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Turn to clean energy for income that's inflation-resilient

Renewable energy investment trusts look cheap relative to broad infrastructure funds and offer good yields
August 25, 2016

Low interest rates, annuities and gilt yields are driving investors towards assets such as infrastructure investment trusts, that offer stable, inflation-linked income. But with many broad infrastructure trusts trading at very high premiums to net asset value (NAV), it's worth considering renewable energy investment trusts, which also offer attractive yields but typically trade on lower premiums.

There are six renewable energy infrastructure investment trusts. Five focus on wind and/or solar generation, while John Laing Environmental Assets (JLEN) also invests in waste management.

The sector has an average yield of about 5 per cent compared with 4 per cent for broad infrastructure investment trusts, according to Winterflood Securities as at 19 August.

Infrastructure funds have long been valued as opportunities to invest in the construction of schools, hospitals and transport, via public private partnerships (PPP and P3) or private finance initiative (PFI) projects. But Iain Scouller, managing director of investment funds research at Stifel, thinks the difference in share prices between the renewable energy infrastructure sector and the broader infrastructure sector is too wide.

"There are significant differences between the funds in terms of risks," he says. "The PFI infrastructure funds have got government-backed cash flow on their assets and don't have to contend with power prices which move around day to day, so yes there should be a bit of a differential - but there's a question as to whether it should be a 25 per cent differential. I would have thought it should be a bit less."

He thinks this anomaly is partly driven by private investors' lack of familiarity with renewable energy investment trusts, the first of which launched just three years ago.

But like the broad infrastructure investment trusts, renewable energy investment trusts receive a significant part of their income stream from government sources via green subsidies that aim to encourage renewable energy production. The two main government subsidies in operation, feed-in tariffs and renewable obligation certificates (Rocs), are directly linked to retail prices index (RPI) inflation.

This makes renewables a good opportunity for income seekers following the Brexit vote and the resultant increase in inflation, says Ben Yearsley, investment director at Wealth Club. "RPI, which is real inflation, is much higher at 1.9 per cent. This means people are being forced out of cash, because in real terms it is losing them money. The good thing about renewables is that they are a) high yielding and b) RPI inflation linked."

The Brexit vote has also had a positive effect on the sector by boosting power prices. "The fuel that sets the marginal rate of power in the UK is gas, which is priced in [US] dollars," explains Charles Murphy, investment funds analyst at Panmure Gordon. "So if sterling falls by 8-10 per cent, the price of gas goes up 8-10 per cent and the cost of power goes up 8-10 per cent. It could reverse, but everybody I've spoken to about the currency reversing says we will need a sense of what we're going to do Brexitwise and there's no sense that that's going to be clear any time soon."

Stabilising power prices should enable renewable energy investment trusts to increase surplus cash flow, which could lead to growing dividends for investors, he adds.

And Mr Murphy thinks the vote to leave the European Union is unlikely to have any effect on the sector's regulatory framework because the UK government has tended not to retrospectively take away subsidies. Rather it has stopped subsidies being offered to new projects. As a result, investors can generally feel secure about existing projects that use green benefits.

Mr Murphy also thinks the green economy has the potential to be a high-growth industry in the future. "This whole area will continue to evolve quite quickly," he says. "Over the next five years batteries [that give the ability to store renewable energy] will become economic and that will change everything."

Mr Scouller thinks renewable energy investment trusts also stand a better chance of acquiring assets in the future compared with infrastructure investment trusts: "In terms of new investments, it's going to be more difficult for the PFI-focused funds to buy assets because yields have fallen quite a lot in the marketplace, reflecting the general yield compression a lot of asset classes have seen," he says. "But on the renewable energy side, there are lots of assets around, with a lot of new solar plants and wind farms built over the past few years. I think there's more of a supply of assets for the renewable energy funds than there are for the PFI-focused funds."

 

Potential pitfalls

However, the possibility of political interference and the variability of the power price on these funds' income generation remain risks for investors to be aware of.

Richard Crawford, investment manager for The Renewables Infrastructure Group (TRIG) investment trust says: "The power sector is a regulated industry and the UK government now has greater freedom. It has got sovereignty to behave as it wishes, rather than having a number of requirements set out by Europe, and at a sovereign level there's a greater chance of changing those policies than at a European level where you've got a number of states that have to agree before any change can happen. That can be good or bad."

