Energy transition report
There’s conventional wisdom that when it comes to investing in renewable energy, the “doing” part is easy: you see outfits made up of two men and a truck, digging to put solar panels in the ground and constructing 5MW, 10MW, or 50MW of generation capacity.
But when looking at these investments, you still have to consider all kinds of variables that you can’t control – whether the sun shines or the wind blows, the likelihood of exceedance, and energy price development. And people don’t tend to give much thought to how, considering these variables, you generate value over the long term – even though that’s the most important issue, especially if you’re looking at a 25- or 30-year asset life; 40 years even in solar. Long-term value requires well-managed assets, and that’s more than modelling, negotiating and buying: it requires real technical and financial asset-management capabilities, and that’s no easy thing to achieve.
When KGAL started investing in renewable energy in 2003, although we made some typical rookie errors, we also quickly realised that being close to the asset is a key factor in preserving and creating sustainable value. So, as we built our portfolio, we also built our team, and today we have more than 50 people dedicated to renewable energy investments, with 30 of them responsible for the asset management of our portfolio alone – including four engineers supplying additional technical know-how for the risk assessment of the new opportunities as well as the performance management of existing assets.
“We take a bottom-up perspective on assets: we look at them individually, then aggregate across technologies, geographies and portfolios”
Many of these specialists have joined us from the world’s leading institutions in many different fields, such as utilities, developers, finance, industry, and investors, and together they are now responsible for 120 assets in locations across eight European countries.
We are observing increasing competition in the renewables investment market, including from generalist infrastructure funds and direct investors that perceive renewables as an easy option for sustainable returns. They’re introducing billions in ‘dry powder’ as they look to increase their allocation to renewable energy, which, in turn, means rising prices and declining returns.
So, in this market, the question that has to be in the back of everyone’s mind is, ‘when do the yields that you are receiving no longer really reflect the risks that you are taking on board?’ The answer really depends on how well you understand the risks and can manage them for the long term.
When looking at new opportunities in the market we make a distinction along the value chain between development, construction, operation and management, and the exit/repowering phase of an asset. Following that – and focusing on our Western European area of interest – we separate mature markets from less mature markets, to create a matrix that you can apply anywhere. For long-term returns of between 3 percent and 3.5 percent, with relatively low leverage, you can choose brownfield (operating) German (mature) wind investments. Then again, that market is super-hot and we believe that to really generate additional value, you must take on and be able to manage greater risk.
If we look at the value chain, how can we do that? If you have the right skillset, one option is to enter greenfield and work on mid- to late-stage project development; take assets through to ready-to-build; structure them; work out the kinks and get through the first years of operations, and then sell – or hold for the long term.
But the 50 or 150 basis points you can pick up this way is a reward that is not without risk or challenges. And it is essential to engage with those challenges to achieve that premium. The key risks we’ve identified range from environmental risks and revenue risks – Where are your revenues going to come from over the lifetime of the asset? When do you exit? – to problems around grid connection delaying development.
Identifying these risks is one thing, but when it comes to interpreting and evaluating their potential impact, and countering or eliminating them, it’s really experience that makes the difference.
So, if you want to deal with those risks and realise those higher returns, proactive asset management made up of a valuable combination of technical and financial skill is really what you need – and not just in the development phase, but also from the start of operations and throughout the working life of the asset.
In mature markets with many existing assets, you can identify and acquire, aggregate and maybe repower some assets: older wind assets, smaller turbines which can be replaced, and underperforming solar assets, of which there are plenty. We think these investments are attractive because you can lock in that base yield – low as it is.
That gives you options around the repowering and offers an opportunity to take advantage of that redevelopment.
There are also opportunities to lock in attractive yields in less mature markets, by pursuing a brownfield buy-and-hold strategy. There are still feed-in tariffs available, in the Baltics for example, though these are fundamentally different from what we saw in the sector earlier on. You might argue that once upon a time Spain and Italy were in the same boat that many emerging European markets find themselves in now – and look where it got them.
