Ecofin Global Utilities and infrastructure Trust (EGL) has announced its annual results for the year ended 30 September 2021, during which it has comfortably outperformed the utilities and infrastructure indices against which it benchmarks itself. During the year, EGL has provided NAV and share price total returns of 22.9% and 28.9% respectively. Both of these are markedly ahead of those provided by the MSCI World Utilities and the S&P Global Infrastructure indices (total returns of 3.5% and 17.1%, respectively).
Five-year track record of outperformance, with marked narrowing of the discount
The end of the last financial year marked EGL’s fifth anniversary (EGL was incorporated on 27 June 2016 and its investment activities began on 13 September 2016 when the liquid assets of its predecessor vehicle, Ecofin Water & Power Opportunities Plc (EWPO) were transferred to it. The formal inception date for the measurement of the Company’s performance is 26 September 2016, the date its shares were listed on the London Stock Exchange). Since the rollover, EGL’s goal has been to deliver a 6-12% per annum (total return) over time and, with the passing of its fifth anniversary, we can see that it has comfortably achieved this. From launch on 26 September 2016 to 30 September 2021, EGL’s NAV total return averaged 11.3% per annum and its share price total return averaged 17.1% per annum.
Premium rating has allowed further share issuance
The superior share price performance reflects the fact that as EGL’s strategy has gained increased awareness among investors, its discount to NAV has been eliminated so that it now regularly trades at a modest premium to NAV. The strong demand for EGL’s shares has allowed it to issue shares to the benefit of all shareholders (increasing its asset base has the twin benefits of increasing liquidity in the trust’s shares while putting downward pressure on the ongoing charges ratio as its fixed costs are spread over a larger asset base). During the year to 30 September 2021, EGL issued 5.725m new shares (worth £10.6m) and it has also issued another 355,000 shares since its financial year end. EGL’s board says that it wants to continue to increase the size of the trust. In terms of further improvements to its ongoing charges ratio, a tiered management fee took effect from 1 April 2021, which should help to ensure that this continues to decline as the trust grows.
Manager’s comments on markets and our sectors
“Economic optimism and equity markets increased for a large part of EGL’s financial year with vaccine roll-outs, the relaxation of COVID-19 restrictions and additional central government stimulus packages. President Biden’s inauguration and early priorities, including around fighting climate change and rebuilding infrastructure with sustainability prioritised, encouraged investors too, despite high equity valuations in many areas.
“Sector leadership in equity markets changed abruptly as we entered calendar 2021 and the focus became the normalisation of activity levels, business operations and earnings, especially in those sectors which had been most bruised during the height of the pandemic in 2020. In EGL’s investment universe, the more cyclical transportation infrastructure and waste management stocks were strong performers. ‘Clean and green’ equities, in contrast, were notable underperformers despite the positive tailwind of massive policy support and an abundance of positive catalysts for long-term growth. A degree of mean-reversion was perhaps due after the dramatic outperformance for the clean energy universe – which was largely unaffected by COVID – in 2020 and the attendant very large new ESG fund inflows.
“Another factor pressuring performance for utilities, particularly renewables as well as other long duration business models, has been higher inflation and the increase in market interest rates. Shares in Enel, Iberdrola, RWE, Brookfield Renewable and NextEra Energy all reacted to the strength in commodities and freight prices threatening to squeeze renewables developer returns in the near term. Notwithstanding these headwinds, we maintained our conviction as renewables’ economic competitiveness vis-à-vis fossil fuel alternatives continues to improve. This should allow large renewables developers to exert pricing power and defend future project returns.
“We see encouraging signs that market prices for power price agreements (PPAs) are moving higher to accommodate increased capital expenditure. In most cases, because project returns are earned over a 20-30 year useful life, the pricing differential required to offset the cost increases is modest. For example, a 50% rise in the price of copper might only require a 3-5% increase in the price of the next PPA to keep expected project returns constant. Simultaneously, other factors such as improving productivity and efficiency of equipment as well as economies of scale continue to improve the economics of renewable energy.
