How to profit from the energy transition

The International Energy Agency predicted last October that Russia’s invasion of Ukraine would bring forward the peaks of oil, gas and coal demand to somewhere around 2030, as countries accelerate the turn to renewables in a bid to secure their energy supplies and protect themselves against future price shocks.

Yet while the vast majority of new power capacity added last year came from renewables, surging energy prices have led western governments to prioritise fossil fuel production in the short term, and prompted some big oil companies to pare back their green technology ambitions.

The message this sends to markets is simple: renewables might be an important part of the future of energy, but near-term profits from fossil fuels are just too good to pass up. Investors with interests in clean energy will no doubt be wondering whether this resurgence somehow threatens the investment case for their assets. The answer partly depends on how long they plan to hold them – and what kind of returns they’re hoping for.

 

Subsidy scramble

The split between short-term energy security and long-term carbon reduction targets is currently writ large across the Atlantic. Oil and gas initial public offerings (IPOs) are once again piquing investor interest in the US after many producers reported record profits last year, but renewables companies are also among those coming to market for the first time. As of mid-February, 10 energy and utility groups had either completed or applied for flotations on US exchanges, according to Renaissance Capital data cited by the Financial Times. If they all come to fruition, this group alone would represent the largest number of IPOs for the sector since 2017.

The prospect of stellar returns has also drawn investors back to the country’s oil majors – shares in Exxon Mobil (US:XOM) have risen 42 per cent in the past 12 months. The global gap in benchmark performance is small but notable: S&P’s Global Oil index is up 6.8 per cent in the past year, compared with a 0.6 per cent fall for the S&P Global Clean Energy Index. There are still big gains to be made from certain renewable businesses: shareholders in companies such as solar panel manufacturer First Solar (US:FSLR) will be more than satisfied with share price growth of nearly 200 per cent in the past 12 months. Aside from examples like these, there’s no denying that the returns offered by renewables producers, many of which tend to be steady and relatively predictable, could look less attractive when compared with bumper oil and gas profits.

But just as policymakers are acting to boost fossil fuel production in the short term, they are also encouraging the creation of much more renewable capacity. The Biden administration  recently approved the $8bn (£6.4bn) Willow oil drilling project on federal lands in Alaska, to the distress of environmentalists, but investors are more interested in another  of the White House’s headline initiatives. The Inflation Reduction Act (IRA), which was signed into law last August, includes almost $370bn in tax incentives, grants and loan guarantees for clean energy developers. It’s a clear acknowledgement of the growing importance of renewables to the country’s economy and energy mix.

EU policymakers are currently preoccupied with devising a subsidy regime of their own so that the bloc’s green firms don’t decamp to the US, while China – whose own supply lines are being threatened by provisions in the IRA and other US and European policies – is also seeking to ramp up domestic renewables capacity.

In the UK, chancellor Jeremy Hunt has committed to unveiling the government’s own response to the IRA in the autumn.

The size and scope of the US subsidy regime has evidently unsettled lawmakers in Westminster, as well as in Europe, and the UK’s size puts it at a disadvantage. However, the energy industry is adamant that the government must do more to stimulate investment in domestic renewables.

In a report published earlier this year, trade association Energy UK said that a range of challenges – including high inflation, uncertainty around planning policy and poorly designed windfall taxes – have driven up the cost of many low-carbon projects. It’s estimated that £500bn in additional investment, much of it from private markets, is needed to hit the country’s net zero targets.

 

Assessing the options

Hunt told MPs in March that the UK is “not going toe-to-toe with our friends and allies in some distortive global subsidy race”. However, UK investors still have viable growth options from which to choose in the world of listed companies. These can be split into three distinct camps. The largest in market cap terms are utility companies, such as SSE (SSE) which builds and operates its own wind farms and has a long history of developing hydroelectric projects in Scotland. Operators of electricity transmission networks, such as National Grid (NG.), will also have a critical role to play in the energy transition.

“Grid infrastructure has entered a significant growth period given the need to expand the capacity and capability of the grid to facilitate the rise in renewable generation,” RBC analysts noted in February. They suggest National Grid, long valued by UK investors as an income producer, is being given “no credit for growth”. With its predominantly regulated asset base (RAB), a share price that had been knocked by higher interest rates, and an estimated 10 per cent compound annual growth rate for its RAB over the next five years, the broker sees the company as having one of the best “long-term steady growth opportunities” in the utilities sector, as more renewable energy generators and electric vehicles seek access to the electricity network.

A major bugbear for other listed renewables players – the amount of time it takes for new projects to get connected to the grid – suggests the regulator should be more supportive of National Grid’s investment demands in the future.

Some 70 per cent of the company’s assets are power related, with the remainder linked to its gas transmission business. At the start of the year, National Grid sold 60 per cent of its gas division to a consortium led by infrastructure asset manager Macquarie. The consortium has an option to buy the remaining 40 per cent, but even if it remains in National Grid’s hands S&P Global said earlier this year the company is “more advanced than global peers in the energy transition” due to its emissions reduction plans.

At the other end of the risk scale from utilities are early-stage companies that operate solely in the field of cutting-edge renewables. Both Ceres Power (CWR) and ITM Power (ITM) develop hydrogen technologies. If made using renewable energy, hydrogen has the potential to be a wholly zero-carbon fuel applicable in a variety of settings, including home heating and transport. Wide as this scope might sound, the fuel is still a long way from commercialisation. In turn, the likes of Ceres and ITM are still likely to be a long way from profitability. The latter started the year by issuing its third profit warning in eight months – sending its shares plummeting once again. Earnings estimates for both companies have continued to be revised down by analysts since that point, according to FactSet, suggesting the cheaper entry point doesn’t yet represent a golden opportunity.

