(Why) do valuation bubbles arise in renewable energy … and what can we do about it?

Article by David Hunter, Chief Investment Officer of Renewity.

A story of ‘not only… but also’!

Nearly every institution we talk to that’s invested in renewables is happy with the experience and would repeat it. The (typically operating) assets they bought years ago have generally delivered as promised. They’ve dependably thrown off cash as expected and, in many cases, have also risen nicely in market value. Exhibiting recognisable behavioural traits, many such investors’ only regret is that they didn’t commit more to the strategy at the lower prices available back then.

Some of those investors baulk at the higher prices being paid today for similar assets and are hesitant to get back into the game at these levels. Some are wary of a possible asset price bubble in renewable energy investing, at least in some sectors. So, is there one? And if so, how did this bubble arise? In short, how do we not only understand these risks, but also mitigate them to maintain or improve forward returns and continue to support the net-zero economic transition.

Is there really a bubble?

Bubbles typically peak when both (recent) historical returns and (forward) risks are at their highest. In asset classes that are thematically “hot” or “emerging” or both, as with climate investing today perhaps, investors may face such a challenge at any time whilst the asset class grows. This is particularly true in the earlier phases of the opportunity-set development, in “core” or “home” (or perhaps OECD?) markets where early adopters first congregate and (within renewables at least) stoke demand for operational assets, often as a “lowest risk” or liabilities/cashflow-targetted entry point.

Looking more long term, key strategic return and risk forces interplay to drive a market pricing mechanism permanently in flux.

On the one hand, climate change and the related clean energy and economic transition offer an immense opportunity set. Supporting substantial future clean electricity demand, these opportunities embody the fundamental investing attractions of renewable energy for a long term portfolio. Taken together with the low relative cost of delivering renewable energy, they argue strongly for further or new allocations.

On the other hand, rising instability risk in grid supply, including from climate and geopolitical interruptions, intensifies energy market price variability. Compounding these uncertainties, a possibly unstable, at best patchwork, demand recovery from Covid might yet provoke additional short term electricity price volatility.

Why is energy price volatility increasingly important? Because in most major markets the mix and nature of the risks to a renewable energy asset’s revenues (and thus cash flows) is changing. Whilst many, if not most, invested institutions have historically bought assets with revenues at least partly underpinned by long term (eg 15-20 years or more) government subsidies and/or guarantees, preferably with inflation-linked components, those regimes are now on the wane or largely closed to new-build assets. Today’s and tomorrow’s investors, by contrast, more often face shorter duration corporate PPAs (power purchase agreements) and /or hedging contracts, leading to significantly increased revenue (volatility) risk exposure. The greater exposure in the future to increasingly volatile energy pricing is already a double whammy to risk exposure. The reduced (rating) quality compared to the past of the counterparty now supporting the contracted element of revenues (eg via a PPA) merely compounds these factors.

So particularly in core markets and with operational assets, not only are forward returns perhaps diminished, but also in many sectors key risks are likely rising… goes the thinking.

If there is a bubble, how could it arise?

A more limited supply of assets meeting with rising capital demand for them pretty much explains all asset price bubbles. After many years of loose or at least supportive (depending on your viewpoint) monetary and policy stances from central banks and governments, initially post the Global Financial Crisis in 2008, and now on steroids since COVID-19 erupted, a surfeit of cash has inevitably ended up boosting the prices of many asset classes. Renewable energy is not alone in this regard.

However, with renewable energy (and other “slower- build” assets), there’s a further factor; namely, a fundamental mismatch between the speed of investor decision-making and getting assets out of the ground, from start to finish, or from “field-to-plug” so to speak. Pension fund investors for example, often maligned as slow decision-makers and broadly expected to continue to raise renewable energy allocations, are actually quite rapid in the context of the timeframe it takes to progress assets from land identification to throwing off the dependable cash flow such investors seek.

Furthermore, it’s worth noting the dual attraction of these assets for investors in that they both decarbonise the economy and generate interesting cash flows. As the climate change agenda accelerates, rising demand for such a combination risks compounding demand/ supply imbalances.

So, not only is there a capital and supply mismatch fundamentally in some, particularly “core”, sectors but also its impact may well magnify in the coming years.

What is the right strategy perspective here?

