James Carthew: Navigating the NAV declines in renewables

Net asset values of renewable energy funds are under pressure from power price falls, inflation and tax rises, but investor demand and the sector’s growing maturity are helping to underpin the income portfolios.

If you follow the renewable energy sector, you will have noticed the reductions in net asset values (NAVs) that have been prevalent over the last few quarters. Last week JLEN Environmental Assets (JLEN ) and GCP Infrastructure (GCP ), which has around 60% of its portfolio exposed to renewable energy, announced NAV falls over the year ended 31 March 2021 of 5.4% and 8.2% respectively.

The simplest of the renewable energy funds – Greencoat UK Wind (UKW ) is a good example – have portfolios of investments in UK solar and wind. In the UK the revenues from these assets are a mix of power sales and government subsidies.

The government subsidies are fixed and therefore predictable and inflation-linked. The profits from power sales depend on the amount of power produced, which is relatively predictable within reasonable bounds, and the price achieved, which by contrast has fluctuated wildly for some time.

To work out an NAV for these funds, you could just try to come up with a price for the individual projects in the secondary market. Transactions do happen but the market is not deep and liquid and so this is not an approach that is used in the sector. Instead, NAVs are calculated by discounting forecast cash flows over the life of the projects. The same approach is used to value infrastructure projects and property portfolios.

Changes in power prices have a direct impact on NAVs, therefore, as do other factors such as corporation tax rates and inflation.

Some of the factors that go into the NAV calculation are more subjective than others. Power price forecasts come from specialist firms that run models that try to predict supply and demand, input costs including fuel prices, and the generation mix by fuel type, for example.

These models cannot anticipate a major demand shock – like Covid-19, which caused demand for power to plummet – or supply shocks as happened when Japan turned off all its nuclear reactors following Fukushima. What they are seeing is that the cost of installing renewable energy is falling and, once installed, there is little cost associated with generating power. They think that this will continue to put downward pressure on electricity prices.

At the start of 2020 broker JPMorgan Cazenove triggered price falls in the sector when it cited a report by Bloomberg New Energy Finance that suggested power prices would fall to levels well below even the most pessimistic forecast. The industry countered that robustly, pointing out that there was little incentive to invest in new projects if the returns were not attractive.

Evidence of that working in practice is visible in the scarcity of new gas-fired plants being built. A new 3.6GW gas-fired plant that Drax won permission to build last year was cancelled in February. It looks as though the numbers did not stack up.

The UK government has forestalled a potential drop off in the supply of new renewable projects by promising to reintroduce subsidies for solar and onshore wind projects. New projects will be eligible to bid for subsidies in the form of contracts for difference in an auction being planned for the end of the year.

In the short term power prices have recovered from last year’s depressed levels. However, the forecasters’ models suggest that they will trend lower over time and factoring this into models has weighed on the NAVs of the renewable energy funds. The planned hike in UK corporation tax from 19% to 25% by 2023 also takes a significant bite out of the profitability of these and other funds.

The most subjective part of the equation when calculating NAVs is the discount rate. This should reflect individual project risks and the rate of return on ‘risk-free’ assets such as government bonds. As we know, long-term government bond yields have been trending higher as people get more concerned about inflation. All things being equal, this would raise the discount rate and lower the NAV.

However, by and large, the investment companies have taken the reasonable assumption that, if the price for wind and solar assets in the secondary market is holding up despite adverse moves in power prices, taxes, inflation and risk-free rates, it follows that the discount rate should be falling. In other words, the risk premium attached to these assets is shrinking.

If the discount rate did not reflect the prices that these assets are changing hands at a gap could open up between the NAV and the realisable value of the portfolio. The consequence could be opportunistic bids for these assets, similar to what we saw some years ago with the bid for John Laing Infrastructure and more recently with KKR’s bid for John Laing which was predicated in the value it saw in its infrastructure portfolio.

The debate is clouded by the increasingly complex nature of the sector, with exposure to assets outside the UK and business models based on storing energy or promoting energy efficiency.

JLEN, for example, prides itself on the diversification of risk within its portfolio and investors seem to have embraced this enthusiastically. JLEN’s largest exposure is to anaerobic digestion projects whose revenues have a higher proportion of subsidy and where the main output is green gas which seems likely to be in high demand as a fuel for HGVs. It, and other funds in the sector, have been building exposure to projects in other countries.

In the US, power is routinely sold on long-term fixed price contracts of 15-20 years, cushioning funds like Ecofin US Renewables (RNEW ) from short-term price fluctuations. The industry might try to encourage a similar model here.

In GCP’s case, where the vast majority of its renewable energy exposure is via loans secured against projects, its NAV reduction includes provisions against some projects it feels might default on their debt. GCP is using some of the most conservative assumptions on factors such as power prices and inflation. It is also not making any offsetting assumptions about the second-hand value of these projects. Its shares have moved to trade on a small discount which seems unjustified given this cautious stance.

Turning back to Greencoat UK Wind, its NAV rose last year and was higher again at the end of March 2021. It hasn’t got the benefit of geographic or sector diversification to buoy the NAV, so how has it achieved this? The clue may be that, for the end-December NAV, the base case weighted average discount rate used to value the fund’s future cash flows was lowered from 7.5% to 6.9%. I think its power price forecasts are more aggressive than GCP’s too. It is worth bearing in mind when looking at the sector that the underlying assumptions used can make a big difference to NAVs.

The next quarterly issue of Investment Trust Insider’s ezine will take a closer look at the debate around power price forecasts.

James Carthew is a director at Marten & Co. The views expressed in this article are his and do not constitute investment advice.

 

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