Those profit warnings, coupled with the collapse of unlisted battery producer start-up Britishvolt, have provided a harsh reminder of how difficult early-stage businesses can find life in an age of higher interest rates. But not all small businesses involved in the energy transition are struggling or even early-stage. Ricardo (RCDO), a consultancy that began life 100 years ago by making lower-emission tanks, nowadays advises companies on how best to transition to a greener future. Half-year figures in March revealed a surging order book with a book-to-bill ratio of 133 per cent. That said, a good run for the shares in recent months has seen the company’s one-year forward price/earnings ratio rise slightly to 16 times, having stood at 12 times when we featured the business in our ideas section last September.

 

Trusty assets 

Investors disinclined to watch green upstarts or converts cope with inevitable growing pains may be drawn to the (comparatively) stable world of renewable energy infrastructure trusts. Larger names in this field include The Renewables Infrastructure Group (TRIG), Aquila European Renewables (AERI), Foresight Solar (FRSL), Greencoat UK Wind (GBX) and Greencoat Renewables (GRP). There are no fewer than 20 such funds listed in the UK and net asset value (NAV) returns ballooned for many of them in 2022 – with some seeing growth of up to 20 per cent.

In most cases, rising power prices were the engine of this performance, although inflation also played a role. The design of the UK energy system means that, somewhat counterintuitively, the price of renewable power is tied to the price of gas. This resulted in wind and solar generators getting paid more for their electricity when Russia turned off its gas lines to Europe. While the introduction of a windfall tax on renewable power generators has not proved particularly onerous for the trusts, they are unlikely to be able to replicate last year’s returns as conditions in wholesale power markets normalise.

 

 

Broker Stifel assumes power prices will average somewhere around £100 per megawatt hour (MWh) in 2023, and inflation will decline towards 3 per cent. “We expect flattish NAVs this year, but we think investors should focus on income,” Stifel analysts said in April. They anticipate that dividend yields across the renewable infrastructure sector will come in at a respectable 6-7 per cent. Steady income from subsidies and power purchase agreements (PPAs), a type of long-term electricity supply contract, help facilitate these returns.

According to Numis analyst Colette Ord, investors should also remember that these funds look to hedge price volatility to ensure their direct exposures to energy prices don’t fluctuate wildly. “Although lower power prices will feed through to earnings over time, it’s not something we see impacting returns this year, or even next year, to any great degree,” she said. “Many of them have even locked [buyers] into really high power prices for the next three to four years.”

Like oil companies, renewable infrastructure funds are also sitting on significant reserves of cash accumulated as fossil fuel prices rose. This leaves them with the capacity to maintain, or even grow, dividends paid to shareholders or to reinvest the money in their existing assets. However, fears about the impact of falling power prices, as well as the impact of higher discount rates, have seen the heat go out of the market. Many renewable funds are now trading on significant – some may say excessive – discounts to NAV. “The Bluefield Solar Incomes (BSIF) and Greencoats of this world have cash in excess of three times their dividend cover – and in the case of Bluefield, that’s after paying back debt,” says Ord. “That gives you a lot of operational flexibility to drive returns, and that’s the key thing I think the market is missing at the moment.”

 

 

The need to close those discounts could prove more significant than some investors realise, suggests James Carthew of fund research firm QuotedData. “The major headwind for the sector is the inability to raise more capital, because a lot of [renewable funds’] business models were predicated on the ability to keep raising more money and investing in more stuff.”

Discounts are higher still in less-mature corners of the sector, such as the energy storage market. If large numbers of new renewable assets are going to be connected to the grid, we’ll need batteries to store the excess power produced when the wind is blowing and the sun is shining. And we’ll also need power reserves to draw on when conditions are sub-optimal.

There are a handful of funds, including Gresham House Energy Storage (GRID) and Gore Street Energy Storage (GSF), which invest in battery storage facilities. But there is still some uncertainty around their revenue streams and subsidy regimes, which isn’t the case for wind farms and solar parks. Stifel analysts said the sector will likely find new ways to protect earnings over time – perhaps via “more creative” financing structures and new revenue contracts.

“The risk is that this follows a period of revenue weakness until these improvements become more tangible in the UK. Hence, while we are cautiously optimistic in the medium term, the short term is uncertain,” they commented in March. For adventurous investors, however, now could be the time to gain exposure to a sector that is only going to become more important as the energy transition progresses.

Sceptics of renewable energy will often cite its intermittent nature as proof that it’s less reliable than incumbent coal power stations or gas-fired generators. Yet from an investor’s point of view, clean energy could be a highly dependable addition to a portfolio. While heady share price peaks can be a feature of oil and gas holdings, the spectre of a deep trough is never far behind. In contrast, revenue from subsidies accounts for 50 per cent of a typical renewable trust’s revenue, while around 30 per cent comes from PPAs.

In other words, the vast majority of revenues are ‘locked in’ for these funds – limiting their exposure to power price volatility. Of course, renewable assets have finite lives, so investors should ensure the portfolios they hold have a robust strategy for the future. “On a long-term view, funds need to ensure there is sufficient reinvestment of income – circa 3 per cent assuming 30 year asset life – to ensure NAVs are sustainable,” says Joe Pepper, an analyst at Liberum.

The recent surge in energy prices has tempted many investors to increase their stakes in the major oil and gas producers, but this doesn’t change the long-term trajectory. Renewables are still the future of energy, and there are plenty of ways for UK investors to gain direct exposure.