall and drought occurrence.
“The interesting thing about hydro in Brazil is that assets are often very old; they were the first to be built and have longevity,” he explains. “These assets can be 40-60 years old – one that we bought recently was built in 1973 and looks immaculate. So we have long series of data on rain periods and droughts.”
Furthermore, the structure of Brazil’s energy market and consortium-based approach means that risk is spread for hydro plant owners if there are shortfalls in energy production.
“As with all forms of
such as solar and
wind, data sometimes
includes best guesses”
British Hydropower Association
At the other end of the rainfall spectrum, even the world’s driest inhabited continent, Australia, has more than 100 operating hydroelectric power stations with a total installed capacity of around 7.8GW, according to government body Geoscience Australia. Most of these plants – which contribute 5 percent of the country’s total energy consumption – are located in areas with the highest rainfall and elevation, with more than half (55 percent) located in New South Wales and 29 percent in Tasmania.
“Hydro assets are a relatively scarce sub-sector within renewables,” says Daniel Beaver, director at Australian asset manager ICG Asset Management. “Anyone can build a wind or solar farm, but it is more challenging to secure a project on a quality hydro resource. These assets were traditionally built and owned by governments.”
The sector also faces climate change effects that could affect the country’s hydropower plants, both positively and negatively. “Climate change can create less predictable weather patterns, which include periods of both drought and high rainfall,” says Beaver. “The Australian east coast is experiencing a La Niña event, which increases the chances of above-average rainfall. Dam levels at ICG-managed hydro assets are close to record highs.”
Drought conditions can lead to a shortage of hydropower as well as to higher energy prices.
“In the short run, droughts mean that less hydropower is available,” explains Peter Bird, a managing director at global consultancy Berkeley Research Group. “But this has an upwards impact on the price of power, depending on just how much power is lost, as well as on local and regional market factors.
“As far as the current situation goes, there will likely be very little impact. Only after two or three years of sustained drought might we expect to see projects failing.”
If drought conditions become more regular, some lending banks might become more cautious when assessing the funding of hydropower projects, says Bird, which could mean that investors have to subscribe more equity and finance and rely less on debt.
However, Bird says that most investors and lenders are “acutely aware” of drought risk for hydropower plants and will already have processes in place to assess the impact of drier conditions.
“Traditionally, they address it by building financial models that incorporate drought risk and ensuring that the projects they invest in remain viable during drought conditions,” he explains. “One-off droughts are likely to have little effect on investors.
“Behaviour will only change once investors and lenders, as well as hydrological specialists, start seeing indications of a permanent change in the frequency of droughts,” Bird adds.
Hydropower is playing an important part in the transition to clean energy, and more capacity is needed, according to the International Hydropower Association’s 2022 Hydropower Status Report. However, in 2021, just 26GW of new capacity was put into operation, “well short of the 45GW that the IEA says is required to meet net-zero goals by 2050 and keep global temperature rises to 1.5 degrees Celsius”.
Eddie Rich, chief executive of the IHA, says that progress could be “supercharged” by accelerating the development of pumped storage hydropower, opening up untapped opportunities in regions such as Asia and Africa, and by modernising existing facilities.
Some $127 billion will be spent on modernising ageing hydropower plants between 2021 and 2030, according to the IEA’s Hydropower Special Market Report, mostly in advanced economies. The modernisation of all ageing hydropower plants around the world would require $300 billion over the same period.
More opportunities are also appearing in the micro-hydro sector, typically classified as those with up to 100kW of installed capacity, says the BHA’s Hamlyn. That sector has even greater efficiency than larger projects.
As such, there is a big opportunity for the sector. And its investment characteristics should continue to appeal to investors, says EV Private Equity’s Jensen, due to the global trend of electrification and the “general stability” of hydropower over other renewables.
“Investment in this sector is, for many players, a long-term decision,” he explains. “Even with global warming, there will be periods with more rainfall and good profitability within the sector.
“It may be too early to pass judgement on the long-term value creation for specific regions and power producers. Nevertheless, seeing that in parallel with droughts in some regions, other regions of the world have record high rainfall and power production, a more global portfolio approach is, therefore, something some investors investigate.”