Powering your portfolio with renewables
Ten-year track record of LSE investment trusts suggests there’s plenty of energy in the sector, writes
Iwrite shortly after President Cyril Ramaphosa completed his state of the nation address and announced a ministry of electricity.
In life, as in sport, the loudest boos come from the cheap seats, and the realpolitik of the situation is that Gwede Mantashe is not a sensible opponent to pick a fight with.
Anyway, there’s lots to sort out in mining (the cadastral system, stalled projects, illegal mining and so on) and there is a natural conflict between the mining sector and Eskom as a vast consumer of mining production. Public enterprises consists of hundreds of companies that also need fixing, besides which Eskom is quite capable of absorbing all available human bandwidth.
I argued on Michael
Avery’s Business Watch that one of André de Ruyter’s biggest problems was that he lacked a strong political lobbyist to watch his back during his tenure at Eskom.
South African investors are energy production newbies, given the long-standing framework of a pointless government monopoly that helped us get into this mess in the first place. I think there will be a lot of shock at just how much economically priced power costs, and some adaptation to how it’s funded.
Coal-fired power is relatively cheap to install but is funded in a pay-as-you-go fashion. Renewables (and the power generated), however, are paid for upfront, and with South African long bonds in double-digit territory, that means they’re expensive.
At the time of writing, the National Treasury has not revealed the intended tax incentive programmes, but I’m hoping for individual breaks as well as something similar to the old section 12J schemes.
As an aside, equity funding of green power would be an excellent sharia-compliant investment as security will be good, cash flows defensible and the product ethical. The key issue for sharia investors would be gearing, because these projects are capital hungry and strict guidelines restrict the gearing an investment can have.
I’m sure South African investors will be keen adopters, with all sorts of in
crowd slang being “wheeled out”. But where would you access knowledge of renewables to guide tactics and strategy? Well, the dear old London Stock Exchange investment trust sector is a good place to start.
The businesses available are collectively capitalised at more than £20bn, which seems like a decent playing field. The key sectors are defined as specialist equity (environmental and utilities & infrastructure) and infrastructure (renewables, battery storage and energy efficiency/transition). There is also a fringe sector that includes hydrogen, but it is speculative and cash hungry, making it unpalatable for me.
Technical obsolescence is an important issue in any high-flying “new economy” sector. For this reason, the battery storage and energy efficiency/transition sectors are also areas I prefer to leave to the fighter pilots.
In the case of solar and wind power, I think the big breakthroughs have been made and implemented, and future improvements should be more incremental.
Wild card game-changers such as wave power or fusion will require development runways of well over 20 years before they start becoming a competitive threat to a solar/wind portfolio.
The track records of commercially viable renewables in the listed space are generally not more than 10 years, so data is limited. It’s also worth noting that as the UK and most other OECD countries have just experienced a savage bond bear market, overall capital returns will be compressed.
Many share prices have been bashed down to useful discounts to NAV (albeit that NAVs aren’t publicly listed), whereas two years ago premiums of 10%-20% were common. I see no reason that these premiums cannot return, given Europe’s hunt for more carbon-neutral energy.
In terms of specific plays in infrastructure renewables, those that offer decent tradability are Aquila
European Renewables, Bluefield Solar Income Fund, Foresight Solar Fund, Greencoat Renewables, Greencoat UK Wind, JLEN Environmental Assets Group and The Renewables Infrastructure Group. These all offer sterling coupons of 5%-6.5%. Your potential growth play is Impax Environmental Markets.
I am indebted to Colette Ord of Numis Securities for specific insights, including the observation that electricity generation and core infrastructure have a 60%70% correlation with inflation, a decent hedge if you are worried about your hard currency investment being vulnerable to inflation.
Additionally, the earnings visibility on renewables is excellent, thanks to contracts of well over 10 years with strong counterparties. This limits the scope for unpleasant surprises on earnings and debt profiles.
Graph 1 shows how shortterm share returns (TSR) and NAV growth (NAV TR) have diverged in the current environment.
This relatively welltelegraphed investment outcome nevertheless offers a risk premium of 4.2% over the prevailing bond rate. That doesn’t sound huge until you realise it is comparable to a portfolio of lower-risk equities. In a yield-starved developed world, that’ sa fairly attractive proposition.
Graph 2 shows risk premiums across asset classes. This is particularly relevant, because implied risk premiums have fallen substantially as interest rates have risen in a savage bond bear market.
Graph 3 shows that what ultimately drives returns is production outcome (sunshine and wind) and pricing — but that is what investors often refer to as “the long term”.
Graph 4 shows that NAV returns (and hence share returns) are pretty stable across various investment companies, so this profile is fairly consistent across the industry.
The uncomfortable extrapolation is this: given these premiums in the UK, South Africans would find that required rates of return in rand could be in the punishing 14% range. That may mean South African projects will have to go into global capital markets to access decent amounts of acceptably priced capital. In turn, that means the country needs to work hard to win back the investmentgrade sovereign credit rating that was so mindlessly thrown away in 2017.
Restoring growth is probably an essential part of that process, which requires an end to load-shedding. If that means the Chinese arriving with a build-andoperate coal power station, we may have to tolerate it. Coal is filthy, but the consequences of South Africa remaining stuck in a lowgrowth trap are dire. It’s expensive to behave like idiots.
Turning back to the investment case for UK renewables, it is important to be on top of sector-specific fundamentals by watching UK stockbroker research.
One example of a “funny” is that many of these firms fund themselves with amortising bonds (bonds that reduce their capital value, an extreme example of which would be a zero-coupon bond), which can distort reporting on the gearing profile. Another “funny” might be whether historical subsidies are still rolling off.
It seems like a strange, positively foreign asset class to South African investors, but just as they adapted to loadshedding, I am sure they will adopt this attractively priced asset class.