Historical data and finance theories provide little guidance on the risk-return profile of the infrastructure asset class. Unlike equities or fixed income, there is little reliable data on historical performance. Therefore, infrastructure fund managers use anything from inflation plus margin to a blend of equity and bond indices to measure performance.
For infrastructure assets, practitioners typically use a multiples-based approach or an income approach such as Discounted Cash Flows (DCF) to calculate value. However, due to the different return profile of infrastructure assets, these approaches need to be modified. For example, for valuing regulated assets, relevant multiples such as EV/RAB or EV/MW can be used instead of more conventional EV/Revenue or EV/EBITDA multiples.
As part of the income approach, the Capital Asset Pricing Model (CAPM) is often used to calculate the discount rate applicable to discounting cash flows. As CAPM measures the required return on equities with reference to the performance of the stock market, its usage to estimate a discount rate applicable to infrastructure asset cash flows is limited.
INTRODUCTION TO VALUING RENEWABLES
Renewable energy assets represent a niche segment of the overall asset class. Compared with others, renewable energy assets have a different risk-return profile due to the following factors:
Long-term incentive schemes in the form of subsidies;
Lower financial leverage;
Lower construction risk;
Lower revenue volatility and input price risk.
Renewable energy projects typically generate inflation-linked income for a fixed period under feed-in-tariff (FiT) and renewable obligation certificate (ROC) schemes in addition to brown power revenues (for 20 years). Although the period of support has been reduced under the new contract-for-difference (CFD) scheme, projects still benefit from a stable cash flow for 15 years.
Infrastructure assets are typically highly geared, comprising as much as 60 to 70 percent debt. However, our observation of UK renewable energy funds shows that some projects are not highly geared at all.
Unlike other infrastructure assets such as power plants or airports, renewable energy typically exposes developers to limited construction risk. They might also have low volume and input price risks compared with other infrastructure assets. For instance, while cash flows of renewable assets such as biomass plants are sensitive to input prices (e.g. wood chip feedstock), the majority of existing assets generate electricity from sources with zero input price (e.g. sunshine and wind) with little to no volatility – a key differentiator compared with traditional energy generating assets.
THE CAPITAL ASSET PRICING MODEL (CAPM)
The CAPM is often used to calculate the discount rate applicable to discounting cash flows.
When using it, we refer to comparable company data from the stock exchange to measure the risk of a subject company. The calculation also requires an equity risk premium which is the incremental return required by investors over the risk-free rate to invest in equities of listed companies. The risk and return profile of a renewable energy asset is different to that of a company – therefore CAPM is unlikely to provide the best estimate for the required return.
Some of the risks associated with equities are not present in renewable assets. Input price variability (raw materials, labor, etc.) and product price variations (due to competition and market conditions) are not as prevalent in impacting the return of renewable assets in a similar way.
Using CAPM also requires an estimation of the beta1 and optimal capital structure, which is challenging. While one might be able to obtain comparable data from listed renewable energy funds or utility companies, the wide variety of power generating assets within their portfolios and inconsistent gearing levels make the calculated beta or optimal capital structure meaningless.
IMPLIED INTERNAL RATE OF RETURN (IRR)
Given the limitations of CAPM, it is more appropriate to use the unlevered IRR implied by the consideration paid for renewable assets. As the pricing is competitive and changes based on the specifications of the asset and market conditions, the implied IRR is a more reliable measure of required return than that calculated using CAPM.
A renewable energy project’s implied IRR comprises the risk-free rate plus the required return for technology, incentive scheme and project-specific risks. It is also impacted by the level of supply and demand in the investment market. The required return used for valuations however, should only account for the asset’s risks, and not include any variations caused by market conditions. It is therefore important to look at the components to an asset’s IRR when calculating an unlevered discount rate.
IRR = Risk-Free Rate + Rtechnology risk + Rincentive scheme risk + Rproject specific risks + ?
Risk-free rate is determined by long-term bond yields. The current low interest rate environment has led yield-seeking investors to acquire renewable assets with IRRs as low as 6 percent. As the interest rates move up, we would expect to see assets traded at higher IRRs and lower prices.
Return for technology risks: this return compensates investors for a technology’s maturity, production reliability and maintenance costs. For example, solar power production relies on the level of solar irradiation, which exhibits lower variability than wind and would generate less risky cash flows.
Return for incentive scheme risk: the various incentive schemes in the UK each expose the asset cash flows to certain risks. For example, while renewable energy projects under the ROC incentive scheme have exposure to wholesale electricity price variations, the new CFD scheme has removed this exposure by providing payouts to fill the gap between the actual electricity price and the contractual strike price.
The risk of changing the support level has also been reduced under the CFD regime as unlike previous schemes, there is no mechanism for the Department of Energy and Climate Change (DECC) to change the strike price set in the contract. Investors therefore expect a lower return for CFD projects than those under ROC and FiT.
Although one of the intentions of the transition to CFDs might have been to reduce the price uncertainty, DECC’s delays to the CFD auction process are now in fact adding to it.
Return for project specific risks: the implied IRR of newly acquired projects may include a premium due to the fact it is difficult to obtain reliable P502 forecast data for small renewable assets which translate into a more volatile cash flow. The stage of the project also affects the required return and the implied IRR.
Residual (?): the IRR can change due to market conditions such as high demand from investors. This would push up prices and reduce IRRs, as was seen in the spiked demand for acquiring >5MW shovel-ready solar projects ahead of the first changes in the FiT scheme. Temporary variations should not impact the long-term required return applied to project cash flows. Therefore the implied project IRRs need to be adjusted in certain market conditions.
As you can see from this brief overview, as is the case with any valuation, the more angles or perspectives you are able to approach a project or company from the better. Academic theories provide a useful methodology but one must always ensure that the resulting value makes sense in the wider context and market where assets are exchanging hands each day. There is no better indicator for value than what someone is willing to pay for it.