“Yet, the most significant factor in support of greater and faster investments in renewables is the higher market price for electricity. This is due to a variety of factors including recovering – or, in the case of China, even materially increasing – power demand, rising prices for coal and natural gas, poor hydro conditions in key regions such as Chile, Brazil and southern China, poor wind conditions in Western Europe, as well as a significant increase in the cost of carbon credits in Europe and Canada. This substantially improves the competitiveness of renewables. With a full-blown energy crisis underway by EGL’s financial year-end, governments are seeking to accelerate the development of renewables and reduce the dependence of energy systems on highly volatile fossil fuels.
“Persistently higher fuel commodity prices will increase substitution and conservation over time, both of which are needed to achieve climate goals, but in the near-term such dramatically higher energy prices are increasing the inflationary pressures. This is not only proving beneficial to power producers, which have outperformed this year in expectation of expanded margins on the back of higher realised prices, but should also over time benefit those regulated utilities operating in real regulatory environments (i.e., whose regulatory asset values are adjusted higher by inflation with a lag).
“EGL’s renewables-focussed utilities holdings started to perform again more recently and portfolio returns were also helped by the return of take-over activity in the listed infrastructure space. Portfolio holdings Covanta (US) and Spark Infrastructure (Australia) were both bid for within months of each other, an unsurprising turn of events given their quality businesses and the deep undervaluation of listed infrastructure compared to private markets. With cash-rich private equity firms continuing to look for investment opportunities in listed companies and larger public groups seeking to unlock hidden value, we expect further deals in the months and years ahead.”
Manager comments on performance
“EGL’s portfolio returns substantially exceeded those of comparable global indices during the financial year. Performance was broadly unaffected by the acute underperformance of utilities and renewables, thanks to successful stock selection and geographical diversification. EGL’s NAV total return was 22.9%. While we do not manage the portfolio by reference to any single index, performance is generally measured against the S&P Global Infrastructure Index, which comprises utilities and economic infrastructure (like EGL’s portfolio), and the MSCI World Utilities Index, which returned 17.1% and 3.5%, respectively, during the year in sterling.
“Actively managed leverage was helpful to returns, contributing +4.7%, but sterling’s strength against the US dollar (+4.3%) and Euro (+5.6%) produced a slightly larger drag on the NAV of -5.2%.
“Leverage provided a small boost to the revenue account too. Although income from investments held up comparatively well in 2020, it increased 23.7% during 2021 helped by a normalisation of dividends from certain French holdings which had suspended shareholder remuneration last year. Also, dividend flows from portfolio holdings were generally strong, supporting our longer term expectation of 5-7% per annum growth in income.
“The stock picking that allowed EGL to outperform its sectors included:
“The share prices of China Longyuan Power and China Suntien Green Power increased by 303% and 338%, respectively. China Suntien’s shares have been re-rating to better reflect the value of and growth prospects for the business as China incrementally pivots to cleaner electricity generation. It has a sustainable competitive advantage from a low carbon footprint and lower cost of power generation relative to rapidly rising power prices in China. Despite equally strong performance, Longyuan’s three main catalysts remain on the horizon: an A-share listing potentially allowing a lower cost of capital; asset swaps with its parent such that Longyuan receives additional renewables projects while shifting its coal-fired assets to its parent; and a reduction in government incentives.
“Covanta, a US waste-to-energy company, was bid for by EQT Infrastructure. Ecofin, which held approximately 1.7% of Covanta’s outstanding shares across client portfolios, wrote to the company’s board, which recommended that shareholders support the terms of the deal, twice to explain why we believed the bid significantly undervalued Covanta, which stands at the very outset of an earnings inflection, and to relay our dissatisfaction that the board did not consult with shareholders during the strategic review. We voted against the offer, but the resolution passed and the deal will close before year-end. The holding was a highly positive contributor to the NAV this year.
“At the beginning of the fiscal year, another environmental share, Veolia, was reintroduced into the portfolio after a long-awaited bid for its main competitor Suez. The bid succeeded as expected and the shares rose by approximately 75% from our purchase level, buoyed by improving fundamentals driven by increased global economic activity and the increasingly tangible prospect of a 40% medium-term accretion from the deal.
