Another way to diversify your portfolio

We are no longer as reliant on traditional, finite energy sources as we once were. Instead, the world is shifting towards alternative and renewable sources of electricity. Many governments are investing in ‘green’ energy, as they try to curtail the effects of climate change. The member countries of the European Union (EU), for example, have had to introduce individual renewable energy targets. These are needed to meet the Renewable Energy Directive’s goals. By 2020, one-fifth of the EU’s energy must come from renewable sources.

Forms of renewable energy include wind and solar farms, hydroelectric, geothermal and biomass power-generating facilities, as well as wave and tidal technology. The need for funding to build and operate these facilities has given rise to renewable infrastructure as an investable asset class.

Finding funding

State funding often fails to provide enough capital to build and sustain sufficient renewable infrastructure. Private funding is therefore needed to make up the shortfall. The capital for new wind farms usually comes from large utility companies. Smaller private developers tend to fund solar power facilities. However, neither kind of organisation is a natural long-term owner of the finished product. This is where other investors, such as closed-end renewable infrastructure funds, come in. As permanent capital vehicles, these funds are well-suited to holding assets with long lives.

Several such funds opened between 2013 and 2014, with the aim of buying working wind and solar farms. To help get the sector up and running, the UK government invested in Greencoat UK Wind, the first fund to be launched. These funds have so far accumulated around £5 billion in assets 1 and are major holders of the UK’s renewable energy infrastructure.

What powers returns?

Renewable infrastructure funds aim for annual returns in the region of 7% to 9%, including dividend yields of around 5% to 6% yields. These returns are sourced from a mix of government subsidies and sales of power to utility companies. Given the security of their cash flows, these funds often raise debt to enhance returns to investors. A loan-to-value ratio of 30% to 45% is common.

For example, investors in solar assets benefit from a 25-year revenue stream. About 50% to 60% of that revenue comes from government subsidies. This is very reliable and increases in line with inflation each year. The remaining 40% to 50% comes from selling energy to power companies and consumers. This will be sensitive to changes in power prices but, where appropriate, funds look to mitigate any short-term power price volatility through the use of Power Purchase Agreements (PPAs). These give some certainty over the price a fund can expect to achieve for its power.

The amount of electricity generated also influences returns. This is dependent on resource variability (level of solar irradiation, wind speed etc.) and plant performance and costs.

An aid to diversification?

Renewable infrastructure assets tend to have long economic lives with relatively reliable revenue streams.

Renewable infrastructure assets tend to have long economic lives with relatively reliable revenue streams. Although there is some sensitivity to power prices, returns are not significantly affected by economic conditions. Hence when equity markets fall on concerns over economic growth this has little effect on the prices of these infrastructure assets, providing valuable diversification benefits.

Recent developments

Initially, these funds invested primarily in operational UK-based solar and wind farms. In recent years, however, they have diversified into Ireland, France, Sweden and Australia with the potential to include US assets in the near future.

We have also seen diversification by technology with investments in batteries. These storage devices could solve a long-standing problem for wind and solar farms, allowing them to store energy and release it into the grid in times of peak demand. Making fuel from organic materials using anaerobic digestion is another area of interest.

In our view, renewable infrastructure can provide an attractive diversifying return stream for multi-asset portfolios. Nevertheless, it is important to continue to monitor the risks presented by overseas subsidy regimes and new technologies.

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