Three major strategic perspectives run counter to the above concerns. They each support the case for further investment and are plain enough to understand. Firstly, investors don’t invest in or consider a single asset class in isolation. When looking around at the other main portfolio components, most investors currently see these also at elevated historical valuations and facing similarly challenging macro and other sector-specific risks going forward to those faced in renewable energy. So as hinted above, renewables as an asset class may just be “fully” valued…like all the rest perhaps…(but may also offer, at least in illiquid form, less portfolio downside at least based on performance during the Covid crisis).

Moreover, smart investors are also thinking more holistically here. They’re weighing up the fast developing and vast potential investment opportunity across the broader economic decarbonisation transition. Of course, renewable energy lies at the crux of our shift to a low-carbon economy, in recent times comprising the largest deal flows of any sector within infrastructure investing. But the overall investment needed in the broader decarbonisation opportunity set (including renewable energy) for us to achieve the Paris Agreement goals by 2050 is almost inconceivably huge (McKinsey put the number at close to $50 trillion). Think of the current vista as probably akin to the time when oil was discovered at scale, alongside the invention of the motor car. And think of all the related investment and development over the following half-century or so on the back of the internal combustion engine and the increasing use of fossil fuels, right through to the second half of the 20th Century. Only this time round the opportunity set is bigger, much bigger.

Finally, there is the impact investing imperative, set out in terms of one or more of investors’ net-zero, decarbonisation, transition, green investing, ESG or responsible investing policies. In all such contexts, the inclusion of renewable energy in the portfolio satisfies a preference for clearly visible and immediately impactful assets that address these mandate requirements. For many institutions this is the cream (and maybe cherry) on top of the fundamental risk/return features of the renewable energy cake. Certainly that was a view supported strongly by participants in a discussion we facilitated at the Next Steps Towards Net Zero For Pensions Masterclass1 event recently, entitled “Navigating the Green Asset Bubble”.

Either way, for an asset class offering such a wide range of investment possibilities, how do investors ensure proper diversification and risk management across such a nascent, fast-changing sector that’s attracting significant capital? What can we do to avoid crashes or what we call “yield compression traps” along the way (ie. what some might call “bubble risks”)?

What can we do as society?

At one extreme you might whisper in the ear of your local central banker on the historic dangers of negative real interest rates, in the hope that a rate rise response might puncture all asset class bubbles. But with inflation targets disappearing in the rear-view mirror, it’s clear that “2oC is more important than 2% inflation” is now a maxim of modern central bank economic orthodoxy. In short, they’re unlikely to budge just because you want to invest more cheaply.

More impactfully, we can seek to accelerate ie reduce the time it takes to deliver renewable energy assets, especially at scale, but also on a small level. We can lobby our local, national and grid operation leaders, making the arguments to shorten the planning cycle and to hasten and expand grid connection approvals. Swifter decentralisation of the grid and more widely available micro-financing, akin to earlier residential roof-top solar deals, might also help accelerate renewable energy penetration. At the macro level, greater

energy market harmonisation and interconnectivity should reduce market price hedging costs. Finally early government support for emerging renewable technologies has proven, in the case of solar and wind, to deliver long term scale benefits, reduce unit costs and accelerate the investment case. Such gains are now coming through to the benefit of society and investors and a similar approach is now needed for the newer technologies such as hydrogen, tidal and small nuclear.

What can we do as investors?

There are several steps to take to ensure investing is done carefully with respect to entry valuations. These can be grouped broadly as:

  1. Diversify…extensively and smartly;
  2. Structure…to get better entry pricing;
  3. Address key risks directly.

Firstly and most importantly, diversify! Not only diversify but also do it early. In fact, with the likely persistent investor demand for new renewable energy capacity (not to mention the deep existential arguments), doing so early may itself be thought of as being strategic, as well as tactical.

Secondly, diversify, be flexible and find or create scale. Invest via a scalable platform with a global outlook, an independent approach and preferably “hub” positioning within the renewable energy ecosystem to:

  1. maximise a relative value perspective, providing the necessary unbounded flexibility to allocate at any time to potentially any country or sector, up and down the asset size spectrum;
  2. best avoid risks of investing into bubbles and yield compression traps by generating wide and deep deal flow; and
  3. offer a multitude of liquidity windows and options.

Invest in newer developing scale sectors and projects, as if the long term really mattered. In short “go in, go early” (again). Geothermal, hydrogen in all its forms, tidal, floating wind and small nuclear are all sectors we expect to grow further and provide part of our future energy needs. As younger subsectors (compared to solar and onshore wind) these can offer better capital / asset supply-demand dynamics going forward.