“Spark Infrastructure received what we believe is an attractive takeover offer at a fair premium, leading the stock to rise over 45% during the fiscal year. The investment fund, which owns a major proportion of Australia’s electricity infrastructure, received a bid from a consortium including the large private infrastructure investors KKR and Ontario Teachers’ Pension Plan. We await the details on the vote but are supportive in principle.
“Drax and SSE performed very well in a poor year for many utilities. Drax was just outside the ‘top 10’ by year-end as we had increased the position significantly earlier in the year. The shares performed strongly on the back of rising power prices in the UK. Our forecasts for the longer term profitability of the biomass supply business and BECCS (bioenergy with carbon capture and storage) prospects are materially more optimistic than consensus. SSE’s share price has been underpinned by press reports that activist investor Elliott is building a stake to push for a value-unlocking reorganisation of the group. The company’s fundamentals are strong, with renewables generation resources (wind and hydro) set to expand considerably, coupled with above-average growth rates in the electricity networks business. This is sufficient to justify sector-leading returns in the medium term.
“Exelon, a major investor in grid modernisation and power infrastructure in the US, saw its shares benefit from discussions surrounding policy support for its nuclear fleet – the largest source of zero-carbon electrons in the US market – from both State and Federal legislators. Rising electricity prices are increasingly positive for Exelon’s fundamentals, giving the company the opportunity to lock in higher prices in the medium-term. The upcoming separation of the business into two entities – one focused on generation and one focused on utilities – has also been supportive to share price performance.
“Finally, NextEra Energy continued to contribute positively to the NAV as the largest position in the portfolio through impeccable execution, reporting solid quarterly results with management conveying an optimistic message about the company’s growth prospects, with limited impact from equipment cost inflation.
“Outside China, shares in renewables-focussed utilities were under pressure for much of the year. Enel, Iberdrola, EDF, RWE, Endesa, Brookfield Renewable and TransAlta Renewables, all prominent holdings in our portfolio, underperformed. Sector-wide concerns centred on developer returns in an environment of higher inflation and interest rates were exacerbated by an array of idiosyncratic issues. The Spanish government’s move in September to tax ‘surplus’ profits for utilities for six months hurt the share prices of Iberdrola, Endesa and Enel beyond that justified by the likely impact of the temporary measures, only for most of the impact to be reversed by the beginning of November. The French government’s inconclusiveness on the restructuring of EDF hurt its share price performance throughout the year, offering only limited room for performance despite dramatically improved fundamentals. Elections in Germany, which to a large extent delivered continuity vis-à-vis the outgoing administration albeit with a notably larger role to play for the Green Party, detracted from RWE’s performance by raising concerns that a faster closure of the company’s coal plants may negatively impact profitability.
“These large European renewables majors have received more favourable attention in recent months and their shares have started to recover.
Managers comments on portfolio activity (purchases and sales)
“As the year progressed, we gradually rebalanced the portfolio with four guiding principles:
- Reduce the portfolio’s sensitivity to steeper yield curves and favour business models with inflation pass-throughs (Terna, Pennon, National Grid);
- Make room for names with above-average commodity exposure, and select names where share prices do not yet reflect the full extent of sharply higher carbon and power prices (Uniper, Drax, A2A);
- Partially rebalance the portfolio with additional transportation infrastructure (mainly toll roads) and environmental names to increase overall cyclical exposure (Atlantia, Atlas Arteria, Ferrovial, Veolia);
- Continue to look for new stock ideas in the US where the energy transition is less advanced but set to be accelerated by President Biden’s climate policies (Exelon, AEP, Alliant Energy, AES).
“Some holdings were reduced or sold during the year to accommodate the re-positioning. The largest of these was A2A, Italy’s largest municipal utility, which had been added to the portfolio in November 2020. Our expectation of a significant increase in its growth ambitions was duly met at the company’s capital markets day in January 2021 and the business continued to benefit from the rise in Italian power prices. The shares appreciated significantly, and the position was sold in June to lock in profits after the shares reached a level that was reasonably close to our fundamental valuation.
“We lost conviction in Edison International, which continues to trade at attractive value but not getting the benefit of the doubt from investors around wildfire risks. Towards the end of the fiscal year, we reduced the holdings in China Longyuan and China Suntien Green as a risk management exercise rather than a reflection of a change in heart for their strong prospects. This proved particularly well-timed considering the shares’ performance over the subsequent couple of months. We also reduced the holdings in renewables major Brookfield Renewable and exited Algonquin Power & Utilities, which have been disappointing stocks of late yet remain richly valued.
