Opportunities being generated in renewables

2022 was an exceptional year for renewable energy infrastructure trusts, with net asset value (NAV) total returns of 19% on the back of roaring energy prices in the wider market. But how are things shaping up for this year, and where do the opportunities lie?

First things first: in order to understand renewables trusts, it’s useful to have some grasp of how values are worked out for the sector, because the calculations are not the same as for other trusts.

For conventional equity investment trusts, the net asset value is a relatively straightforward concept: it’s the value of all the assets the trust holds, minus any debt or loans.

In contrast, as Mick Gilligan, a partner and investment trust expert at broker Killik, explains, infrastructure (for instance solar panels or wind turbines) is a depreciating asset, and the land it is built on is usually leased for a finite period.

A renewables trust’s NAV is therefore based primarily on the cashflows (revenue and costs) that its assets are forecast to generate over a period of time.

“There are a lot of assumptions used to estimate future cashflows,” says Gilligan. “The main inputs are future power prices, where several third-party forecasters tend to be used. There are also assumptions about ongoing costs, inflation, and interest rates.” Asset life, capital expenditure and tax are also taken into account.

A discounted cash flow (DCF) approach is then used to convert these future income streams into a current value. This involves looking at future cashflows from each underlying project and discounting those cashflows back to the present day, using a discount rate based on market interest rates plus a risk premium.

The various different sources of income will have varying degrees of risk and uncertainty attached to them, and so the discount rate applied will vary. “Think of the discount rate as the level of compensation that you would need for taking on the risk of the investment,” Gilligan continues. “Lots of risk means a high discount rate; very little risk means a low one.”

He gives a simple example of a project where there are no physical assets, with an expected cashflow of £100 in one year’s time, discounted at 10%. In that situation, the NAV would be £90.91 (100 divided by 1.1).

“If we then assume similar cashflows each year thereafter, these would increase the NAV further, and then we could add any residual value for solar panels, remaining lease length and so on.”

So what is the outlook for renewable energy trusts’ NAV returns in 2023? The stellar performances of 2022 are unrepeatable this year, according to broker Stifel; it anticipates that NAVs will remain pretty flat.

However, it continues: “Investors should focus on the income side, which continues to be robust from a combination of subsidies and power price agreement (PPA) fixes, with dividend yields of 6%-7%.”

There are various aspects to these opportunities.

At broker Winterflood, analyst Shayan Ratnasingam points out that the sector as a whole is now trading on a 9% discount, down from the double-digit premiums seen between 2019 and 2021.

“Where ratings should naturally settle in a new higher interest rate and inflationary environment is anyone’s guess – but I doubt it will be at the high premium levels seen previously,” he remarks.

Gilligan believes the current discounts are primarily a reflection of higher interest rates (and therefore higher discount rates and thus lower NAVs). “Trading results that I have read recently seem largely in line with expectations,” he says.

Looking ahead, more ‘normal’ power prices are now feeding into forward markets and price forecasts, and inflation is also gradually easing; both of these factors are likely to work against NAV growth. Further unexpected interest rate rises would also detract from NAV growth.

In this context, Ratnasingam voices a preference for total return strategies that can benefit from capital gains, such as VH Global Sustainable Energy Opportunities (currently trading on an 8% discount).

He also highlights the attractions of funds with long-dated, contractual, inflation-linked revenue that can provide investors with real dividend growth, arguing that they have embedded value and deserve to trade at a premium.

“We have already seen a number of funds increase their 2023 dividend targets in line with inflation, including Greencoat Wind (UKW), NextEnergy Solar Fund (NESF) and Octopus Renewables Infrastructure (ORIT),” he adds.

Gilligan is cautious on the wind and solar plays, given that their NAVs are valued using long-term power price forecasts. These are difficult to predict and could fall in future more than forecasters estimate, if more renewable generation is added to the mix, he suggests.

In preference to energy generation, Gilligan favours battery storage and energy efficiency. “National Grid recently announced a major reform in the way that projects can connect to the grid to speed up connections and accelerate the move to net zero,” he explains.

“The UK is estimated to need 120-140GW of renewable generation by 2030 to get to net zero. The current figure is around 80GW, with over 250GW of contracts in the pipeline. We think this is a helpful tailwind for battery storage operators.” He picks out Gresham House Energy Storage (GRID) and Atrato (ROOF) as good choices.

“We also like SDCL Energy Efficiency, given it has contractual income that is not reliant on power prices, and much of it is indexed,” he adds.

Clearly, predictions for renewables trust performance are difficult because of the high number of variables shaping returns, and returns can be volatile from year to year.

Nonetheless, there remain attractive benefits: high dividend yields and in many cases predicted dividend growth of around 5% for 2023, significant levels of ‘locked-in’ revenues from subsidies and PPAs, and greater project diversification as funds have grown.