Invest earlier in the asset cycle (did I already say, “go in, go early” yet again?). Whilst such opportunities typically include higher risks (which at the very early stages can be binary) and usually also require smaller tickets (eg pre-construction), building up optionality on future income stream development makes sense for a minor part of one’s portfolio, provided your overall exposure is well diversified.

Invest globally outside your own home market… ya’know, like you do in other important strategic asset classes such as equities and bonds. In emerging markets for example, renewable energy is typically a foundational pillar in many countries’ growth strategies; whereas in developed markets it is largely a replacement strategy for existing fossil fuel-sourced capacity. Furthermore, governments in some emerging markets may emerge from the Covid crisis with healthier balance sheets than their more “developed” counterparts, partly and paradoxically due to their less well-developed healthcare and social support sectors. In short, the supply, demand and macro dynamics in emerging economies can lead to more attractive pricing and forward risk-adjusted returns than in some more developed markets.

The latter should not be ignored however and should remain a core staple of renewable energy portfolios for most investors. In developed markets we continue to see many managers with healthy pipeline, continuously originating pockets and projects of added value by focusing on relationships and strategies across areas such as:

  • earlier development insights and flows;
  • pivot capitalisation moments (eg shorter term bridging equity);
  • deals requiring smaller capital sizes or more complex deployment schedules;
  • newer technologies or those with lower feed-in source dependability (eg waste-to-energy vs solar or wind);
  • co-location of storage with energy generation; and
  • scale option deal acquisitions through platform investment.

Direct deals at scale also continue to offer strong double-digit returns in mature economies.

As implied earlier, investors could also look at different factor exposures outside the core aspects of the renewable energy value chain available in most illiquid funds (ie. generation, transmission, distribution, storage and grid efficiency). We see a plethora of “low carbon”, “net zero” or “sustainable” infrastructure and private equity funds coming to market alongside “cleantech”, “greentech” and “transitional” venture capital offerings. As an allocation alongside renewable energy, these options can offer interesting, thematic factor exposures by duration, nature, liquidity and pricing across the energy sector and others that use large amounts of this essential commodity (eg transport, construction, manufacturing, tourism, etc.). How we produce, store and consume energy need to change hugely and so broader energy use opportunities are growing massively and quickly as managers and money follow the energy production-to-use path (our own steady pipeline flow of direct deals across the transition totals over $2bn in just the last 9 months).

Investors can also consider secondaries as a potentially useful foil to enhance or change the shape of portfolio cashflows, reduce portfolio risks and take advantage of short-term opportunistic pricing on specific existing operating assets.

Finally, address the key energy market (merchant/spot) price risk directly in one of three ways. Either select managers / managements who have this skill set in-house, recruit your own team of experienced energy market traders or use an independent energy market price adviser as an additional input.

Summary

At the strategic level, renewable energy can both support critical sustainable infrastructure growth for our overall economic net-zero transition and deliver excellent contributions to investors’ yield as well as portfolio risk, return and diversification. Moreover, it delivers an immediate, transparent, high, carbon mitigation impact, both directly and indirectly. Finally and importantly, it is now also battle-hardened and proven to perform relatively strongly in the face of a macro, global shock (witness relative performance during the initial COVID-19 hit to markets in the 1st half of 2020 and since).

For all these reasons a renewable energy allocation is thus usually additive to general portfolio characteristics and outcomes, including risk and forward expected returns. This is the case even in the face of yield compression traps or valuation bubbles that may arise in particular sectors or territories, as with every asset class. It is therefore no wonder that many investors are considering an allocation to renewable energy either directly or indirectly (eg within a general diversified infrastructure exposure). Those that have done so already, typically seek to increase allocations further, having already nailed their colours to the renewables mast.

Across size, sector, stage, technology and geography there remains a rich landscape in renewable energy to diversify entry pricing risk. The key challenge for most investors is to implement smartly. Clearly, to exploit efficiently the wide range of strategies, managers, available tactics and opportunities requires a specialist service provider. Investors should therefore seek a focused partner that not only offers easy access to the opportunity set marshalled by a deeply expert and experienced team, but also can maximise reach and flexibility in this fast-developing, global asset class critical to all our futures.

1. www.sgpensionsenterprise.com/next-steps-towards-net-zero-for-pensions