Just like conventional private infrastructure, the renewable energy infrastructure space incorporates a wide variety of strategies spanning the risk-reward spectrum: at one extreme we find contractual, stable and income-generative (quasi bond-like) investments; at the other end we find a more development- and construction-oriented flavour. Target net IRRs on funds range from 6-8 percent for conventional renewable technologies in developed markets to more than 20 percent.
Yet, unlike classic infrastructure, which provides a substantial middle ground of modest value-add or high core-plus deals, renewable energy infrastructure is more polarised between two extremes. Indeed, how much ‘value-add’ can a manager provide once a wind farm is operational? Inevitably, many of the higher-return strategies involve entering projects at earlier stages of the lifecycle or venturing into those less proven segments of renewables.
Although a number of managers do offer funds targeting an intermediate return outcome, these portfolios are likely to be comprised of a barbell-type blend of conventional renewables and more opportunistic strategies rather than deals which individually deliver net IRRs around the 8-12 percent mark. This means that the decline of subsidy arrangements does not only affect those funds with more modest IRR targets but those in the intermediate space.
The chart illustrates some of the available sub-strategies along risk-return axes. We classify those at the bottom as ‘commoditised strategies’: here we find the solar and wind projects with cast-iron economics and cast-iron government support. This segment is characterised by established facilities, conventional technologies and part-guaranteed revenues, particularly in Western Europe. The bucket also includes some late-stage construction projects, such as those with EPC wrappers (whereby the contractors, rather than the developer, bear the bulk of the risk).
As we travel up the risk-reward spectrum, we see investors turning up various risk dials in search of higher returns. These include: similar strategies but with newer technologies, such as storage or energy-from-waste (operational/maintenance risk); deals in developing markets (political risk); and conventional technologies but at an earlier construction stage (construction risk).
In addition, there is the potential for excessive leverage in view of those increased risks. We refer to these as ‘crossover strategies’ because they tend to involve a more conservative aspect (eg, a well-established technology) and a more aggressive aspect (eg, more construction risk).
Investors should carefully scrutinise manager capability for a move towards greenfield investing. This is not always robust.
Storage and intermittency are particularly powerful themes at present: the wind does not always blow, the sun does not always shine. While renewables are becoming relatively mainstream, the infrastructure around these technologies – batteries, ecosystems to facilitate energy transition, infrastructure to cope with unanticipated fluctuations in voltage – is still rather nascent.
For example, we see managers that are investing in gas-peaking facilities alongside renewables to create an integrated offering that bridges the gaps. These projects are often exposed to merchant power price risk but benefit from their monopoly position that requires them to provide capacity to the grid.
At the top of the chart, we find ‘frontier strategies’. Examples may be deals with sole exposure to merchant power prices; newer technologies, such as geo-thermal or bio-energy; projects in emerging markets involving construction risk; and conventional projects in mature markets involving more development risk. Much of this segment is developer-led, with some indeed either launching funds or partnering managers.
IS THE BOTTOM FALLING OUT?
We are currently in the last wave of subsidy arrangements for renewable energy projects. The UK, for instance, saw the final wave of ROC-approvals during the last two years. While there will still be some assets coming through the construction phase, and the market for trading these assets will continue, the lack of new creation will lead to overall shrinkage in supply. In addition, we see the returns on these assets undergoing compression: they are already down to the 6-7 percent mark in the UK and even lower in France and Germany.
What will be at the ‘bottom’ of our chart in the new, post-subsidy universe? We see managers increasingly exploring corporate PPA deals, whereby large companies underwrite long-term agreements to purchase a certain amount of power at certain rates. This type of arrangement is quite mainstream in the US (circa 8GWh of corporate PPAs were entered into in 2018, according to the Green Investment Group) and more nascent in Europe. At present, they sit somewhere in the middle of the available risk-reward spectrum. It is worth taking time to think carefully about the risks involved and, in particular, how many corporates today will still be here in 30 years’ time.
If one were to play devil’s advocate for a moment, one might see the decline in availability of deals at the lower-risk end of the spectrum as an opportunity for those prepared to play in the somewhat higher-risk territory. This might involve taking projects through development and construction (as well as securing long-term revenues) and selling these on to patient long-term investors looking for an annuity stream.
There are some very compelling opportunities available at present at this end of the spectrum. In the US, for example, certain tax incentives will begin to be phased out from 2021, producing a raft of available deals where investors can develop projects and essentially play a cost-of-capital arbitrage.
Renewable energy funds, like other thematic strategies, have benefited from the rising interest in ESG broadly and impact investing in particular. Yet, ESG credibility is not straightforward. While renewables may appear to represent an easy way to tick the ‘impact’ box, today’s sustainability-oriented investors are concerned about the broader ESG picture, not simply the clean-energy label. Although much of the renewable energy manager landscape has been able to ride on the coat-tails of ESG-conscious investing in private markets, the ‘E’ is only one component of ESG.
As the ESG agenda matures and benchmarking improves, renewables managers will need to demonstrate their credentials beyond the ‘E’. For example, bfinance has come across investors concerned with wildlife protection during the construction of assets, with the health and safety measures in place for workers at a biomass plant and even with the reputational effect of any dividends being channelled via offshore tax havens.
One interesting trend in renewables is a growing emphasis on the ‘S’: the social impact that can be delivered. This is particularly applicable for projects in emerging and frontier markets, where that new energy supply may be critical to supporting and developing the nation’s economy.
DEATH OF A FIXED-INCOME PROXY
So, what does this all mean for investors? Clearly, the proliferation of renewables strategies in the market is a positive development. However, asset allocators will need to gain more comfort in merchant-project economics, as government incentives and subsidies are phased out. Even where subsidies persist, investors seeking higher returns will need to take on more construction, power price, counterparty, political or operational risks as yields continue to compress. The sector should no longer be approached as a ‘fixed-income proxy’.
Yet this challenge also brings opportunities for those capable of navigating the less conservative end of the spectrum.