In light of our upcoming investment trust forum on the 5th of October, I thought I would take this opportunity to look at one of our panel discussion topics. As the title suggests, it focuses on what the future might look like for renewable energy investments.
The bulk of the exposure to this theme is found in the AIC’s renewable energy infrastructure sector. This provides the opportunity to invest in a broad range of assets, from regulated energy utilities all the way to green hydrogen. Despite its diverse range of companies, the last 12 months has proved to be a miserable time for shareholders, with the average share price total return down almost 16%. This has been a tough pill to swallow for investors, as they have watched the market return to its fascination with large cap US tech (which has dragged global indices higher, with the MSCI ACWI up roughly 10% over the same period).
The culprit has, of course, been rising interest rates, and while the tech titans have managed to shrug off their supposed negative correlation with rising discount rates, the same cannot be said for the renewables.
The challenge for most of the income-focused funds, which make up the majority of the 22-strong sector, is that with risk free government debt now yielding close to sector averages, there is very little incentive to invest purely on an income basis. Why take the risk when you can hold a short-term gilt to maturity for a yield of over 5%? It has not helped that the UK’s track record so far in managing inflation has been pretty poor by international standards, causing peak interest rates to be pushed steadily higher.
Fortunately, it is difficult to imagine further dramatic tightening by the Bank of England from here, particularly given the trajectory of the UK economy, where growth looks anaemic at best. If things do continue to deteriorate and the BoE is forced to reverse its policy, renewable infrastructure yields of over 6% will begin to look increasingly attractive, especially as the average discount in the sector is now over 20%.
This becomes even more relevant when you consider the resilience of the sector’s fundamentals despite the rise in discount rates. With an average NAV return of around 6% over the past year, several managers have shown frustration during annual results that this performance is not better reflected in their share prices.
Aquila European Renewables (AERI) which, back in 2021 was trading on a premium of almost 10%, recorded its best performance since its IPO over the last financial year with NAV growth of 12.7% and revenue 20.4% ahead of expectations. Despite this, the company now trades on a discount of over 20% with chairman Ian Nolan noting that he believes the fund is considerably more valuable than this implies.
One silver lining, at least for funds with strong cash flows and stable balance sheets such as AERI, is the ability to leverage these to buy back shares. The company has been busy repurchasing €20m worth of its own stock over the last financial year, in addition to a 5% increase in its dividend target.
JLEN Environmental Assets is another whose discount is at odds with its underlying performance. The company grew NAV by more than 7% over the last financial year yet continues to trade on a discount of almost 14%. The fund has an impressive track record, which is generally reflected in a premium for its shares. This was as high as 12% in July last year (and was briefly over 30% prior to the pandemic). Its recent performance has proven that while rising rates (which decrease the present value of a company’s future cash flows) do have an impact, inflation adjusted earnings can more than offset this.
Outside of the income-focused funds, rising rates have had an even more dramatic effect. HydrogenOne (HGEN) – which is targeting capital growth in the nascent green hydrogen sector – has been caught up in the broader rotation away from sectors of the market that are perceived as risky. Companies thought to have large capital requirements and relatively weak balance sheets, and which are reliant on external funding for growth, have been hit particularly hard. Despite the efforts of HGEN’s manager to communicate its stability, which we support and have written about recently, it continues to trade within a deeply negative discount range. An investment here may not be for everyone, given its volatility and relatively niche focus. However, with HGEN’s shares trading at an almost 50% discount, the potential upside is considerable.
Given the thematic tailwinds driving investment in renewable infrastructure, and the continued execution of the business plans of the funds within the sector, it’s difficult to see how such significant discounts can be justified for long, particularly considering the historic premium at which these assets have traded.
QD view – The new reality for renewables