The need to decarbonise the global economy to address the myriad issues that are being created by climate change is now well understood. For this, a range of solutions is required but it is clear that for many economies, the UK included, renewables – primarily solar and wind but with smaller contributions from other technologies such as tidal and run-of-the-river hydro – will be the backbone of the future energy mix, and these will need to be complemented by carbon-neutral technologies such as nuclear, biomass and the like. This will require considerable investment in both generation capacity and grid infrastructure. The closed-ended structure of investment companies means that they are well positioned to support this change and there is a raft of London-listed investment vehicles focused on renewables infrastructure.
Intermittency begats storage
The key issue for networks that are shifting away from traditional thermal sources of generation such as coal and oil, to renewables, is the intermittency of the latter’s generation. Traditional coal- and oil-fired plants take some time to fire up/cool down but can run continuously and are therefore suitable for baseload capacity. Solar and wind generate power according to their own schedule, which may not coincide with demand from the network, hence the need for storage solutions to allow suppliers to store power when the generation resource is abundant and release it when it is in short supply.
A busy week on the storage front
In the investment companies’ space, there has been a decent chunk of new information released to the market this week focused on energy storage. On Wednesday, NextEnergy Solar (NESF) put out a 31-page presentation detailing its proposed energy storage strategy (click here to read in full); on Thursday, HydrogenOne (HGEN) held a capital markets day – our James Carthew and Andrew Courtney attended (James has covered this for Citywire in an article that should be published next week); and also on Thursday, Harmony Energy Income Trust (HEIT) published a strong first set of results, you can hear a bit more about this from James in the playback from our weekly show (click here to view).
Lessons for all from NESF
In its strategy announcement, NESF lists a number of key reasons to increase battery storage in its portfolio, but these can be applied to the distribution grid as a whole. The first we have covered above (energy storage provides flexibility to renewables to address their intermittency and match fluctuating demand with fluctuating supply) but it also says that the co-location of batteries with solar assets multiplies benefits and cost savings; and that energy storage can generate revenues through multiple pathways (and this bit, while important, can get quite complicated – something we hope to return to in greater detail in a future publication).
Solar exhibits a predictable generation profile during a single day. This varies throughout the year as the season changes but the rule of thumb is that solar irradiation can be predicted to be within +/-7% with 95% confidence on a given day. As solar resource is consistent, batteries (and potentially other storage systems) are able to capitalise on wholesale market price fluctuations by storing power when renewable output is high and the wholesale price is likely to be low (sometimes renewable generators receive nothing for inputting power into the grid when supply outstrips demand) and dispatching this at peak demand when prices are highest. For existing generators, the benefits are obvious. In a world with more co-located batteries, why discharge into the grid at time when you aren’t going to get paid?
Grid connections – the most significant hurdle
Currently, the single biggest challenge to adding renewable capacity and battery storage to the grid is the availability of a grid connection, for which there is a significant backlog. NESF thinks that this puts it and, by extension other existing generators, at an advantage when it comes to deploying battery storage. Having the land available to site the batteries will help too (presumably the land cost will either be less or non-existent). NESF thinks that the additional flexibility provided by co-located batteries will allow the generation assets to achieve superior terms in power purchase agreements (PPAs) and enhancing revenues for power through shifting output to the grid at times of higher demand.
Energy storage – multiple pathways to revenue generation
For batteries, revenues can be driven by volatility (buying low and selling high) and by providing stability or flexibility services to the grid (the balancing mechanism or the capacity market). For a renewable asset in isolation, its level of generation and therefore output is entirely dependent on the availability of its underlying resource. However, with the addition of batteries, the output can adapt to changing market conditions. With the addition of batteries, generators can ‘revenue stack’, that is, generate revenues from different sources as conditions change. This is supported by the grid’s adoption of energy storage as part of its plans for managing the network. The chart below, taken from NESF’s battery storage proposals, shows an example of how it expects the revenue stack from a standalone 2 hour battery project to evolve between now at 2050. It is clear that the day ahead market and balancing market are key contributors but revenue can be derived from a number of sources and that this should adapt over time.
The market has evolved dramatically in the last few years with nascent battery technology being refined and de-risked in the process. Previously, evolving and early stage technologies, which required substantial capital expenditure (capex) with long-return horizons gave rise to uncertain revenue streams. With lower levels of renewables, more stable prices gave rise to narrower opportunities for arbitrage. Today, battery technology is much more established and tested, capex is lower and returns horizons are reducing. Greater price volatility brought about by greater deployment of renewables has increased the opportunities for arbitrage with revenue streams much more proven. NESF describe this as a ‘Fast followers benefit from lessons already learnt”. Figure 2 illustrates how adding energy storage can move a solar asset to higher level of returns while moderating risk.
Working in sweet harmony
HEIT is the newest energy storage fund to join the sector, following its launch in November 2021 (its IPO raised £210m which was added to with a £14.8m c-share issue in October 2022, plus it has £130m of debt facilities at its disposal). Like its peers, HEIT saw its discount open up following September’s mini-budget (see further discussion below), which also undermined its c-share offer. The discount subsequently closed up as markets settled but has opened up again recently (3.0% at the time of writing).
HEIT had a pretty good first year, providing an NAV total return on its issue price of 24.7%, which included the payment of dividends totalling 2p. These were two quarterly dividends of 1p each but, now that it is more fully invested, HEIT is doubling the quarterly dividend to 2p. This is equivalent to 8p for the current financial year, which is an attractive 8% yield on the issue price (the first dividend is due in March 2023, so there’s still time to capture all of these).
