Invested interest

Renewable energy desperately needs to attract institutional investors such as hedge funds, pension funds and insurance companies. Mark Jones explains how they can do it

Historically, the UK power industry has been dominated by vertically integrated utilities. This infrastructure is predominantly held on balance sheet, which absorbs credit headroom and reduces spending potential at a time when the UK needs around £110 billion of funding to plug an energy gap requiring c60GW of new capacity by 2025.

Institutional investors, such as pension funds and sovereign wealth funds, are currently involved with a significant proportion of non-energy UK infrastructure assets. The same cannot be said in the energy arena. In onshore wind, for example, institutional investors own only around 5 per cent of the 5GW of operational capacity. Offshore wind, conventional generation and nuclear power are similar stories.

The energy sector must make a better job of courting institutional investors. A healthy inflow of capital from these investors combined with government initiatives, such as the Green Investment Bank, and well capitalised banks is the only plausible way we will bridge the funding gap and release the capital needed to re-power and decarbonise UK energy.

The refinancing opportunity in wind alone is significant. With a UK target of 13GW of onshore wind capacity and 18GW of offshore wind capacity by 2020, the opportunity is in the region of £75 billion in capital to be recycled and re-invested. So, what could attract institutional investors to this opportunity?

First, the opportunity needs to look, smell and feel like an institutional investment asset class. This means packaging up the assets as an equity product (similar to shares in a corporate), a bond or a real estate product. Second, renewables can offer higher yields compared with equities and medium-term bond yields (see bar chart). Third, diversifying volume risk and having credit worthy counterparties on power purchase agreements (PPA) and operations and maintenance agreements is required.

Although there have been a number of direct investments into UK energy assets, Greencoat UK Wind, a UK investment trust that invests solely in proven UK wind infrastructure, has shown a way forward. Managed by Greencoat Capital, the fund has recently completed a £260 million initial public offering on the AIM market of the London Stock Exchange, which was significantly oversubscribed. The fund acquired interests in six projects, totalling 126.5MW, from SSE and RWE.

Subscribers included SSE and the Department for Business, Innovation & Skills, who together contributed a total of £60 million. The remaining £200 million is believed to have been snapped up by private investors and institutional investors. The Green Investment Bank also took a stake in Rhyl Flats – the RWE-owned offshore windfarm.

The backing of the UK government no doubt helped to attract investors. However, the deal also reflects the extent to which there is an appetite for renewable energy investment opportunities from the institutional investment community provided it meets their requirements: the product is a tradable equity product (provides liquidity) and the target dividend yield is 6 per cent (between 2 and 2.5 per cent above FTSE 100 equity dividend yield performance). In addition, rather than single projects with concentrated volume risk, Greencoat has aggregated six assets, reducing the impacts of volume and wind intermittency on the investor returns.

With the success of the Greencoat offering, the question is what other opportunities might be out there for utilities to release capital from their balance sheets. This will likely depend on the size of the asset.

For example, a sub-20MW operational project could attract high net worth individuals seeking access to tax-advantaged investments. This means that even mid-range performing assets could have a viable exit, because the tax breaks increase the investor’s return.

A project or collection of projects in the 20MW to 75MW range is more likely to resemble the Greencoat initial public offering. Interestingly, it appears that the more immediate opportunities are in UK solar as opposed to wind, due to low technology and volume risk. The public route is an option but a privately placed fund should not be ruled out in the way funds are typically raised.

Projects in excess of 75MW may appeal to large institutional investors as direct placements. For example, Munich RE, which invested in three onshore windfarms acquired in late 2012; Masdar, which invested in the London Array offshore windfarm; and, going back to 2007, there was the M&G Investments entry into the Zephyr portfolio.

Provided the investment product suits the investor need, the key to getting a deal done will be a willingness from the utility to offer commercially viable terms on PPA and operations and maintenance agreements. This may cause conflict. Because the utility will no longer own the asset, there is no strong rationale to offer market-leading terms on contracts, which in turn reduces asset value to the incoming investor. An approach to align interests through utilities retaining minority stakes may be more favourable.

The political and economic challenges of the past five years have placed utilities in a difficult situation. There has been investment in installed capacity but the total required funding far exceeds what utilities can provide. Investors are also put off by the regulatory uncertainty surrounding UK energy.

If this subsides, and the balance of institutional investment begins to align with traditional infrastructure, the challenge facing utilities will be what to invest in next. Electricity Market Reform, the ongoing debate around the Energy Bill and the conflict around subsidies, contracts for difference and Renewables Obligation Certificates, has left a lot of uncertainty. What is certain is that decisions will need to be made soon so that we are not left long on assets and short on capital.

Mark Jones is an associate director at Savills Energy, specialising in asset disposals and fundraising in the renewable energy sector

This article first appeared in Utility Week’s print edition of 26th April March 2013.

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