Renewables: Infrastructure-lite

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Renewables are typically smaller than mainstream infrastructure investments. As Christine Senior writes, this poses both pros and cons

Traditional infrastructure embraces a wide range of different assets, mostly large projects that need significant amounts of capital and take some considerable time to build. By contrast renewables tend to be smaller, relatively quick to get up and running, yet they offer some similar characteristics.

Renewable projects focus on the generation of heat or power from sources of energy such as wind (either offshore or onshore) solar, biomass, and energy from waste, as well as hydro electric or tidal energy. But it is wind and solar power where the main interest lies at the moment.

The EU’s climate and energy package creates favourable conditions for renewable investment: a 20% target for energy production from renewables by 2020 is one element in its so-called ‘20-20-20’ targets, alongside a 20% reduction in 1990 levels of greenhouse gases, and 20% improvement in energy efficiency. The worldwide emphasis on carbon reduction and green investments generally has created a good environment for renewables. 

A significant attraction of the sector is the widely offered government incentives. Feed-in tariffs pay a subsidy that brings down the cost of generation to power producers to bridge the gap between grid parity, the cost of electricity in the market and the cost of producing through renewable sources. Feed-in tariffs are a feature of many energy markets in Europe, Asia and the US. In some countries there are power-purchase agreements which guarantee a fixed price for electricity sold by power generators to utility companies, thus guaranteeing stable and predictable returns to investors. Agreements often include a link to inflation, which increases the attractiveness for pension funds.

While there are a number of specialist managers for the asset class, some real estate managers have also been extending the scope of their investments to renewables. Both asset classes share some characteristics, and although some of the knowledge and skills required might be similar in both, they also require different expertise.

Keith Kelsall, client portfolio director at Aviva Investors, sees differences but also synergies. He says real estate value is more affected by GDP risk in the economy, while renewables with government incentives have a more steady income. “There are a lot of synergies,” he says. “With real estate, in many cases you can also add solar power to roofs of buildings. That offers some combined benefits. And the same with an energy centre. It will supply power to a major user or could supply power to a number of users within a certain radius.”

Raphael Lance, head of renewable energy funds at Mirova, the responsible investment arm of Natixis Global Asset Management, has seen little evidence of an advance by real estate managers into renewables so far, but he sees some features common to both asset classes. “There are similarities in the way projects are structured,” he says. “The overall deal structure is very close. You have a special purpose company that is created, you have leverage, it’s also fairly decorrelated from the rest of the market. If you have a lot of experience in doing real estate deals, it’s not very complicated to move to renewable energy.”

Renewables tends to be considered as a subset of infrastructure. Amarik Ubhi, senior associate at Mercer, says renewables are considered more akin to infrastructure than real estate. “Typically, renewable energy has more moving parts than real estate – a greater degree of operational risk and more sensitivity to political and regulatory risk – but usually less exposure to macroeconomic risk,” he says. “Those factors tend to differentiate renewable energy for us as an infrastructure-type asset rather than real estate. However, there is a spectrum of renewable energy investments, some with more moving parts than others, depending on the geography, technology and stage of development involved, and the revenue and cost structures in place.”

Renewable energy is a technical asset, which demands knowledge of managing the operations, which might be energy performance certificates at the greenfield stage to energy trading prices at the operational stage. Another feature which differentiates renewables from either real estate or other types of traditional infrastructure is the structure of the yield. 

Partners Group’s David Daum says a big difference between renewables and real estate – or other private equity-style infrastructure investments – is the high cash yield. “[In renewables] the cash yield is higher than the IRR normally, and you are not dependent on any exit value,” he says. “For real estate or other infrastructure assets – airports toll roads, etc – quite a bit of value creation is only realised when you sell the asset. You normally want to achieve a higher price than the price you bought it for, and you get dividends. While with renewables it’s mainly dividends that count. At the end of the 20-year period, you don’t have any terminal value. That makes it less dependent on any cycles.”

Renewables can play different roles in a pension fund’s portfolio depending on whether it opts for debt or equity investment. Pension funds, ever on the lookout for sources of income, are turning to alternatives, so renewables debt looks attractive.

Daum says: “Fixed-income 10 years ago was yielding 4% to 5%, but nowadays it’s yielding 1%, or even less for short-term government bonds from AAA-rated countries. Pension funds have a yield problem. They look at the renewable energy class, consider it similar to what a bond offers, and think by holding it for 20 years they get a nice cash yield, the yield lacking in their fixed-income portfolio. In addition, they aren’t so sensitive about the IRR, so they invest either without leverage, or leverage of 30-50%, while other investors may lever it at 75%.”

Wind and solar power have the advantage of having been around for some time, so the technology is mature and tested. Solar photovoltaic and onshore wind farms, in particular, are operationally straightforward. 

