Sunny side up

At the end of April, Mohammed Bin Salman, Saudi Arabia’s deputy crown prince, confirmed plans to list a slice of Saudi Aramco, the country’s national oil company. The transaction, which could value the company at over $2 trillion, would set a precedent by its sheer size. But raising money may not be the kingdom’s prime objective: as energy prices remain low and volatile, the country is looking to diversify its economy away from its oil roots.

As we meet with three renewable energy specialists on a mid-May morning, Saudi Arabia seems rather far away. With the spring monsoon in full swing, London skies are offering commuters little chance of reaching their offices dry. Yet the decisions of a Saudi prince hint at a shift with much relevance for the discussion we are about to have: for public and private actors worldwide, going green has become a trend not just for climate change considerations, but also for economic reasons.

That is certainly true of institutional investors. “At the beginning, investing in renewables was something limited partners did out of their infrastructure pocket. More and more often, however, we meet LPs that have dedicated allocations,” says Riccardo Cirillo, a managing partner at UK-based fund manager Platina Partners.

Dominik Thumfart, a managing director at Deutsche Bank, adds that their decision is partly opportunistic: there has simply been more dealflow in renewables than elsewhere.

“A lot of the deal pipeline in recent years has been taking place in the renewables space. But the sector also has some common traits with PPPs: it falls under a regulatory framework which offers direct governmental revenue support, or utilities are required to enter into PPAs [power purchase agreements] with developers and owners of renewable assets.”

COP21, the climate change conference in Paris in December, certainly gave the effort a boost, observes Oldrik Verloop, head of international client advisory at Hamburg-headquartered Aquila Capital. “A clear aspect of the conference is that it has put the effects of climate change higher up on decision-makers’ agendas. That’s true of both regulators and asset holders.” Yet he reckons macro factors have a more direct influence. “Urbanisation, changing demographics, energy consumption, funding gaps, what is currently happening in equity and bond markets, those are the drivers behind the inflows we are currently seeing in infrastructure.”

Global liquidity conditions also have their importance, adds Thumfart. “We now have six central banks around the world that are pursuing negative interest rate policies. Any asset class that gives you positive yield will, by definition, form part of your asset mix.” Cirillo, though, sees a parallel to what happened in real estate, with renewables allowing LPs to adopt a particular angle on the infrastructure play. “We’re increasingly facing investors who see renewables as value-added infrastructure, perhaps because of the rich cash yield they provide or because clean energy is less mature than other sectors.”

Verloop sees another interesting overlap with real estate. “Investors are looking to diversify their current allocations away from one type of technology or a given country. Many that have solar and wind assets, for instance, want exposure to hydro or to take a bit more venture capital risk by going into new technologies.” The corollary: LPs are now avoiding what he calls “mono-structures”, focused on one type of technology or geography.

This evolution has pushed a number of traditional infrastructure fund managers into the renewables space, Cirillo says. “You’ve always had dedicated funds such as Platina. But there’s been a trend where some funds that were probably more focused on core infrastructure have gradually integrated renewables in their sectorial focus.”

COMPETITIVE PRESSURE

Despite all of this, raising money has not become any easier. “Many institutions that have started targeting renewables in the past two to three years have posted disappointing results,” says Cirillo. “Some investors have been looking at renewables as a sort of halfway between private equity and infrastructure. They were expecting to get double-digit returns and five-year liquidity on their commitments.” Unless you are in the distressed space, he argues, that is generally a tall order.

Verloop believes the LP landscape remains rather differentiated. “Investors in continental Europe have been at the forefront of moving into funds. The larger pension funds have gone direct, especially those from North America, Scandinavia or the Netherlands. Mid-size pensions are also looking to move into the asset class, but they don’t always have the in-house capabilities to source and manage assets for, say, 25 years. It’s the common rationale: the need for returns to match future obligations.”
Thumfart sees one potential bump on the journey. “Investor appetite is still in some way mitigated by foreign currency considerations. A number of pension funds or even insurance companies are very cautious about long-term currency risk in emerging markets. Some European players are also shying away from Australia, for example, due to exchange rate volatility.”

By the same token, he adds, renewables are propelled forward precisely because they often offer investors the easiest entry point into new markets. “One of the key differentiators of onshore wind, solar and hydro compared to other forms of generation is the fact that your fuel doesn’t cost anything. That makes these relatively easier technologies to understand when you’re looking to get exposure to new markets. It is key to getting comfortable with the electricity offtake agreement.” Countries like Mexico, Colombia and Chile have benefited from this, Thumfart says, while India is also shaping up to be a very promising market.

Cirillo agrees. “In Africa it’s exactly the same. Institutional investors are now present in a number of countries where you wouldn’t have expected them a few years back.” Two markets he highlights are Namibia and Egypt. An Indian investment Platina made between 2012 and 2013 is one of the firm’s best performing assets, he notes – before allowing for exchange rate fluctuations.

Verloop adds another destination to the mix. “One country where we see a strong potential to build out solar capacity is Japan. Core European markets still have strong potential, notably in the hydro space.”

Despite all the talk about strengthening competition, he hardly sees the renewables space as irremediably crowded. “Barriers to entry are relatively high, so we haven’t seen that many new entrants. In addition to having a track record and acquisition experience, one should be able to make decisions relatively quickly. That means having processes, due diligence partners and the in-house capabilities to move swiftly. Having a bridge financing facility in place is another benefit.”

Over the last couple of years, Cirillo says, institutional investors have made a bigger push to go direct. But he doesn’t think that trend will be sustained. “It’s not exactly an easy job,” he comments.

