When will renewable energy investment trust prices recover?

While equities and bonds have taken a battering, infrastructure has become an increasingly popular asset class in the past year, with a reputation for helping investors' fortunes while traditional strategies were busy plummeting. 

Renewable energy in particular looked attractive in an environment where energy can be sold at gas-linked prices, while production costs have remained relatively stable by comparison. The AIC Renewable Energy Infrastructure investment trust sector gained 13.7 per cent in the year to September 20 2022 – at which point some of these companies had begun to actually look expensive.

Fast forward a month and the picture is strikingly different. Discounts widened dramatically as the sector lost 10.3 per cent in the month to 15 October, although it recovered some of its losses at the beginning of this week following new chancellor Jeremy Hunt's reversal of much of the elements of his predecessor’s 'mini' Budget.

The losses were initially triggered by the rise in gilt (UK government bond) yields, and later compounded by the government’s announcement of a revenue cap for the sector last week. Huge levels of uncertainty about interest rates and the revenue cap have added to bearish sentiment in fragile markets.

The revenue cap

On 12 October a “cost-plus revenue limit” was proposed for low-carbon electricity generators by the government as part of its Energy Prices Bill. The limit is meant to “ensure electricity generators are not unduly profiting from the energy crisis caused in part by Russia’s invasion of Ukraine” and enable them to “move onto fixed prices”.

Although the limit is due to come into force at the beginning of 2023, how it will work, to whom it will apply, and the level at which it will be set are all unknowns. If you are wondering how the revenue cap will impact renewable energy trusts, the answer is that currently nobody knows.

When news of the cap first hit the papers, a level of £50-£60 per megawatt-hour (MWh) was initially floated, much lower than the €180 (£156) per MWh set by the EU. The markets seemed to price it in and sent share prices tumbling. This now appears to be the starting level in the negotiations, rather than the expected outcome.

Depending on its final level, the cap could end up having zero impact on trusts’ net asset value (NAV), or becoming a fairly serious problem. “If the price cap is set too low, that can act as a disincentive for developers and operators of the assets in the UK,” says Adrian Todd, senior research director at Investec. “Europe might be seen as a more accommodating region by contrast. That would be challenging for existing investors because the risk premium investors might require for the assets could widen.”

Impact on trusts

Irrespective of the level at which the price is ultimately set, it will impact trusts in different ways depending on their geography, asset mix, exposure to market pricing and price projections. 

Iain Scouller, managing director at broker Stifel, notes that Greencoat UK Wind (UKW) has the highest UK exposure and derives a high level of revenue from market prices. But it is budgeting a power price of £100 per MWh for 2023. 

"Assuming the price cap is at or above £100 per MWh we wouldn't expect any material impact on the NAV," he says.

Bluefield Solar Income Fund (BSIF) also has the vast majority of its assets in the UK, as does NextEnergy Solar Fund (NESF), while Renewables Infrastructure Group (TRIG) has more than half.

Earlier this week, Downing Renewables & Infrastructure Trust (DORE) issued a timely update saying that while about 59 per cent of its 2023-25 revenue is forecast to come from its UK portfolio, only 4 per cent of its 2023 revenues are expected to come from merchant power sales in the UK (sales at day ahead prices on the wholesale market), with the rest being covered by fixed-term contracts. The trust budgets an average power sales price of £82 per MWh for 2023-25.

Additionally, James Carthew, head of investment company research at QuotedData, notes that the battery storage funds are not going to be directly affected by the cap, and that JLEN Environmental Assets (JLEN) will be much less impacted thanks to the diversification of its income sources.

CfDs

The energy bill has some potentially good news for the sector as it hints at plans to run a voluntary contract for difference (CfD) process in 2023. CfDs are long-term contracts with a fixed price that, unlike the revenue cap, protect generators from low energy prices. They were introduced for new projects in 2015. “With a revenue cap investors remain fully exposed to the downside, while the upside is capped. That’s not an attractive combination,” explains Todd.

The revenue cap will apply to generators that are not on CfDs. “To me, [CfDs are] the best way forward, it just removes the uncertainty,” says Carthew. “If you are invested in these assets, you get a really long-run, absolutely predictable, inflation-linked income, which is fantastic.”

Interest rates and corporation tax

Not all the sector's woes have to do with the price cap. Rising interest rates impact infrastructure valuations because they drive discount rates up and increase financing costs.

Rising interest rates were already a global problem, particularly in the US, before the September 'mini' Budget exacerbated it in the UK.

"It feels like the discount rate problem is getting worse from when it first started to threaten valuations," says Carthew. 

But the relationship between interest rates and discount rates is not linear – the risk premium varies, partly depending on the assets' prices on secondary markets. It is too soon to say what exactly the impact of interest rates is going to be with some confidence and, once again, it will vary between different trusts.

Greencoat UK Wind, Aquila European Renewables Income Fund (AERS), Ecofin US Renewables Infrastructure Trust (RNEW), US Solar Fund (USF) and ThomasLloyd Energy Impact Trust (TLEI) have all reported rises in discount rates in response to moves in the risk-free rates, notes Shayan Ratnasingam, research analyst at Winterflood Securities. 

"Given that base rates have moved since 30 June 2022 in their key markets, we can expect further moves in the September valuation and year-end announcements," he says.

But infrastructure trusts tend to have significant inflation-linking built into their income, which can offset the impact of interest rates.

It is quite hard to disaggregate the effect of the price cap from the effect of rising gilt yields on share prices, explains Todd. As yields are now near where they were before the price cap was announced, comparing current share prices with the 7 October share prices should give you a pretty good idea of the effect of the cap implied by the market. 

But there is still a lot of noise, he adds. Real long-term yields did not compress as much as nominal long-term yields, long-term rate expectations remain remarkably volatile and there has been some variation in how different funds in the infrastructure space have behaved.

Lower valuations in the sector might prompt some mergers and acquisitions activity. Earlier this week, the board of US Solar Fund announced plans for a strategic review that will consider various options, including a sale of the portfolio, citing "structural challenges in the US solar sector alongside a recent sustained discount of the share price".

Analysts at broker Numis noted that "the scale of portfolios of infrastructure and renewable energy investment companies are likely to make them attractive to pension funds, and other buyers, if valuations remain cheap given the quality of the long-term cash flows". Something similar happened in 2018, when John Laing Infrastructure was acquired by a consortium of pension funds at a time when the sector was trading at discount.

Volatile future

Stifel analysts said that “once the price cap and 2023 CfD round is finalised, we expectthe funds’ share prices to be significantly higher than today”.

Todd says that "there is a good chance that above budget inflation and above budget power prices for this year could offset the negative impacts of a revenue cap", although this will depend on the cap level.

At the same time, it is hard to fault the market for pricing in some bad news when there are so many unknown variables – including political uncertainty. Further volatility is to be expected for the moment.

"Basically, you've got a situation where we don't quite know where rates are going to end up," says Carthew. "We don't know where the price cap is going to be set. I think it's entirely reasonable in that kind of environment that everything's going to be trading at discount."

As at 17 October 2022. Performance as share price total return. Source: Numis.