Despite recent record power prices, renewable energy-focused investment trusts are now largely trading at material discounts to net asset value. That’s created some good buying opportunities in this space, particularly as many of the trusts have historically traded at a premium.

Over the long term there is a clear catalyst for growth in renewable energy given global governments have set ambitious targets for reducing their carbon emissions and for improving energy security by building out domestic supply.  

While investors wait for this long-term opportunity to play out, investment trusts with assets in this space are generating an attractive stream of income for shareholders underpinned by contracted output from their renewable energy assets and, in some cases, subsidies.

Not only do renewables trusts offer attractive yields, but dividends are also growing with most trusts’ income having at least some linkage to inflation. A recent addition to our Great Ideas portfolio, Greencoat UK Wind (UKW) has paid an RPI-linked dividend since its inception in 2013 and has confirmed a target to increase dividends by 13.4% in 2023.

Electricity is typically sold under short, medium and long-term contracts and while power prices have already moderated from the elevated levels prompted by Russia’s invasion of Ukraine in 2022, David Bird from Octopus Renewables Infrastructure Trust (ORIT) believes ‘power prices will be high versus the old normal for most of the rest of the decade’.

Beyond this, one risk for investors to consider is that a big expansion in renewables could, over the long run, lead to significantly lower power prices and affect returns.

MAKING A POSITIVE IMPACT

For anyone who is prioritising doing good with their money, the trusts with a significant emphasis on developing and constructing their own renewables assets are making a genuine environmental impact by bringing on capacity to replace more polluting sources of energy.

While development risks are a factor for investors to consider, they also offer the scope for more significant returns and help trusts mitigate competition for the purchase of operational assets.

This needs to be balanced with the need to sustain dividends. Octopus Renewables’ Chris Graydon explains: ‘We don’t technically have policy limit (on developments) but in reality, there is a 30% limit on a gross value basis if we’re at that level to still be able to pay out a well-covered dividend.’

Numis recently summarised the sector’s appeal: ‘While regulatory interference and real asset repricing is a headwind, we believe the investment case remains intact with some high-quality businesses paying attractive yields.’

WHY HIGHER DISCOUNT RATES HURT THE SECTOR

There are two reasons why these attractions are not reflected in current valuations. One is the regulatory risk and concern about windfall taxes and the other is an increase in discount rates used to calculate the present value of future cash flows.

The sector has already been hit by the EGL (Electricity Generator Levy) of 45% on the extraordinary revenue of low carbon electricity generators, effective from 1 January 2023 to 31 March 2028. It will apply above a benchmark price of £75 per MWh (megawatt hour). Prices topped out just above £620 in September 2022 and are currently around the £100 mark.

Rising interest rates have led to higher discount rates on long duration assets like renewable energy infrastructure. Two key elements make up the discount rate – the risk-free rate which is typically taken as the yield on government bonds and the risk premium which reflects the risk associated with investing your money. The risk-free rate has moved materially higher.

We take the view that higher discount rates have now largely been factored into the valuations and assumptions of renewables trusts.

WHAT ARE THE REGULATORY RISKS?

On the regulatory front, the push by the US and Europe to attract investment in renewables should, in theory, lead the UK to follow suit. In the US the Inflation Reduction Act, signed into law in August 2022, is expected by consultant Wood Mackenzie to increase annual investment in renewables from $64 billion in 2022 to $114 billion by 2031.

Allianz observes that in Europe the short-term reaction to the US IRA – entitled the ‘Green Deal Industrial Plan’ by the EU Commission – builds predominantly on allowing more national support, including tax benefits, by relaxing state aid rules further.

Yet for those investment trusts with most of their assets in the UK, the recent Budget offered precious little encouragement – with the focus on carbon capture and nuclear which has been designated as ‘environmentally sustainable’ in green taxonomy to give it the same access to investment incentives as renewable energy.

Foresight Solar’s (FSFL) Ross Driver told Shares chancellor Jeremy Hunt missed a bit of a trick by neglecting the renewables space and made an unfavourable comparison between the investment allowances afforded oil and gas companies and what is on offer for owners of renewables assets.

DIVERSIFIED OR SPECIALIST?

Many renewable energy trusts are already diversifying across different geographies to mitigate the risk. Foresight Solar has a pipeline of assets in Spain which, if fully developed, would represent 37% of its total capacity.

Some trusts have limited or no exposure to the UK; Greencoat Renewables’ (GRP) assets are exclusively in Europe, for example.

Bluefield Solar’s (BSIF) James Armstrong tells Shares this is a ‘real challenge for the UK’, adding that ‘money is fungible’ and could easily move to more attractive jurisdictions if the UK fails to keep up.

As well as being diversified by geography, trusts are increasingly diversified by technology too. The renewables trust universe is a mix of generalist and specialist funds but even those which previously focused on one area are branching out. For example, Bluefield Solar moved into wind in 2021 and several trusts have started investing in battery assets.

Some battery assets are ‘co-located’ meaning they are on site at a wind or solar farm but most are just connected to the wider electricity network to support National Grid (NG.) in balancing supply and demand.

Foresight Solar may have moved into what Ross Driver terms the ‘complementary’ battery space but for now he says the trust is steering clear of wind assets. ‘The beauty of solar is it’s very reliable technology,’ Driver explains. ‘You may not always get super strong days of sun but it will still be working and delivering. Day tends to follow night. Whereas you can have prolonged periods of low wind.’

Because wind assets are less predictable and have greater complexity than solar, investors typically require a higher level of return in exchange.

TWO TRUSTS TO BUY AT BIG DISCOUNTS

Octopus Renewables Infrastructure Trust (ORIT) 93.5pDiscount to NAV: 14.5%

Yield: 6.2%

Ongoing charges: 1.15%

This trust offers diversification both in terms of technology and geography with a mix of wind, solar and battery assets.  

It trades at a significant discount to net asset value and recently committed to increasing dividends in line with CPI for a second consecutive year. The trust has a large team of asset managers from its parent group and its links with the retail-facing Octopus Energy are beneficial as the latter is, according to David Bird, ‘a hugely influential voice in the sector with an inside track on government and opposition policy’.

Foresight Solar (FSFL) 110p

Discount to NAV: 13%

Yield: 6.9%

Ongoing charges: 1.14%

Foresight Solar has 61 solar projects and battery storage assets with a total capacity of 1,095 MW. Jefferies notes that Foresight Solar ‘has reiterated strong guidance on dividend cover over the next few years, even net of the EGL’. ‘This strength on the income side could also be matched with capital growth opportunities given the potential for development pipeline acquisitions,’ it adds.

The trust recently secured access to a pipeline of six development-stage assets in Spain with a total potential capacity of 467 MW.

The discount to net asset value could make financing these development assets a challenge but manager Ross Driver notes the initial outlay is small, with a ‘modest’ down payment made to vendors at close and further consideration conditional on grid connection milestones.

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