Solar energy has already attracted pension fund interest. But will it become the preserve of infrastructure or real estate managers? Alex Price gives his assessment
The renewable energy market is coming of age in the UK, kick-started by government subsidies that have transformed a relative cottage industry into a mainstream institutional asset class.
Despite recent cutbacks by the government, the subsidies still allow investors to deliver a sensible index-linked return. As a result, renewable energy is emerging as an investment opportunity, which has so far existed somewhere within the infrastructure - or occasionally property - allocation but is turning into its own asset class. The questions for 2012 are where will allocators place the investment class and which managers will win the right to oversee what is likely to be a rapidly growing area for mandates.
It is easy to understand why there is growing interest in the sector: the UK government’s own projections predict solar output alone to grow by around 30 times between now and 2020, creating a market that could be worth roughly £10bn (€12bn) at today’s prices. While these prices will come down, it should be noted that solar is only a small part of the renewable sector and is dwarfed by wind power.
Even though the government subsidies, which are driving the long-term index-linked income streams, ideal for matching pension fund liabilities, will come to en end, it is worth remembering that energy prices are still correlated to inflation. The result is an industry that - as was the case for hedge funds 10 years ago - has attracted many investors who are all waiting to see what others do first before investing. But once the gates open there will be a flood of investment, since the market is suitable, both in terms of returns and scale for institutions.
We think 2012 will be a year when investment managers recognise the potential size of the market and compete for the mandates from pension funds.
Palmer Capital views renewable energy assets such as solar parks and wind turbines as being akin to traditional commercial real estate. Onshore assets are all relatively small financial commitments, and the development process of securing land, obtaining planning consent, constructing and leasing assets to a counter-party are similar to commercial property development.
Income varies with performance (and, in part, due to energy prices), in a similar way to real estate. The renewable assets also have the advantage of a 20-year-plus guaranteed income stream (backed by the government) at a time when the average UK commercial property lease is less than six years. The assets also have the advantage of being amortised to zero over the life of the lease, taking away a key commercial property risk (residual value) at a time when increased depreciation is increasing this risk.
Palmer Capital has generated strong interest in a UK solar park investment strategy from UK pension funds and annuity investors, and from both infrastructure and real estate allocators. We have found that the debate over where the asset class sits within multi-asset portfolios is more of a resolvable issue than an excuse not to invest.
The debate is important because it highlights the conceptual difference between how the two types of manager - real estate and infrastructure managers - look at the asset class. The real estate investor tends to want to put it into a core allocation, holding it without gearing with a view to using their equity to maximise the index-linked income it can generate. Many mandates will target 4-5% real returns per annum and these assets can fulfil such a requirement for the next 20 years.
The infrastructure investor, on the other hand, wants to use leverage to achieve the optimum equity returns as part of an absolute return, in contrast to a liability-matching mandate.
So the financing structures of renewable assets will change as the debate between real estate and infrastructure investors is settled - unless the reduction in bank lending settles the debate in the meantime.
As the UK heads towards its legally mandated goal of 15% of energy production from renewable technology by 2020, overall renewable energy production will grow by approximately five times. The key to maintaining this target will be to ensure institutional capital flows into the sector once the subsidies come to an end. This can be archived though long-term contracts with the buyers of the energy.
We believe the equity finance is there to achieve this, given investors’ appetite for low-risk and stable index returns. For the reasons above we expect to see far more renewable technology assets hitting the real estate sector in the future.
Alex Price is chief executive of Palmer Capital