“This renewables exposure was replaced through our investment in Transition, which was listed in Paris in June with a mission to invest in the energy transition, and the IPO of Acciona Energia, a 100% pure renewable energy company listed on the Spanish exchange with 11GW of renewables in operation, heading for 20GW by 2025, and a very attractive valuation.”
Manager’s comments on income and gearing
“In the Interim Report we forecast that income from investments would increase this year by 15%; the final tally shows +23.7%. While we anticipated a strong year-over-year increase in cashflows and dividends for the portfolio constituents given the relatively low base of 2020, this was boosted by the resumption of payments from a few companies forced to suspend payments during the pandemic. The NAV also benefitted from a special dividend of £1.28m from Pennon, funded by the disposal of its waste business, which was categorised as a ‘return of capital’ rather than revenue. Over the coming years we expect the growth in income from investments in the portfolio to revert to approximately 5-7% per annum.
“The level of gearing averaged 14% during the year. Borrowings were stepped up to approximately 16-17% early in 2021 and maintained until September, when leverage was scaled back following strong performance. At year-end gearing was 12.6%, although this measure included a 1.9% quasi-cash position in Transition, as well as two companies (Covanta and Spark Infrastructure), together 5.9% of the portfolio, which are subject to take-over offers. The portfolio yield was 4.2% as at 30 September, 2021.”
Manager’s comments on outlook
“Extreme weather events, environmental disasters and spiking energy costs this year are more than ever pushing the public’s attention to the increasing impact of climate change on our daily lives. Regulation and attitudes (including investor and consumer preferences) point to an increasingly constructive context for rapid progress towards sustainability targets, but significant action is both needed and likely.
“Even before COP26, there were several favourable policy developments for infrastructure modernisation and development and more have been announced since. Xi Jinping reiterated China’s target of carbon neutrality by 2060 and added that China would increase support for other developing countries in expanding low-carbon energy and not build new coal-fired power projects abroad. The EU released its “Fit for 55” plan with specific 2030 targets for renewables across the energy, building, industry and transport sectors. Japan issued a new draft energy policy with much higher renewable energy generation targets, particularly focused on offshore wind. Progress on the US Infrastructure Bill and Budget Reconciliation was slower than anticipated, but many measures announced so far would be very supportive of energy transition end-markets.
“These serve as positive catalysts for EGL’s sectors, at a time when government policy, once the main and often only driver of energy transition investments, is being complemented by increasing corporate demand for solutions to improve the sustainability of their business models. Companies are turning to renewables to lock in their electricity cost base, gaining the double benefit of long-term cost visibility and reducing or eliminating their carbon footprint. While the smaller renewables developers may struggle to tap into this opportunity due to delays and cost increases, the larger utilities should emerge stronger, with increased demand for their renewable output and more projects to choose from.
“We remain confident that new investment in the renewables industry will maintain historic levels of returns going forward. Renewables remain the lowest cost option for new electricity development almost everywhere, and the speed and scale of substitution continues to accelerate. Decarbonisation of the grid with these resources will be a multi-decade undertaking. Supply constraints forcing price increases for natural gas, coal, oil and electricity will not derail and instead should accelerate the (not always smooth) transition underway.
“We believe that EGL’s portfolio can deliver solid growth in a variety of economic and market environments. We continue to find opportunities, with companies in the portfolio and on our watchlists proving their resilience. The development of their pipeline of opportunities provides investors with greater visibility on cash flow growth over the coming years. Valuations in our sectors still largely reflect historical norms rather than the substantial growth we envisage given the course of policy and corporate capital allocation plans, and they became increasingly attractive during the year as the broader market extended its rally. We are seeing the impact of well-funded private equity investors bidding for listed infrastructure companies and expect corporate activity to continue and even accelerate in the coming years. With government policy, public opinion and corporate governance all pushing in the same direction, the underperformance of renewable energy equities earlier this year should prove to have been nothing more than a short-term setback.”