Tim Humphreys
Renewable energy companies are the typical ‘go-to’ exposure for the multi-generational thematic of energy transition. However, some renewable energy investments can carry higher risk.
An alternative way to play this transition, and one we argue with less risk, is through the regulated utilities sector. Utilities have a critical role in the energy transition, with attractive investment characteristics for long-term infrastructure and ESG focused investors.
The opportunity lies in the fact that utilities have been overlooked by markets, so far, as an essential part of the transition to renewable energy. We believe that is about to change.
Organisations like the United Nations have set targets for the transition to new types of cleaner and renewable energies, including wind, solar, geothermal, hydro-electric, hydrogen gas, and carbon capture utilisation and storage (CCUS), amongst the many examples. The Paris Agreement seeks net zero carbon emissions by 2050. The capital-intensive nature of energy development and conversion along the entire value chain means that the transition to full renewable energy may take several decades.
More and more governments are signing up to a ‘net zero by 2050’ target. For investors, this means we are still at an early stage in the development of renewables, and in the transition towards renewable energy dominated economies, and thus the opportunity to participate is rich with options.
Policy measures to tackle climate change are highly likely to strengthen over time, and their objectives made more ambitious. This current and emerging policy backdrop will continue to create more and more investment opportunities for the utility and renewable energy companies.
Pricing risk
As infrastructure investors, we are focused on the stability and predictability of a company’s cash flows. This is to ensure that the portfolio provides the characteristics investors expect of the infrastructure asset class – downside protection and low correlation to global equities – but at the same time, contributes to meeting our long-term return objective.
The most significant risk with investing in renewable energy companies is merchant (or wholesale electricity) pricing risk which also ties back to the contract/PPA tenure, and pricing applicable to each asset and the company overall. Nearly all renewable energy projects or companies carry a level of merchant pricing risk – it depends on what percentage of output is contracted and how this evolves over time.
Generally speaking, companies with meaningful merchant price risk (~20% or more of revenue) and with an insufficiently long weighted average contract/PPA duration (less than 10 years) do not display the cash flow certainty to qualify as Essential Infrastructure under our definitions.
The challenge with merchant price risk is the difficulty and complexity in forecasting electricity prices – both in the short term and longer term. Long-term electricity prices should converge towards long-run marginal costs and therefore are a function of expectations of future fuel costs (zero for renewables), capital costs, cost of capital, capacity factors and operating costs for different types of electricity generation. Therefore, and by definition, this is influenced by technological trends which are inherently difficult to forecast.
Also, renewable energy assets, particularly solar, can fall victim to their own success. That is, solar plants located in a similar region or even the same country tend to generate electricity in high correlation to each other (that is, when the sun shines it shines for all solar producers at once), impacting realised pricing outcomes.
This in turn can mean competitive electricity price outcomes increasingly displaying ‘duck curve’ characteristics – low prices during daylight hours, and higher prices at other times, meaning realised price outcomes for solar plants can be materially below average market prices, affecting their project returns. Batteries are increasingly being paired with solar to store this energy for use when it is of higher value.
For infrastructure investors longer term PPA contracts provide a high level of certainty of cash flows such that the tail risk, after the initial contracts expire, is less meaningful to achieving an overall acceptable risk-adjusted return. But, it is challenging for infrastructure investors to invest in these types of assets, which have exposure to competitive price outcomes or shorter term PPAs.
Investment opportunities
We are excited by a number of investment opportunities in renewable energy companies globally. Despite improving fundamentals, the share prices of many renewable energy companies globally have been under pressure, creating attractive opportunities for long-term investors.
Our most favoured renewable energy companies are NextEra (US onshore wind and solar) and Ørsted (global offshore wind), both global leaders in renewables in their fields. Both these companies are in unparalleled competitive positions to grow strongly, successfully execute and deliver attractive risk-adjusted returns for their shareholders.
In North America, many regulated electric utilities are integrated by nature, in that they own power generation assets that supply their customer bases, together with the poles and wires. These utilities are, in nearly all instances, undertaking significant investments in renewable energy (onshore wind/offshore wind/solar) and at the same time retiring coal-fired generation with an ultimate objective of reaching net zero by no later than 2050. These investments are being made within a ‘regulatory construct’, meaning attractive, but relatively low, risk adjusted returns for equity investors, while at the same time allowing infrastructure investors to really participate in the decarbonisation journey,
Critically, much of the electrical infrastructure in developed markets is ageing, requiring a wave of investment.
For investors seeking to gain exposure to the energy transition, investing in regulated utilities offers an attractive alternative to renewable energy companies as in most instances they display lower risk but comparable, and in some cases superior, return and growth profiles. The attractiveness of these investment opportunities, from an energy transition perspective, is commonly misunderstood or overlooked, however we suspect this will change.
Go regulated
Regulated utilities can take the form of either: transmission and distribution companies (sometimes referred to as ‘poles and wires’); or ‘vertically integrated’ companies, where the utility owns the entire vertical supply chain – including generation, transmission and distribution electrical assets, all of which are fully regulated. ‘Poles and wires’ regulated utilities exist in Australia, the UK, Europe and also some areas of North America, and own the physical wires that transmit and/or distribute electricity. By contrast, in Ausbil’s Essential Infrastructure definition, ‘vertically integrated’ companies can only be found in North America.
Regulated utilities are critical enablers of the energy transition. Their role is to support the increasing role of renewable energy in the generation stack by investing significantly in the electricity grids. Major transmission investment in the form of high-voltage assets in particular is required to connect new renewable energy assets. Such investment also supports further interconnection between different electricity markets and countries, particularly important given the challenges associated with the intermittent nature of renewable energy. These investments are included in the rate base (or regulated asset base) of the regulated utility for which they are entitled to earn a reasonable return on, and of, capital, while also recovering their associated operating costs.
It should be also highlighted that investment opportunities for the regulated utilities are not confined to supporting the energy transition. There is a broader investment need to ensure the electrical grids are resilient and able to reliably supply energy as the climate changes.
For example, it is well understood that climate change is making extreme weather events more common (such as, hurricanes, wildfires and floods), creating ever-increasing challenges for infrastructure assets to maintain reliable and safe supply. This is driving another significant investment need, further enhancing the growth potential of this sector.
While regulated utilities are largely overlooked by the equity markets, there are huge long-term opportunities for low-risk, secular investment across major thematics such as the energy transition and climate change. Few sectors enjoy such powerful tailwinds, and that is why we believe that regulated utilities currently represent such an attractive opportunity.
The energy transition is clearly a complex challenge and there is some uncertainty over how it will ultimately be realised. Decarbonising energy systems requires balancing the sometimes competing objectives around the speed of decarbonisation, affordability and reliability of supply.
Companies and regulators need to balance the speed of decarbonisation initiatives with affordability considerations. There will also be different impacts across customer groups, at different points in time, and as large investments are made this can put upward pressure on end customer bills. This creates complex equity considerations that require a detailed understanding and analysis of policy responses and regulatory constructs. Assessing this level of regulatory detail is complex, and one of the reasons that we are confident we can find inefficiencies in how equity markets price these companies, and in so doing, showing outperformance potential in this asset class.
By Tim Humphreys, Head of Global Listed Infrastructure