However, he remains optimistic about the sector because of the leading role the UK has taken on climate change policy, much of which has been consistent with European thinking.

Regarding the power price, Mr Murphy says if oil had stayed under $30 a barrel, as it was in February, it would have caused dividend cuts further down the line.

"On wind farms, the power price is about 15 per cent of your revenue and on solar funds it's about 40 per cent, so when it falls by about roughly 30 per cent that does quite a lot to your income line and makes it tricky to deliver the return you said you would when you started," he explains.

Renewable energy trusts' returns are also affected by weather conditions. Wind power is more variable than solar power and this is reflected in the trusts' different financial models.

"Greencoat UK Wind (UKW) is quite conservative," explains Mr Murphy. "[Its managers are] very cognisant that the speed of wind can be variable.

"In any one year you might have 20 per cent more or less wind, so they don't want a very tight financial model because that will cause them problems. Whereas with the solar funds, because sunshine or irradiation only varies by about 7 per cent each year, they feel they can run a much tighter financial model, so offer a lower return and the same sort of dividend yield. But they are much more vulnerable to any unexpected changes in their models."

It is important to consider the amount of leverage or debt that a renewable energy investment trust has because it can transform the nature of the income stream investors receive. "Banks aren't stupid; when they lend [to these funds] they lend against the subsidy revenue so they've got first dibs," says Mr Murphy. "The more leverage you stick in, the more revenue that goes to paying off the bank debt and the less that goes to you as the shareholder, so your dividend then becomes a function of the levered price of power, which is much more volatile."

Because the Rocs and feed-in tariff subsidies wind plants and solar farms benefit from are typically guaranteed for 20 to 25 years, it is important to consider how much time a trust's projects have left.

"The thing to keep in mind is that these are not physical property, these are annuity streams," explains Mr Murphy. "After 25 years you're meant to take down the wind or solar farm, which means you have to pay the debt back as opposed to refinance it, which you could do if you were [borrowing] against a building. After 10 years, a building would still be there so the bank would lend you the same amount again. But with renewable energy the banks will think you've only got 10 years of subsidy left, so will lend you that much less."

Mr Yearsley agrees this could be a concern, but not for at least the next 10 years.

"In one sense they are a wasting asset. So you have to ask yourself the question, what's the value of these [schemes] after 20 years? You could look at them as a high-income play where the capital value erodes over time or you might think about selling them on well before that," he says. "There will be an optimum time to sell these and you need an experienced manager who can hopefully reinvest the excess cash flow and generate extra returns to maintain the capital."

 

Funds to consider

Mr Scouller favours John Laing Environmental Assets Group and The Renewables Infrastructure Group for their diversification.

He says: "[The Renewables Infrastructure Group] has got a mix of both solar and wind assets, and UK overseas (primarily French) assets, while John Laing Environmental Assets has a mix of solar, wind and PFI-type assets in the waste water space. So they're both quite diversified, in contrast to some of the other funds that concentrate on just wind or solar."

Mr Yearsley is a big fan of solar funds and started investing in the sector after installing solar panels on his house in 2011. He holds Foresight Solar Fund (FSFL) and Bluefield Solar Income Fund (BSIF) in his individual savings account (Isa) and likes the straightforward business model of solar investing.

"It's simple - when the sun shines you make money," he says. "I'm personally less positive on wind because if it's too windy they have to turn the turbines off and if it's not windy enough, that's also a problem. Whereas you can't get too much sun."

However, despite his personal preference for solar he says there is also value in wind investments such as Greencoat UK Wind, which is substantially larger than the other two funds and therefore offers investors better liquidity.

 

Renewable energy investment trusts

TrustPremium to NAV (%)Yield (%)Market cap (£m)Gearing (%)1-year share price return (%)3-year cumulative share price return (%)Ongoing charge*
Bluefield Solar Income Fund0.67.23121241171.20
Foresight Solar Fund2.76.02871004na1.36**
Greencoat UK Wind12.75.46991187311.49
John Laing Environmental Assets 8.75.92761004na1.52
Next Energy Solar Fund 5.23.03531006na1.38
Renewables Infrastructure Group10.63.081210011241.19
Renewable energy investment trust sector average6.85.1524
Broad infrastructure investment trust average18.83.91845
FTSE All Share 920

Source: Winterflood as at 19/08/16, *AIC as at 22/08/16, **Morningstar as at 22/08/16