But there are a couple of critical differences today. First, there used to be a huge disparity between the Spanish feed-in tariff of 40 cents and the market price of 5 cents; there’s still a disparity today, but we’re looking at one-and-a-half or two times – not eight. And, also, chosen well, political factors are unlikely to hit as hard today.
The second key difference, and really the more important one, is that right now renewable energy investment is being driven by a competitive cost of generation. It’s quite clear that renewable energy can compete against other sources, beyond levelised cost of electricity, eye-to-eye – to true grid parity. This long-term driver offers some insulation against short-term shocks to the system and offers the prospect of a return which is sustainable for the long term.
“Long-term value requires well-managed assets, and that’s more than modelling, negotiating and buying: it requires real technical and financial asset-management capabilities”
And finally, implementing operations effectively requires you to have a system in place to monitor and control your assets under management: you must be able to measure and analyse what you’re doing, see what’s underperforming and understand the shortcomings.
An important thing to note is that we take a bottom-up perspective on assets: we look at them individually, then aggregate across technologies, geographies and portfolios. This approach enables us to identify, interpret and implement opportunities for optimising performance – in other words it shows us where we can create value.
Effective and proactive asset management enables us to add value to both the top and bottom line in renewables portfolios. For example, by increasing availability of assets, or making technical adjustments to improve productivity, or boosting profitability by bundling your assets’ output. On the cost side, if you have critical mass in your portfolio, you could look at bundling your own OEM services and tendering those – it’s not straightforward to combine a portfolio of 15 to 20 assets and tender them for maintenance because the issue is not just contractual but is also concerned with understanding the asset.
If you have the right skills, this can really lead to sustainable returns. A bottom-up approach is really useful in this context, too; understand the drivers so you can create value and focus on what’s essential.
There’s a case study from our own portfolio which really illustrates this approach. At the end of 2009 we bought a recently commissioned solar plant in Germany, with 60,000 solar modules and a 5MWp output.
Before long, we saw performance dropping and, after some investigation, it became clear we had a technical issue with the panels. The word on the street suggested the manufacturer might be the issue, and sure enough they stepped up fairly quickly, initiating a voluntary goodwill programme for replacing modules; by the end of Q4 2010 we changed a quarter of the modules and were back on track – for a while.
We kept monitoring the assets and we could see performance starting to dip again. We presented our detailed data backed by technical expertise to the manufacturer again, and after some back and forth we came to an agreement whereby a third of modules were changed again. Once more we saw an uptick as a result, but it didn’t last – the problem was clearly not going away.
We were ultimately able to negotiate an ongoing change programme with the manufacturer, whereby we cover some costs for logistics and under which we have now replaced two-thirds of modules so far. This happened because we stayed close to the asset: we could understand, identify and interpret the performance data and then take steps to optimise it.
The change programme has a payback period of about 4.5 years – which is fine in a 25-year fund. A short-term investor might have walked away after the first quick win. Or a less-experienced investor might have accepted the issues as unavoidable degradation and been satisfied with what they were able to achieve.
The postscript to this story is that in 2013 we recorded a 13 percent increase in revenue and 16 percent increase in EBITDA on that asset alone. It’s only one in a portfolio, but those figures put us back on track with the ambitious plan we had at the time. If we had walked away – as many did – after that first round of replacements, we would essentially have abandoned that value. So, proactive asset management can mean the difference between making money or not.
Renewable energy investment can deliver sustainable, differentiated returns compared with other real assets – and even compared with infrastructure investments. When it comes to the variables which no one can influence – resource yields, energy prices – you need to take a position on how you evaluate those risks and what they mean for your return expectations. And to capture those variable factors you need a skillset that ideally requires a combination of technical and financial abilities.
We believe it is a major advantage for us to have those skills in-house: if there’s a problem, we don’t have to call an independent engineer to quote and diagnose it – we can see what we’re dealing with ourselves. Moreover, we can work proactively across portfolios to see where value is being created or lost. So, I hope it’s clear why, although buying well is important, in our view managing well is the real key to unlocking value.
This story is sponsored by KGAL.