Saturday, June 1, 2013

Renewable investments can have positive effects on portfolios

By: Susanne Wermter
Susanne Wermter, senior fund manager Renewable Energies at Aquila Capital, says that a combination of wind, water and sun can have a balancing effect on a portfolio's return.
Global renewable energy development is striding ahead. Total worldwide investment in renewables excluding large hydro last year increased 17% to a record $257 billion, a six-fold increase since 2004 and 94% higher than 2007, according to the Global Status Report Renewables . By the end of 2011, renewables contributed a total of 20.3 per cent to global power production and this figure is set to rise. An estimated USD7 trillion is set for investment in renewable energies worldwide between 2010 to 2030
Institutional investor appetite for renewable energies on the rise
With traditional fixed income assets offering low yields many institutional investors are in search of alternatives to meet the steady flow of payment obligations. Other asset classes, such as equities, have frequently generated unsatisfactory results in the past due to high levels of volatility.
Against this backdrop, real assets are being viewed in an increasingly favourable light not least because they are driven by long-term macro trends independent of the capital markets such as population growth.
Renewable energies, including photovoltaics, wind energy and hydropower, offer investors an attractive risk/return profile, a low level of correlation with traditional asset classes (equities and bonds) and long-term stable cash flows. With insurance companies and pension funds focused on asset-liability management, this combination of benefits makes renewable energy a highly attractive asset class.
Renewable energy also benefits from the favourable political conditions where their use is being actively promoted in a bid to reduce our dependence on fossil fuels. The supply of fossil fuels can be expected to reach its peak in coming decades and then decline and by then, energy demand will probably be twice the supply that can be met by fossil sources alone. Furthermore, the so-called ESG (environmental, social, governmental) factor is playing an increasingly important role in supporting the investment case for renewable energy, which holds a clear advantage over fossil fuels in terms of sustainability.
Understanding the strengths and risks
Investing in renewable energies requires understanding not only the benefits but the risk too, several of which are very different from traditional capital market-oriented investments. For example, renewable energy investments offer a degree of inflation protection as the price of electricity - provided it is sold via the market - factors in inflation. Another advantage is that renewable energy plants are long-term assets and the same applies to the liabilities which are serviced by them. They are also subject to rigorous regulatory requirements. This makes it easier to prepare yield forecasts as revenues can be reliably calculated.
On the other hand, a clear dependence on a favourable regulatory framework and, by extension, continued political support must be also taken into account.
To mitigate potential regulatory and political risk we would advise that renewable investments should be diversified on a regional level and investors should keep an eye on general market development risks, particularly energy price forecasts.
As renewable energy is a comparatively "young" asset class, due diligence can also prove difficult. Furthermore, renewable energy includes a range of various assets with differing risk/return profiles and this means that investors are faced with a potentially complex valuation process. Investment risk depends to a large extent on the technology used, remuneration system, project phase and price. The risk can be reduced by diversifying across different technologies, projects and countries with their respective remuneration systems.
When valuing projects, investors should work together with experienced partners who can evaluate the revenue side in terms of power production as well as the quality of the technology and the location. Investing in renewable energy projects typically involves a relatively extensive evaluation phase at the start but over the longer term the amount of work is comparatively low.
Renewable energy is dominated by three key segments: photovoltaics (solar), wind and hydropower. For its solar investments, Aquila Capital concentrates on financially stable countries with feed-in tariffs with a focus on the euro area. Investments in installations already in existence or under construction offer security as they do not involve project development risks. The characteristically low volatility of returns - typically around four per cent a year which is comparable to bond portfolios - is a factor which makes investments in solar schemes particularly attractive.
While state guaranteed feed-in tariffs play a key role in selecting solar projects in Germany and France, their impact on wind is less clear cut. Production costs of wind energy lie close to market level and in a few years, there is much to suggest that it could become more attractive for a wind farm to sell the power directly to the market.
For institutional investors it is worthwhile investing in existing installations or those under construction. As wind energy shows higher earnings volatility than photovoltaics for example, an examination of the project should focus carefully on the specialist wind report. Wind forecasts are often overoptimistic and imprecise as wind farms can be exposed to very strong micro-climatic influences. The quality of wind forecasts has risen considerably in recent years but specialist expertise is imperative. In our view a successful wind energy investment can only be achieved by working with long established partners with extensive technical expertise and experience.
Hydropower is one of the oldest technologies for generating power and is by far the most important form of renewable energy generation worldwide, accounting for more than 15 per cent of global electricity production.
Hydropower is the most economical form of power generation and the plants have a long service life of up to 100 years. The efficiency factor of a hydropower plant lies at between 90 and 95 per cent compared with that of natural gas plants at 58 per cent or coal power stations of 40 to 45 per cent. Hydropower plants are already economically self-sufficient and largely independent of subsidies. Further advantages lie in the high and stable predictability of the returns.
However, the number of suitable and economically viable hydropower locations is limited. The potential for further hydropower locations in core Europe appears to be exhausted but interesting possibilities can be found in Scandinavia and southeast Europe.
Diversification is key
Investing in solar, wind or hydro can have a positive diversifying effect on a portfolio yet analysis shows that further diversification exists within the different types of renewable energy. For example, sun and wind correlate negatively in their return profile while hydropower shows practically no correlation with the two other segments. If the three segments illustrated here are combined, considerable diversification advantages can be derived in the form of far lower volatility in conjunction with higher returns over the entire year.
In conclusion, we believe that renewable energy investment can have a positive impact on the portfolio as a whole. A combination of a favourable political climate and undeniable macro-trends strengthens the investment case for institutional investors looking to mitigate risk, increase diversification and generate returns. But like any asset class, risks abound and investors are advised to work with an investment manager with expert knowledge and a strong track record.