It is difficult to understate the extent of the changes being felt across the power industry.
For the first time in more than a century, electricity generation is undergoing a root-and-branch redesign, as we move from centralised, fossil fuel intensive and dumb systems to decentralised, clean and smart networks.
For investors this opens up a host of opportunities, but knowing how best to exploit them is challenging given the pace of regulatory and technological change. Dan Wells, a partner at Foresight Group, discusses how investors can build the diverse, balanced power portfolios required.
The energy market is undergoing fundamental changes. Can you break them down?
This transition has been driven principally by the decarbonisation agenda. There was an initial build-out of renewables wrapped up in a subsidy framework, which created scale and allowed renewables to become competitive.
But we’ve hit an inflection point. Think of the electricity system as a tree where power generation is the roots, the transmission is the trunk and the distribution network is the branches. Generation is now being spread out much more across the tree, and embedded in the branches, the twigs and the leaves. And electrons are starting to move not just in a linear fashion from centralised generation to consumption, but all around the grid. The grid becomes more of a stock exchange for electrons than a wire taking them from A to B.
What opportunities does this create for investors?
One consequence is that the value around electricity has shifted away from the generation of electrons to their management. It will become increasingly cheap to produce power but more complicated to manage it.
We look at the world based on the three fundamental characteristics of renewables. The first is that they are cheap – cheap to build and very cheap to run. In the long run, they will outcompete other generation sources because of their close-to-zero marginal cost of production. The second feature is their intermittency and the third is their highly diffuse location throughout the system.
These give rise to our three investment baskets for renewables: basket one is generation; basket two is the flexibility required to accommodate the intermittent supply; and basket three is the connectivity needed to link up the distributed profile.
These have produced a wave of investment opportunities but there are real challenges for institutional investors who find it hard to allocate capital in large tickets at a time when the pace of regulatory, policy and market change is so fast.
How should investors size up assets in the energy infrastructure space?
Assume we are talking about a typical infrastructure investor, who wants a long-term yield along with some capital growth or protection, and a return that’s somewhat higher than a typical equity or bond investment. This investor shouldn’t have to analyse the technology but look instead for an asset with a suitable suite of contracts and risk mitigation attributes.
For example, one use of energy storage is for short-duration balancing – keeping grid frequency in the right area. This requires technologies that respond in seconds and the cost reductions in lithium ion batteries mean there are genuine investible opportunities in this area. We’ve looked closely at markets in Europe, North America and Australia. The UK is the most investible because it has the right contractual stack.
In the UK, lithium ion batteries benefit from capacity market and frequency regulation contracts that deliver a good contractual coverage of up to 60 percent of revenues over the life of the project in certain cases. In other markets either projects are uneconomic, and storage is not ready as an investible asset class, or they’re the wrong level of contracted revenue. In California you might have 100 percent of contracted revenues with the utility, but that doesn’t work for us because the returns on the asset are typically pushed down to a regulated cost of capital.
What would a solid, diversified portfolio of energy infrastructure assets look like?
The key is to analyse the underlying revenue and risk profile of the assets, to look at how the sub-asset classes work together and then sensibly build a portfolio. You have to understand that the system has many components and the way they work together is often correlated, sometimes negatively. The system of the future will be characterised by very cheap intermittent resources, so a portfolio needs an element of flexibility.
A sensible balance might be a portfolio stacked towards generation, with a minority split between the connectivity and flexibility baskets. In finance terms, we would expect the connectivity basket to be low beta and for the returns from this sub-sector to exhibit very low volatility.
We’d expect there to be a degree of natural hedging between the variable renewable baseload and the flexibility part. For instance, during a cold, non-windy winter in Europe you would expect the underperformance in the generation component of your portfolio to be offset by over-performance of the flexible generation part – for example small-scale gas engines that kick in when demand exceeds supply. A diversified portfolio is, therefore, a very important part of the mix.
While the range of opportunities is great, does the energy system of the future still throw up big-ticket opportunities for larger investors?
Fragmentation creates challenges but there is still the ability to deploy equity in large chunks. Interconnectors and transmission assets will remain large-ticket items and that’s where we will most likely be investing in consortia. They are a very efficient way of putting capital to work.
However, investors, in our eyes, also need to be able to take a more programmatic view because of the decentralised nature of certain forms of renewables. This means building aggregated portfolios. An example might be behind-the-meter commercial, industrial and residential storage combined with solar applications. To get meaningful amounts of capital deployed, you have to employ a platform approach, which requires some sort of origination “engine” to generate and dealflow – in other words partnering with a sales or installation business. You can still put finance to work in an infrastructure quality risk/return context because you can establish pools that only get drawn down once the projects are shovel-ready or operational, and actually they can be very attractive, diversified pools of assets.
But investors need to work with the right kind of specialist because it demands a somewhat different skillset than simply investing in a multi-billion dollar CCGT project.
Can you tell us about any deals you’ve recently closed or are working on?
A recent deal that is a perfect illustration of the way investors should work is the 72MW Shotwick solar park which Foresight Solar Fund Limited recently acquired and is the largest solar project in the UK. It is underpinned by a corporate power purchase agreement, which is a relatively rare thing in the UK, and it has specific complexities regarding the way grid access works. The complexity of the asset allowed us to put our expertise to work. We are also actively acquiring energy storage assets in the UK.
You need a slightly different mindset for each of the three baskets. Investing in a solar-generating asset like Shotwick requires a long-term view; in particular you need to form a view on the long-term asset life and your return over that period. With energy storage and flexible generation, it’s more about how quickly you can amortise the capital expenditure because there is more uncertainty in the long term.
Most importantly, if you have these assets held in a single portfolio you are able to benefit from the portfolio diversification. That’s what makes everything work together in a balanced, cohesive manner.
This article is sponsored by Foresight Group and appeared in the 2017 Investing in Energy Special published in Private Equity International in July 2017.