LONG-TERM VIEW

In addition to these dynamics, Cirillo is bullish about dealflow. “We’ve never had such a big pipeline. As far as new build is concerned, it’s mainly solar. Often, we also get into special situations with technically distressed assets. A lot of projects have been rushed through the construction phase to get the last ROCs [renewable obligation certificates] in the UK or feed-in tariffs in Spain or Italy, and this is where we can enter and add value.”

An evolution in financing structures, Thumfart explains, could unlock a further stream of deals. “When operating in emerging markets, we always encourage local regulators and government representatives, but also the asset management industry, to work towards a regulatory framework where local asset managers can get comfortable with providing long-term debt for infrastructure projects. Because you can’t avoid currency risks.”

He points to India’s ambitions to build 100GW of solar by 2022, for instance, which would require banks to provide about $75 billion out of the $100 billion required.

“The local bank market doesn’t have the capacity to absorb that and international banks, with few exceptions, won’t be able to provide long-term funding there. So there is a huge opportunity for local asset managers to fill the funding gap and generate attractive returns on assets with high revenue visibility. With regulatory changes, the financing market will invariably move to a bifurcated system where banks continue to provide financing for the construction and the commercial ramp-up phase, but as assets move into the operational, low-risk phase they will go over to local-currency institutional money.”

Verloop remarks financing is readily available, especially in traditional infrastructure markets. But asset managers remain cautious, he observes. “Yes, interest rates are at record lows in Europe, and we’ve had the first minor rate rise in the US. But one thing we don’t see is investors lowering their hurdle rates. So I don’t observe a bubble in renewable infrastructure. We have lower returns today than three or five years ago, but that’s because we’re moving from feed-in tariffs to grid parity.”

“After regulatory changes were enacted in parts of Europe a few years ago, most people thought the storm had passed,” Cirillo says. “So return expectations could have decreased. That hasn’t really happened, because of the big elephant in the room: lower electricity prices. The volatility of power rates, combined with the decreasing importance of feed-in tariffs for the subsidy component of your return, explains why expectations have largely remained unchanged.”

Still, Verloop believes renewables remain very much a low-risk asset class. While wind used to have generational risk, for instance, he argues enough data points are now available to make forecasts credible. Regulatory risk has meanwhile decreased for both wind and solar as frameworks move away from feed-in tariffs. He also sees risks associated with hydro as very low, by virtue of the fact that the technology has been around “broadly unchanged for more than 100 years”.

Thumfart agrees: “Renewables remain a low-risk asset class both from a relative and absolute perspective. For one, the price volatility of fossil fuels is not going to go away, which has a massive impact for political decision-makers. We also forecast massive deployment of renewables in the near future. We see solar as sweeping the Southern Hemisphere, for instance, within the next decade. And in developed markets, there will be a continued rise of offshore wind power generation.”

Offshore wind, he says, is now better understood, with a growing track record in construction and operation. There is also a recognition of the job-creating effects of developing such projects. “We know of several turbine suppliers, plant contractors and project developers that expect offshore wind to come to commercial deployment on the east coast of the US much quicker than previously thought. It will also come to selective markets in Asia.”

ABLE AND NIMBLE

Could anything disrupt the industry, though? One oft-cited potential menace in the wider infrastructure market is the danger of being caught short by technological changes. But Verloop believes innovation will only be a bonus.

“There are clear technological advancements taking place. But I would say investments in these are not to be put in the infrastructure bucket, where investors typically target protected, reliable and stable cashflows from OECD countries. Electric cars, energy storage or tidal energy are being looked at from an investment perspective, but they should command much higher returns. What we do see though for solar panels or wind turbines, for example, is a steep decline in prices.”

Still, such technologies could have a big impact on investors, especially if they are rolled out in a wide-ranging and speedy fashion, says Thumfart. “If the European Commission were to announce more ambitious plans to electrify European car traffic, you would suddenly have a rise in power demand as opposed to the fall in consumption we’ve witnessed over the last three years. That would provide support to power prices.”

The current decrease in demand may also be a sign of different investment opportunities, especially if the slowdown is linked to energy efficiency improvements. “We’ve been investing a lot of time in energy storage over the last three years,” Cirillo says.

”We’ll probably make an investment very soon in Germany in that area.” He cites Total’s May acquisition of Saft, a French-based battery marker, as proof that energy storage is being taken very seriously by industry incumbents.

What volatile electricity prices will require from investors, however, is greater in-house skills to insulate themselves from unexpected swings. “A detailed analysis of power prices has become one of the most important risk analyses for investors. It’s a different kind of job, and I’m not sure all the renewable energy specialists had power price analysts in-house prior to this,” Cirillo says.

Thumfart observes that nimbleness will also be the name of the game in a landscape where auction processes are being introduced in more jurisdictions. “Renewable energy project developers will need to have several balls in the air at all times to make sure they get the pipeline they want, because they won’t win every auction.”

With existing teams potentially stretched by the seismic changes currently reshaping their industry, it is no surprise that incumbents are also zooming in on the renewables space. “The Stone Age did not end for lack of stone, and the Oil Age will end long before the world runs out of oil,” said Sheikh Zaki Yamani, a Saudi who served as his country’s oil minister from 1962 to 1986.

It would perhaps be premature to declare the Oil Age over three decades later, amid an oil glut that’s been keeping a lid on prices for the best part of the last two years. But Yamani’s prophecy certainly doesn’t ring hollow.