3 November, 2022 / Opinion
Guide to renewable infrastructure
Parmenion's senior investment manager Mollie Thornton explains the risks and opportunities of investing in this asset class
What is renewable infrastructure?
Infrastructure means the physical assets that are essential for society. Renewable infrastructure is a relatively new and growing sub-asset class within this and mainly involves investing in solar, wind and hydro power plants, as well as areas like geothermal energy and energy storage. The exact areas will depend on the specifics of each portfolio.
Investing in listed renewable infrastructure is through listed equities as well as investment trusts (also listed) which own and operate the solar, wind and hydro assets.
Some investors may choose to invest in renewable infrastructure across developed and emerging markets, although focusing on developed markets helps reduce political and regulatory risk.
What are the key return drivers?
The returns from the asset class primarily come from agreements the renewable energy companies have to provide power. Typically, the agreements are with high quality counterparties like governments. The counterparties pay an agreed series of payments (often inflation-linked). In many cases the payments do not depend on how much power is used, just that power is available, which means there is high visibility of cashflows and less dependence on power demand. In this way, infrastructure can be less economically sensitive and can provide good diversification against mainstream equities.
Renewable infrastructure benefits from strong tailwinds at the moment, as governments seek to decarbonise their energy systems and improve energy security and affordability. For example, a significant portion of the $369bn funding under the recent Inflation Reduction Act in the US will be invested in renewables. This supports the long-term returns of the asset class.
Infrastructure assets are physical so they have an embedded intrinsic value. It would be very expensive with high barriers to entry for new companies to come in and build new solar, wind or hydro plants to compete with existing assets.
The majority of the overall expected return for developed markets listed renewable infrastructure comes from the cashflow yield, plus potentially a small element of capital appreciation. So renewable infrastructure can be a valuable asset for investors needing regular income.
Understanding the risks
In terms of its volatility profile, renewable infrastructure typically sits between mainstream equities and bonds.
Liquidity is something that needs to be closely monitored. Even for listed infrastructure companies and investment trusts, liquidity can dry up during periods of market stress. This is also reflected through bid/offer spreads and in the case of Investment Trusts, premiums / discounts to NAVs. So it’s important for investors in infrastructure to take a long-term view and ensure the allocation is held as part of a diversified portfolio alongside more liquid assets to avoid becoming a forced seller. Also close monitoring of the fund manager is essential.
Renewable infrastructure investors receive a series of cashflows over the long term, whose value is calculated based on long-term interest rates. When interest rates rise sharply, as we’ve seen during September 2022 for example, this feeds through into negative returns for the asset class. So, the asset class involves interest rate risk. However, this is partly offset by the fact that renewable infrastructure has a good level of inflation exposure and its value increases as inflation rises.
Infrastructure funds which invest in investment trusts tend to have overall costs of over 1% allowing for both the fund manager and investment trust fees. So, this is a relatively expensive asset class, due to the high degree of active management involved. Investors need to be comfortable with the benefits the asset class brings to their portfolio to warrant these costs.
Renewable infrastructure can be a useful diversifier in multi-asset portfolios alongside equity and bonds.
The asset class is relatively defensive due to the visibility of the long-term cashflows, in many cases paid on an availability basis and backed by governments.
Renewable infrastructure provides an inflation-linked yield, which is attractive for investors needing regular income.
Long-term trends mean increasing demand for renewable energy, supporting the long-term returns for the asset class.
But investors need to be mindful of liquidity and costs and reflect this in the sizing of an allocation. The asset class generally falls in value as interest rates rise, although this is partly offset by the fact that its value rises as inflation increases.
Part of the Bonhill Group.