Of course, while HEIT is now more fully invested, most of its portfolio is not operational – of its nine projects, only Pillswood is operational with another seven being under construction and one in the planning phase. However, this should not be an issue as HEIT’s managers have secured the necessary GRID connections, which as discussed above, is the big limiting factor. Once connected, HEIT’s new projects will be able earn money trading intraday fluctuations and through the capacity market.
More to come – a hot pipeline for HEIT
At its inception, HEIT secured an exclusive right of first refusal to acquire up to 1 GW of battery energy storage projects from Harmony Energy Limited. To date, some 494.4 MW has been acquired, leaving a balance of at least 505.6 MW (and presumably it could acquire more). The investment adviser has identified more than 400 MW in Great Britain which have the potential to be acquired over the next 12 months, which could also commence operations over the next 36 months. A large part of the time differential here is that needed to put the grid connections in place, although the manager has shown itself to be relatively adept in securing these. However, there is an additional consideration.
A large part of HEIT’s NAV growth during the period of its maiden results relates to the revaluations of projects as these become operational (this de-risks the projects thereby allowing a lower discount rate to be applied). With an extensive pipeline, there should be more to come. Furthermore, with a national shortage of battery capacity linked to grid connection delays, there are greater opportunities for those with batteries to earn higher revenues and, against a backdrop of volatile energy prices, greater revenues for battery funds.
More balance in the balancing mechanism
The principle that the electricity networks need to be balanced is well understood but the means by which this is achieved are arguably more opaque. National Grid ESO is responsible for balancing the GRID and has long and short-term mechanisms through which to achieve this. While it has contracts with an array of suppliers, large and small, it has tended to favour larger power stations, possibly from an ease of execution perspective, over battery storage operations, which tend to be smaller. This has curtailed the balancing revenues from smaller operators such as HEIT and its peers. However, this is changing and should create greater opportunities for operators with battery storage solutions to earn revenues.
The Capacity Market
The capacity market is a mechanism introduced by the UK Government to manage security of electricity supply in the UK and to safeguard against the possibility of blackouts. Capacity market participants are paid to ensure they are available to respond when there is a high risk that a system stress event could occur.
The cost of the scheme is borne by the electricity suppliers, who pay for the scheme in line with their market share through the winter months when electricity demand is at its highest. This tends to be between the months of November and February, on weekdays, between 4pm and 7pm.
Two capacity auctions take place each year:
The T-4 auction is used to buy most of the capacity that is anticipated to be needed for delivery in four years’ time. Contracts can run for 15 years.
The T-1 auction is used to top-up capacity for the forthcoming year. The price achieved reflects the degree of shortfall of capacity from earlier T-4 auctions.
Capacity market clearing at higher prices
Arguably reflecting the backdrop at the time, the Capacity Market auctions of February 2022 saw record prices in both the T-1 and T-4 auction (an undersupply of qualifying generation plant was a big factor as some of the older generation plant, largely coal and nuclear, failed to take contracts). The T-1 auction cleared at its maximum amount of £75/kW/yr and the T-4 auction cleared at a record high level of £30.59/kW/yr.
While none of HEIT’s projects participated in the T-1 auction in February 2022, Pillswood, Rusholme and Little Raith each secured 15-year index-linked contracts (commencing in October 2025) at £30.59 /kW/yr in the T-4 auction. Farnham and Broadditch projects secured similar length contracts in the T-4 auction 2021 (commencing in October 2024) at a clearing price of £18 /kW/yr.
Fast forward a year to the most recent auction held on 14 February 2023 and HEIT’s Pillswood, Broadditch, Farnham and Rusholme projects each secured T-1 Capacity Market for delivery from October 2023 at the price of £60/kW/yr, the second highest T-1 price on record. The combined contracts represent a total of £3.65m of revenue in exchange for services to be delivered between October 2023 and September 2024. HEIT’s Bumpers project, as well as its recently acquired Wormald Green and Hawthorn Pit projects, each pre-qualified for the T-4 auction held on 21/22 February 2023 (for delivery from October 2026). HEIT’s Rye Common project is expected to pre-qualify for the 2024 auctions, once final planning for Phase 2 has been obtained.
A point to note when looking evaluating the Capacity Market is that, unlike the balancing mechanism, Capacity Market revenues can be earned simultaneously with normal daily operating strategies (see Figure 1 above).
Discounts offer opportunity to access long-term structural growth themes
Discounts opened up across the renewable energy infrastructure sector in the aftermath of September’s disastrous mini-budget. The uncosted high-growth-low-tax strategy pushed up interest rates, and therefore borrowing costs, while at the same time the budget created uncertainty regarding windfall taxes, now referred to as an electricity generation levy. The government has since provided clarity on this and, arguably, the worst forms of intervention that the market was fearing have been avoided.
Despite the improved clarity, the discounts continue to prevail (click here to see an up-to-date peer group comparison on the QuotedData website). This seems way out of kilter with the scale of the opportunity and the high degree of inflation linkage present in the underlying contracts. We think that inflation may not be coming down quite as rapidly in the US as had previously been thought, bringing with it the prospect of higher interest rates and unsettled markets more generally, may be weighing on this sector and equity markets more generally. On balance, we think that the current discounts are likely overdone and can envisage a scenario where these funds return to premium ratings once again. If so, current discounts may offer an opportunity to buy into these long-term structural growth themes at attractive prices and with the chunky yields on offer, which are generally well-covered by revenues for the operational funds, investors are paid to wait.