This article is sponsored by Schroders Greencoat
Schroders Greencoat (formerly Greencoat Capital) was founded in 2009 and is now one of the largest renewables investment managers in Europe. Last year, Schroders acquired the business, and it is now furthering its expansion into North America.
Matt Ridley, partner at the firm, oversees the private markets business. He has played a key role in raising capital for – as well as investing and managing a broad range of – renewable energy mandates.
Why is this the right time for renewables?
There is now a clear path in the market towards achieving net zero, and the frameworks for the role of power markets are largely in place to get there. The scale of the opportunity is vast across all the markets in which we operate: the UK, continental Europe and the US. This immense opportunity, coupled with the fact that some of the traditional funders of infrastructure are stepping back, or needing to recycle capital, means the potential for investment returns over the coming years has improved.
In addition, the last year has amply demonstrated the benefits of a diversified portfolio that includes renewable energy assets. And above all else, it has demonstrated the value of assets linked to inflation in the way many renewables are.
The surge in fossil fuel prices has also meant that renewable energy is now cheap – the cheapest it has ever been. The opportunity to triumph over traditional energy sources has never been greater.
All this gives investors good reasons to invest in this space, and confidence that the predicted cashflow is there. One plausible cloud on the horizon is the so-called ‘denominator effect’, but even this may be an investment opportunity.
How could the denominator effect present an opportunity?
The denominator effect refers to the weighting of an investor’s allocation between liquid and illiquid assets. In the UK, the LDI (liability-driven investment) crisis has led some pension funds to seek to reduce their exposure to illiquid assets, which includes renewables. If the liquid assets fall in value more than the illiquid portion, the percentage allocation to illiquid assets is higher.
Around 30 percent of investment in UK renewables is estimated to have come from UK defined benefit pension schemes, so any pressure on their allocations because of liquidity concerns would be a worry. The value of liquid assets has fallen relative to illiquid assets, and this is the case for many investors in many markets.
However, this presents an opportunity for better investment returns for other investors. If the prices of those assets were to be re-rated for the ‘wrong reason’, this is a clear buying opportunity.
Development will be important in grasping those opportunities. Are investors being appropriately rewarded for the risks concerned?
A lot of capital is going to need to be directed to this space and it is important that appropriate return potential is there for investors. We prefer to buy operating renewable energy projects. Development is more complex, and an investor is taking much more risk.
The development of an energy project has four key dynamics, each of which can go wrong. A developer needs land, needs planning permission, needs a grid connection and needs an energy supply contract. These are four big risks. If any one of them fails, the entire project can be derailed.
It is very important that the capital returns on such developments justify the risks involved. This is what investors must scrutinise.
In the past, many development vintages benefited from a lowering of interest rates over time. This serves to reduce the discount rates used to price assets, and so increases the value of the asset. In many cases, this spread compression will have made up a significant part of the returns.
It will be interesting to see how this pans out in a climate of quick and significant interest rate rises. We expect that to put pressure on returns from development investments.
Are there new energy areas that are of interest, though?
I am very excited about hydrogen. It is true there is a lot of hype, but I believe at least some of it is indeed justified.
Hydrogen has a vital role to play in getting the global economy to net zero, not just as a fuel but as what I would call a ‘storage vector’. What I mean by that is where hydrogen can be used as a back-up or baseload power source in periods of low wind and solar resource. Providing that dispatchable power is so important for the operator of a grid network.
If we can create green hydrogen storage then it can be used as the fallback when the electrical grid is overburdened or when the wind doesn’t blow, or the sun doesn’t shine.
I am sceptical about hydrogen cars. I feel that race has already been run and it has been won by electric vehicles. I am also sceptical about the ability to ship hydrogen or transport it via pipelines to the user. It is certainly possible, but is it the most effective use of green hydrogen and the electrons that created it?
The important point is that hydrogen does have immediate potential where it is already in place and where it is close to its end user. This means considerable opportunity in chemical and industrial applications where grey hydrogen is already there and can be replaced by green at source.
I am also optimistic because of the strong political support we have had. In the UK, we have had a good lead from government. The UK government’s hydrogen business is very interesting and is likely to establish a fixed-price regime that should serve to create an attractive risk profile for investors. Ultimately, I see hydrogen becoming a core part of infrastructure portfolios.
How do you feel about nuclear power? Are you getting involved in the small modular reactor enthusiasm?
No, we are not as yet, but we do think there is potential for the traditional pressurised water reactors.
Nuclear is undoubtedly cost effective over the long term and must be part of a general net-zero solution for the countries that need it. It provides baseload and can be located relatively near to demand. It can therefore serve to minimise system costs as a whole, as well as covering periods of low wind and solar resource.
In that case, which energy assets are you focused on?
I am excited by the breadth of opportunities that the energy transition challenge is creating. The bedrock of both the energy transition, as well as our strategy, is operating assets with good cashflow, and we have created a fleet of offshore wind farms, together with significant solar and bioenergy generating capacity. I anticipate us investing in more.
We are also very focused on tackling storage and efficiency. In this regard, clearly the evolution of grid scale battery revenue streams is something I am excited about. I think storage investing can increasingly become core to renewable energy investors, so long as the revenue streams are priced appropriately.
The key point for investors is to ensure that the risk-return is appropriately priced; new markets and investment themes give potential for higher returns but this must map to the right risk-return framework.
Our intention is to continue with our existing philosophy: buying assets that are core to the energy transition with reliable cashflow. If anything, this has become more important at a time of economic uncertainty, and when the overall direction of travel has become more clear than ever.
The US lags behind Europe in its use of wind power. Is this something you are seeking to address? And what is the effect of the Inflation Reduction Act?
The IRA doesn’t necessarily change the macro dynamics in the US. But it does add to the existing momentum in the right direction.
It supports the build-out of new renewable power plants that might have been marginally viable before the IRA passage. Given the less cohesive national energy transition plan in the US, the IRA gets to the heart of the matter – which is driving to a low cost of power. It also sends a strong political signal that there is widespread support for more renewables, which indirectly helps with permitting, new transmission build-out, and influences power purchasing decisions.
We own an enormous fleet of offshore wind farms in the UK and the EU and have considerable expertise in that area. By contrast, offshore wind in the US is rather nascent, so this is indeed an opportunity for us to apply our specialist knowledge.