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The awaking hydropower giant

Institutional investor interest in renewable energy is surging. Stuart MacDonald of Aquila Capital examines the role for hydro in the renewables mix.

The anticipated growth in the world’s population to 9.6 billion by 2050 (1) means a global revolution is needed in our utilisation of natural resources, particularly in the way that we produce, distribute and consume energy.

Given that wind, water and sun are infinite sources of clean energy it is hardly surprising that of the investment in generating capacity, more than 60 percent is for renewables, principally wind (22 percent); hydro (16 percent) and solar photovoltaic (13 percent). It is estimated that renewable energy generation will triple between 2010 and 2035, by which time it will account for almost a third of the global energy mix (2).

As it gains more prominence, institutional investors are becoming increasingly interested in renewable energy, with a growing number of pension funds now investing in the asset class. Indeed, research (3) commissioned by Aquila Capital found that 83 percent of institutional investors in Europe expect to increase their exposure to renewable energy over the next three years.

Given that investing in renewable energy is still relatively nascent, many investors are still unfamiliar with it. Investing in renewable energy requires understanding not only the benefits but the risks too, several of which are very different from traditional capital market-oriented investments. A key attraction of renewable energy investments is the degree of inflation protection they offer, as the price of electricity – provided it is sold via the market – factors in inflation.

Investing in renewable energy is a long-term commitment with an investment horizon of five to 15 years. The predictability of returns over such a substantial period is a powerful reason to invest, especially for pension funds looking to match long-term liabilities.

On the other hand, clear dependence on a favourable regulatory framework and, by extension, continued political support must be also taken into account. There is significant political support for alternative energy, which manifests itself in subsidies and tax breaks. Investors do need to be aware, however, that these benefits can be rescinded, as they were in Spain and Portugal, for example, during the Global Financial Crisis.

Investors very much view renewable energy as a growing opportunity within the infrastructure asset class but while they tend to see it as homogenous, in reality the most popular sources – namely hydro, wind and solar – demonstrate very different characteristics in terms of costs, returns and risks. This means that investors are faced with a potentially complex valuation process, and investment risk depends to a large extent on the technology used, remuneration system, project phase and price. Expanding an infrastructure portfolio with hydropower assets complements an existing allocation to wind or solar.

Out of the various renewable energy sources available, hydropower currently represents the largest share of renewable electricity production. A proven, mature and typically price-competitive technology, it currently accounts for more than 16 per cent of global electricity production (2), making it a giant of renewable energy. Although hydropower investment deals have been limited in the past, there are increasingly opportunities in both developed and emerging markets that are becoming available to investors.

While hydropower requires relatively high initial investment, it has a long lifespan of up to 100 years with low operation and maintenance costs. Notably, hydropower has among the best conversion efficiencies of all known energy sources. The efficiency factor of a hydropower plant lies at between 90 and 95 per cent compared with that of natural gas plants at 58 per cent or coal power stations of 40 to 45 per cent.

Hydropower plants are already economically self-sufficient and largely independent of subsidies. Further advantages lie in the high and stable predictability of the returns. Given these positive characteristics, it is unsurprising that there is a growing recognition of the potential for hydropower to complement other renewable technologies.

The number of suitable and economically viable hydropower locations, however, is limited. In Western Europe most of the hydropower plants that will ever be built already exist. The potential for further hydropower locations in core Europe appears to be exhausted but interesting possibilities can be found in Scandinavia and south-east Europe.

Investing in hydro is not so much about building new plants as taking over those already established. Energy companies and state-owned operators are selling shares in established plants to institutional investors to free up cash and enable them to concentrate on electricity distribution. This enables asset managers to bundle opportunities to become attractive to institutional investors from a transaction volume perspective.

Investors who wish to build a portfolio investing in alternative energy need to diversify across asset types, regulatory frameworks and electricity price structures. Building such a diversified portfolio is complex. Many factors need to be considered to ensure that investors have an equally weighted combination of projects that delivers attractive risk-adjusted, long-term returns.

As renewable energy develops these factors change, thereby requiring a highly active asset management approach. It is therefore important to have an adviser who understands how best to buy and manage assets, the relevant legal and regulatory frameworks, and which geographic locations to focus on.

1.Source: UN World Population Prospects
2.Source: Bloomberg New Energy Finance
3.Source: Research carried out among 54 institutional investors across Europe 3-14 February 2014

*Stuart MacDonald is a managing director at Aquila Capital, the European alternative investment manager.