Why the sun is rising in the UK

The UK’s solar photovoltaic (PV) market has grown at an extraordinary rate over the past four years. From the domain of the ‘renewables enthusiast’ in 2009, it has grown into a serious £2 billion (€2.5 billion; $3.4 billion) industry today. This growth is set to continue until 2020, with the government targeting a tenfold increase in total market capacity.

Put in real numbers, there is currently about 2.7 gigawatts (GW) of solar PV in the UK. The government has recently announced that it would like to see this rise to between 10GW and 20GW by 2020, the relevant European Union (EU) carbon reduction target date.

As is often the case, the UK has lagged its European counterparts by several years, notably Germany, Spain and Italy. In this particular case, the lag has benefitted the UK as incentive mechanisms have benefitted from European experiences and – probably more importantly – manufacturers’ pricing levels dropping significantly in real terms over the last few years, thereby lowering the absolute support required to catalyse the industry as a whole.

‘Not smooth’

That said, the development of the UK solar PV market has not been particularly smooth. The initial catalyst for the market was launched in 2010 in the form of a Feed-in Tariff (FiT). The FiT is a government-supported incentive mechanism, which insures that any renewably-produced kilowatt hour (kWh) of electricity receives a 20- or 25-year guaranteed price which is linked to inflation.

This incentive mechanism was designed to support long-term investment and was proposed as a better scheme than the Renewable Obligation Certificates (ROCs) system which had been actively supporting the wind industry for over a decade.

The FiT revolutionised the solar sector and there was a huge up-take of solar PV installation, both by individuals and corporate developers. So large was the up-take and so rapid, that it clearly took the government by surprise and FiT levels were rapidly cut back to take the heat out of the market. While there was much grumbling – and a legal challenge – to these changes, ultimately the support levels were reduced.

These cuts were sensible and maintained expected returns at levels that were initially targeted by the government. As installation volumes rose, installation costs more than halved. Additionally, under previous incentive levels there was a massive outbreak of sub-standard developers trying to make a quick buck, resulting in poor practice and some bumper profitability at the expense, ultimately, of taxpayers. The reduction in the incentive helped to weed out some of this industry-damaging activity.

Secondly, while the cuts were not managed particularly well, the ensuing legal challenge did provide an important precedent. While future cuts could be introduced, any asset that was locked into a historical support mechanism at an established rate could rely on that support for the life of the asset. This is very important as it gives an investor confidence that the cash flows they invest in can be legally relied upon for the full term of the incentive.

Heat lowered

The cuts in FiTs brought them down to similar levels as the ROC scheme and, with the cut in installation cost, returns stabilised to sensible levels. The heat was taken out of the market, a lot of the short-term players where driven out and, as a whole, the industry has stabilised.

The additional effect of a rapid evolution of the market and relatively simple technology meant that there were a high number of disparate developers. This resulted in a highly fragmented market. While in total the market is large, there still are very few major players. The result was a relatively fragmented market in terms of investment. A large number of projects and portfolios were funded by individual investors, small opportunistic investors and the tax-incentivised Enterprise Investment Scheme (EIS) and Venture Capital Trust (VCT) funders.

As the market has matured and scales have increased, there has been a growing opportunity and appetite for larger institutional investors to aggregate portfolios of assets and invest for scale.

This is evidenced by a number of landmark transactions, notably Aviva’s purchase of the Homesun portfolio in 2012. This consisted of a £100 million portfolio of residential FiT assets. More recently, we have seen the listing on the London Stock Exchange of a number of aggregating vehicles, such as TRIG and Bluefield.

Now that scale is viable, the real benefit of solar PV investment can be realised by the institutional investor market.

Competitive

Solar PV represents a real asset investment opportunity, with low technology risk, short-term development timeframes, long-term predictable income and, due to the nature of the government incentive schemes whether ROC or FiT, an uncorrelated inflation linkage for up to 25 years. While returns are not exceptional, ongoing yields and conservative internal rate of return (IRR) assumptions make this asset class very competitive when compared with other long-dated income alternatives.

It is important to appreciate that looking forward there will continue to be changes to the market support mechanisms. As development and installation costs fall, so will (and so should) support mechanisms fall. However, what is clear and reliable is that historical government support will not be affected and this leaves a significant opportunity for the institutional investor.

The first opportunity lies in the aggregation of a market that is already operational and generating income. Despite a few players creating some aggregation, there is still a very fragmented market providing real long-term aggregation possibilities for the larger investor.

Secondly, despite changes in support, the UK solar PV sector has real momentum and investment opportunities are growing in scale and quality. The developer market is aggregating and, as a result, investment scale is becoming economic for the larger investor.

In future it is probable that the very large ground-mounted projects will be relatively small in number. The government has made it clear that they prefer a distributed power generation model and, in addition to this, political pressure will curb the wholesale carpeting of greenfield and high-grade farm land with solar parks.

Opportunity for the bold

But there is still huge opportunity for commercial scale, roof-mounted PV development and at Oxford Capital we have recently invested in significant portfolios of commercial roof-mounted PV assets. The commercial roof model also has the additional benefit of being able to secure more bespoke power purchase arrangements direct with the power consumer in the building thereby increasing return and lowering power price deflation risk.

To conclude, the UK solar PV market has grown significantly over the last four years. It has evolved from a fragmented and somewhat opportunistic sector into a mature and sizeable market and will continue to grow. The asset class itself has proved extremely reliable and performance and cash flows are predictable. When connected with solid government support mechanisms and a likely rising power price market over the next 20 years, solar PV makes a very alluring proposition to the institutional investor.

As scale develops further and the market continues to stabilise, investment yields and IRRs will tighten as we at Oxford Capital have seen over the last 12 months. The bold investor who understands the implications of recent history in the sector and can see beyond the short term will almost certainly benefit in the long term by accessing a very reliable asset class before the rest of the market catches on.

Oliver Hughes is an investment director, infrastructure at Oxford Capital, the Oxford, England-based fund manager.