This article is sponsored by LGIM Real Assets.
The energy transition is building steam as Europe, the UK and the US continue to increase renewable capacity. The simplicity and falling cost of solar installation are at least partly behind this growth, but when might we see wind power development pick up? How are policymakers supporting renewables, and how stable will this be in years to come?
Marija Simpraga, infrastructure strategist at LGIM, shares her thoughts.
How has renewable energy capacity developed in Europe this year and what does this mean for investors?
Preliminary data from EU grid operators implies that 2023 is on track to be a record year for renewable energy capacity additions – the first 10 months saw more than the whole of 2022, itself a record-breaking year. This is largely down to a combination of policy and energy prices.
Decarbonisation of the energy market and a push for security of supply continues to underpin the secular growth trend for renewable energy generation in Europe and, in policy terms, we have seen rules simplified on permitting and planning. The power price forecasts are between 20 and 40 percent higher on average, according to Aurora Energy Research, over the long term than before the pandemic, and this structural shift upwards is boosting project economics.
Asset supply is therefore increasing in Europe, offering investors more choice and flexibility when constructing their portfolios. The fact that these additions now include a wider range of jurisdictions is helping investors gain a good level of geographical and technological diversification; Poland, for example, has seen a steep rise in solar PV installations. The pipeline is growing and investors are gaining access to more types of asset, from solar and wind through to batteries.
Where has most of the growth come from?
We have seen growth in both solar and wind, although both have faced challenges.
Solar has benefited from a sharp drop in solar panel costs this year, back to pre-pandemic levels. It is also relatively easy to scale and deploy, with more straightforward planning rules than for wind.
This is boosting solar deployment and we are seeing lots of growth in residential or non-utility-scale solar. Nevertheless, the solar industry has some supply chain issues with inverters and transformers, which has led to some delays in build-out.
Wind has faced a few challenges, in particular with the supply chain where equipment manufacturers have experienced delays to parts following the pandemic, and have been impacted by cost inflation from raw materials, transport and turbine components.
In turn, equipment suppliers have struggled with impairments and write-downs, and the market is still working through this as companies need to repair their balance sheets. So, pricing pressures are more acute in wind, plus delivery times are longer and installation is more complex than solar.
Nevertheless, we are seeing good investment opportunities in wind. For example, the L&G NTR Clean Power (Europe) Fund has recently acquired an 87MW onshore wind farm in late construction in Finland and has a number of wind projects in its pipeline across Europe.
To what extent will some of the pressures facing wind installations ease over the coming period?
It is currently challenging, especially in offshore wind and in new markets, such as the US and Asia. These markets need to establish supply chains, as well as assembly and logistics hubs for wind power generation equipment, and it is here that projects have suffered most. We have seen some US developers walk away from large projects and take write-downs.
We have also seen issues in the UK, where the most recent offshore contracts for difference auctions did not deliver the usual capacity. That was because the UK government wouldn’t allow bidding caps to be lifted, which would have, in effect, forced developers to absorb the increase in costs.
“Solar has benefited from a sharp drop in solar panel costs this year, back to pre-pandemic levels”
The technical guidance issued by the UK’s Department for Energy Security and Net Zero for next year’s auction, however, will see increases of more than 60 percent in what developers can bid, and that will substantially increase the viability of proposed projects – the pricing levels set out are more attractive to developers and, as such, we expect a greater aggregate capacity in next year’s bidding round.
In addition, onshore wind auctions in, for example, France and Ireland, have been successfully redesigned in the past six months with higher prices and indexation to attract more bids, resulting in more megawatts awarded.
Further afield, most forecasters believe we are seeing a supply-side shock that will work through the system. Equipment costs will increase over the short to medium term, but technological developments are coming online that will drive down costs in the long run.
Turbines are becoming more efficient and policy support could bring down the development costs and create more attractive structures. Overall, I think the outlook is more positive over the longer term.
What effect are policy measures having on investment opportunities?
The US Inflation Reduction Act and the EU response to that through initiatives such as the Green Deal Industrial Plan and the existing measures under REPowerEU are positive for investors. Estimates vary as to how much financial support these equate to, but they will offer hundreds of billions of dollars or euros.
We believe both will make a significant difference to the scale and speed at which renewable energy capacity is deployed. In the US, the measures offer an upfront reduction to capex, which allows developers and investors to recover their costs more quickly. There is a manufacturing element to the IRA, with credits for clean technology development and manufacturing. That is providing a pipeline of opportunities that wasn’t there before.
In the EU and UK, the emphasis is on creating the frameworks for predictable, long-term revenue sources through contracts for difference and power purchase agreements, supported by initiatives to reduce timeframes for planning. These kinds of long-term offtake agreements stabilise cashflows, and that is attractive for infrastructure investors. Both are exciting new opportunities for investors, and the fact that they are structured differently adds further diversification benefits.
The resilience of power networks has been an issue for some time. What is happening here and how much of an investment opportunity could this be?
This could be a significant investment opportunity and it is surprising that it tends not to be more prominent in strategies. For every $1 we spend on renewables, we need to invest around 90 cents on the grid to make it work, according to BNEF data for 2023.
We will require a huge amount of investment in cables and interconnections over the next few decades. It is also a well understood asset that is often already in investor portfolios. We will see more in the long term, but for now there is the political question of who pays and how.
Governments are grappling with this, but there will need to be a formula for how to allocate costs appropriately – that has yet to be devised. It will have to come, though, because we can’t have exponential growth in renewable capacity without investment in the network.
What future trends are you expecting in renewables?
Firstly, we think we will see more battery build-out. In Europe, there is significant activity in Germany, Spain and Italy, but the pipeline will build further.
The UK is seeing a phenomenal amount of battery capacity being developed. This should provide vital services to the network and help achieve energy security and decarbonisation goals, while also reducing costs to the consumer. We are also seeing a lot of activity in Sweden, which is starting to introduce battery storage.
Second, we have seen a repricing of assets to reflect the higher interest rate environment and the higher returns some investors are seeking. The paper valuations on asset investments have come under pressure and these have become an attractive entry point for investors – for example, listed renewables vehicles have experienced a widening price discount to NAV, putting pressure on these vehicles to realize assets.
And finally, we believe there will be more rooftop solar deals in the residential sector. Rooftop solar assets outside of the legacy feed-in tariff schemes are relatively new in Europe. This is becoming a growing market as more rooftop solar is installed across the continent – Germany in particular is experiencing rapid growth. And in our view there is further scope to grow, especially in areas with high solar irradiance, such as Southern Europe, where utility bills are also quite high currently.
We have seen pushback on the energy transition from some quarters. How confident can investors be that these policies will continue to support the growth of renewable energy capacity?
Europe has little choice but to continue to grow renewable energy generation. Local gas reserves are dwindling and, in any case, using gas doesn’t square with Europe’s climate objectives. Europe is firmly set on the decarbonisation and energy transition path and there is very little prospect of that changing.
In the US, the IRA is intended as a long-term policy. However, the political environment could shift. If a different administration comes in after next year’s elections, things could change. This is causing some uncertainty and it is likely to be putting the brakes on some investments.
Some of the conversations I have had in the US reflect concerns among investors that policy measures could be reversed quite quickly. There is an argument that once there is critical mass behind new projects, especially in post-industrial towns and cities, it would be hard to undo the IRA, but that is not guaranteed.
Of course, political risk is part and parcel of infrastructure investment decisions and so the industry is used to managing this. However, it is not used to seeing the level of political uncertainty and potential for policy swings in OECD markets; that is a new challenge.
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