In praise of renewable energy funds

While there is some scepticism about what the COP28 climate change summit currently taking place in the United Arab Emirates will deliver, one thing is not in doubt. The world must – and will – continue to embrace renewable energy. In particular, the development of wind and solar projects continues to accelerate; investment in related technologies and the infrastructure needed to connect these projects to the grid is also growing fast.

However, take a look at the performance data for the Renewable Energy Infrastructure sector of the investment companies industry and you could be forgiven for feeling confused. The average fund in the sector has delivered a negative return of around 14% over the past 12 months. Shares in the typical fund are trading at a discount to the value of its underlying assets of close to 20%.

That does not seem to stack up. How can an asset class on which the world is currently staking its future be delivering such disappointing performance? The answer is familiar. Stock markets do a poor job of valuing long-term opportunity – largely because they are too easily swayed by short-term sentiment.

The biggest problem for these funds over the past year or so has been the dramatic rise in interest rates seen in the UK and other Western nations. Higher interest rates ostensibly undermine the renewable energy sector for several reasons: they may raise funds’ borrowing costs, for example, and they can reduce the theoretical value of funds’ assets, since this is worked out by discounting with reference to gilt yields, which are linked to rates.

Nor has it helped the sector that the political wind on renewables has appeared to change direction. New oil and gas projects are getting the go-ahead on energy security grounds. In the UK, a recent auction of licences for wind power projects failed because the government was not prepared to offer sufficiently attractive incentives.

Against this backdrop, the market’s mood on renewable energy has soured. Funds that invest in these assets have suffered as a result; some of their investors have decided to move on to the next opportunity.

That feels like a mistake. For one thing, the headwinds that the sector is facing are not nearly so strong as might be imagined. There is little evidence that funds’ borrowing costs have increased significantly; much of their debt was taken on at fixed rates of interest. As for the discounting issue, this is largely compensated for by the inflation-linked income that many funds benefit from. In any case, the actual value of assets – what funds can sell them for – seems to be running ahead of their theoretical value, if recent transactions are anything to go by.

Leaving aside these more technical considerations, however, the fall from favour of this sector overlooks the big macro themes that will drive global economics in the years to come. Climate change is the biggest challenge facing society over the coming decade – why would investors not want exposure to an asset class set to play a starring role in the world’s efforts to rise to that challenge?

Politics is certainly a short-term game and policymakers will no doubt continue to wax and wane on many areas of this debate. But most governments get it – witness the huge investment in renewable energy in countries such as China, for example. In the UK, meanwhile, the next wind energy auction already looks set to offer more attractive prices.

For ordinary investors, moreover, the 20 or so Renewable Energy Infrastructure investment companies are really the only way of securing direct exposure to this investment theme. They offer attractive yields as well as the prospect of long-term capital growth.

That’s not to suggest the sector is right for everyone. However, its performance in recent months should be viewed as an opportunity.