Why hydro should make a bigger splash

Photovoltaic and wind power investments have become established features in the asset allocations of many institutional investors over the past decade. However, despite accounting for an average of 15 percent of the world's total energy mix and two-thirds of the capacity produced by renewable sources, institutional investors' exposure to the third classification of renewable infrastructure – hydropower – has yet to reflect its significance in the global energy matrix. 

Research(Source 1) commissioned by Aquila Capital showed that just 7 percent of European institutional investors have any exposure to hydropower, compared with 37 percent to photovoltaic and 29 percent to wind power investments. 

However, this could be set to change. While hydropower plants are mostly owned by large and medium-sized energy suppliers, several of these firms are selling their hydro assets in order to offset losses in other areas of their businesses. Low electricity prices have turned the gas sector, for example, into a loss-making business for some electricity suppliers and hydroelectric plants have been sold off to shore up balance sheets.

Furthermore, assets have been divested for purposes of consolidation, as examples of major European energy suppliers in Southern Europe and Scandinavia have shown in recent years. These enterprises are shifting the essentially regional focus of their businesses with a view to making their processes and operating structures more efficient and they are re-assessing energy generating assets located outside their core focus.

BUY-TO-HOLD

Aquila Capital's research(Source 1) revealed that over half (52 percent) of institutional investors are committed to diversifying and growing their renewables exposure, so we expect that institutional investors with a buy-to-hold strategy will take advantage of these new opportunities to invest in a sector that has previously offered few openings. But if institutional investors are about to focus more heavily on hydropower, where are the best opportunities? What are the characteristics of hydropower and how should they look to expose their portfolios to a sector of which they generally have little or no experience? 

The load profiles of the three forms of renewable energy differ significantly – making them all the more attractive as elements of the same portfolio. For example, photovoltaic plants exhibit high volatility over the course of the day and do not produce electricity at night. The output from wind plants is highly dependent on location. Both are highly reliant on seasonal factors.

Of the three renewable energy sources, hydropower's output tends to be more predictable and steady and is not substantially reliant on the time of day or season of the year. A report published by Aquila Capital earlier this year, entitled Real Assets – Hydropower Investments, estimated that hydropower has a correlation coefficient of less than 0.3 with photovoltaics and wind power.

As a result, combining hydropower with the other renewable energy asset classes yields distinct diversification advantages, namely a decrease in overall portfolio volatility and an increase in returns. A study(Source 2) by Vienna University of Technology revealed that diversifying across the three asset classes and across geographies results in distinct stabilisation effects at the portfolio level.

ECONOMICALLY VIABLE 

Apart from diversification, hydropower offers further prominent benefits. In addition to being an economically viable technology in terms of maintenance and operating costs, hydropower also has among the best conversion efficiencies of all energy sources with an efficiency factor of between 90 percent and 95 percent. On average, a hydropower plant generates approximately five gigawatt-hours of electricity per megawatt of installed capacity per year, which is around five times as much as a photovoltaic plant. Hydropower also exhibits the highest peak load hours within the renewable energy subset.

Hydropower plants tend to operate on an economically self-sufficient basis without state subsidies or cross-subsidies. As the technology and market participants are mature, there is little need for large-scale support schemes or state-guaranteed feed-in remuneration. The exposure to spot market price risk can be reduced by entering into long-term Power Purchase Agreements (PPAs). As a result, the share of debt financing for hydropower plants is usually significantly lower than for other renewable energy investments.

For all its benefits, investing in hydropower is complicated. It is a highly specialist area and institutional investors need to consider some key factors before investing directly, through partnerships or fund vehicles. 

There are several reasons that make access to hydropower as an investment opportunity more difficult. It tends to require higher up-front investment per capacity unit, making it less scalable than wind power or photovoltaic plants. The technical know-how required for hydropower investments is more challenging, since the success of a power plant depends not only on technical and structural components but also on active management of the asset and electricity production. 

COMPLEX

Accessing investment opportunities is also more complex than in other renewable energy sectors. But given how well hydropower complements photovoltaic and wind investments both meteorologically and technically, and its economic viability without having to rely on government subsidies, the additional complexity is justified for many investors.

For an investment in hydropower to be successful, projects must be actively managed over their entire lifetime, which not only demands extensive know-how, but also requires portfolio management, valuation, controlling and risk management resources.

The successful implementation of long-term investments in hydro assets requires expertise in different fields. Asset managers or investors must possess technical know-how about operations; must be capable of performing hydrological assessments; and must develop scenarios involving output pricing and volume agreements. The final assessment of the profitability of investments should be made in conjunction with the relevant experts and investors.

In order to source attractive investment opportunities, direct market access and an extensive sector network are key. Many existing power plants tend to be sold through a tendering process. Potential participants are well advised to have undertaken a preliminary appraisal accompanied by a thorough due diligence process. Assessing technical integrity, financial, legal and tax conditions form a comprehensive process before acquiring a portfolio of assets.

There are also geographic considerations. Hydropower stations have been built in approximately 100 countries. However, the share of the energy mix varies significantly from country to country and can reach up to 99 percent in Scandinavia. The importance of hydropower stations has increased further in recent years in response to the promotion of renewable energy to help fulfil political goals of reducing CO2 levels.

SMALL-SCALE

From a global perspective, Europe has little potential to develop large additional hydropower plants. For this reason, buying existing plants and developing small-scale hydropower is the normal acquisition strategy in Europe. By contrast, less established markets such as Asia and Africa still have expansion potential of 77 percent and 91 percent respectively, but tend to be a small part of a core investment strategy for institutional investors.

Research(Source 1) by Aquila Capital shows that in Europe, institutional investors prefer to buy existing operational plants. Institutional investors tend to be reluctant to bear the country-specific risks in Asia and Africa, such as poor infrastructure and political and regulatory uncertainty.

Hydropower investments are distinguished by characteristics that cater to the requirements of institutional investors that aim to cover long-term liabilities. Even in times of economic weakness and rising inflation, they deliver long-term, stable cash flows which are uncoupled from wider financial markets, providing diversification versus traditional asset classes such as equities and bonds.

These attributes make hydropower a highly attractive investment. Given the volatility that has been seen in equity and bond markets in recent years, institutional investors should consider how an increased allocation to hydropower can significantly improve a mixed portfolio's overall risk-return ratio.