Onshore wind farms are considered more tried and tested than their offshore counterparts, which are more challenging to build and maintain. And the wind and sun, although subject to the vagaries of climate, come for free. That is not the case for all renewable energy. Biomass projects have to source fuel, and that can pose risks from suppliers and may entail costs, be it waste products from food or agricultural waste or crops grown specifically to be turned into fuel.  

PensionDanmark goes direct

 

PensionDanmark has the size and clout to invest directly in renewables. Its decision to invest in the sector was prompted by the opportunity to increase expected returns and the need for diversification. 

CIO Claus Stampe says: “If you look at infrastructure and renewables, there is no doubt in our mind we are able to make investments that have a significantly higher expected return than current bond yields, at a risk that is significantly lower than equities, and also has a sensitivity to the business cycle that is very much lower than equities.”

The pension fund, which won Best Infrastructure Investor at this year’s IP Real Estate Global  Awards, has built up a wealth of expertise since its first foray into the asset class in 2010 when it invested in a Danish offshore wind farm. It targets a direct infrastructure allocation of 10% by 2015 and the allocation is mainly in renewables, especially onshore and offshore wind power. 

The management of its investments is split between an in-house team of six and a specialist fund, Copenhagen Infrastructure Partners.

So why go direct? When PensionDanmark was considering infrastructure as a replacement for part of its fixed-income portfolio, there were some reservations about going via existing funds. Stampe says the fund option was rejected because it meant a higher risk profile than the fund wanted and the costs were too high.

Using the in-house team only to build the exposure they were seeking would have been impossible, and two years ago PensionDanmark created Copenhagen Infrastructure Partners, hiring specialists in offshore wind farms. 

The first CIP fund is dedicated exclusively to investing for PensionDanmark but a second fund will invest for a number of other, mainly Danish, pension funds. Stampe says there is strong interest in participation.

PensionDanmark is keen on greenfield investments because of the enhanced return potential and working with Copenhagen Infrastructure Partners gives them an edge. Stampe says: “During the last couple of years more people have moved into this asset class. In an auction process, there is strong bidding for these investments now, so returns are coming down.”

Compared with large infrastructure projects, renewables are smaller in size and quicker to commission and get up and running and producing revenue. For investors that means cash can be invested more quickly and get to work immediately, unlike larger infrastructure where cash may be drawn down over a long period.

Sachin Bhatia, institutional investor relations manager at Oxford Capital Partners, says renewables offers a quicker way into the infrastructure asset class. “A lot of capital is waiting to be deployed in infrastructure and there aren’t enough big projects up and running quickly enough to warrant waiting around,” he says. “If a pension fund wants an allocation to infrastructure, they are more mindful to go for a manager that can aggregate smaller projects and deploy their capital within six months rather than looking at a mega manager who will take three years for capital to be committed.”

But the very size of projects can itself be a handicap. James Wilson, co-head of Macquarie Infrastructure Debt Investment Solutions, says: “Because the projects are relatively small, it can be difficult to invest significant amounts of money quickly. Also, as the market is characterised by a broad array of operators and developers who are sometimes not as sophisticated as you see in other infrastructure sectors, there can be a real difference in project finance-ability. Because the projects are small, it can be challenging to aggregate up to a reasonable investment size. So it’s relatively resource-intensive to get invested and invested well in the sector.”

At the top line level, any project is subject to the political and regulatory risk that arises from its geography. The example that weighs heavily on the renewable sector is Spain in 2010 which suddenly cut subsidies to solar photovoltaic energy producers as a means to tackle its budget troubles. An advantage to investing in UK renewables is that subsidies are safe from such raids because they are legally protected. 

Barney Rhys Jones, investment director of infrastructure at Oxford Capital Partners, says: “The feed in tariff for early-stage and smaller technologies was to encourage residential rooftop panels. The government tried to change the rules on feed-in tariffs and they were taken to court by the industry and lost. We like renewables in the UK because the renewable obligation is enshrined in legislation and, secondly, because there is a legal precedent on the government trying to renege on their commitment.”  

Renewables presents a different risk-return profile depending on the investment stage – the development stage, the construction stage or the operational stage. The development stage which takes in the planning and commissioning, including getting the permissions and signing contracts, has the potential for the highest returns. The major risk is all the work put in may not result in the plant actually being built. 

At the greenfield or construction phase, the contracts are in place, the long-term financing agreed, but there are different risks. The building work could overrun, or unforeseen problems on the ground may crop up. The lowest risk-return profile is the operational stage. The plant is built and working and may have a couple of years’ track record on performance, so future returns are more reliable and predictable.

Mercer recommends diversification with renewables for investors who want exposure. 

While pension fund investors see some types of renewable investment as a sub asset class of infrastructure and so most likely to figure in their alternatives allocation, for others it acts as higher yielding alternative to fixed income. 

Wilson says: “Because we are focused on debt, particularly inflation-indexed, we see debt in well-structured renewables projects as an illiquid alternative to index-linked gilts. So if it is investment grade, it fits within illiquid fixed income part of the portfolio.”

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