Faith Glasgow on what energy price increases mean for renewable energy infrastructure.
“In the past, renewable energy tended to cost more than gas, not only because gas was cheap but also because the infrastructure was not being built at scale; so renewables operators were incentivised with subsidies from the government.”
High inflation and soaring energy prices might be a toxic mix for consumers and businesses, but as always there are winners as well as losers. In this case the closed-ended funds investing in solar, wind and other renewable energy infrastructure have been doing very nicely this year, thank you, with many enjoying share price increases of 10% to 15% in the first half of 2022.
But it’s by no means immediately obvious why renewables providers focused on harnessing energy from the sun and the wind should be doing so well, just because the price of gas has rocketed on the back of supply issues following Russia’s invasion of Ukraine. As Philip New, former CEO of independent innovation agency Energy Systems Catapult, explains, it all comes down to the way electricity prices are set. “There are various different sources of electricity; some, such as nuclear power stations and wind farms, cost a lot to build but relatively little to operate, while others, such as gas-powered generators, cost less to build and more to run because of the fuel involved,” he says. “The way the system currently works is that it’s the marginal cost of production that determines the price of electricity – so if you needed 100 units, the price would be set by the cost of producing that 100th unit.” And because gas is so much easier than unpredictable and hard-to-store solar or wind power to dial up or down as energy demand fluctuates, its price is the critical marginal factor. Gas price hikes mean the price of electricity, from any source, will rise too. However, says New, it’s not quite that simple. “In the past, renewable energy tended to cost more than gas, not only because gas was cheap but also because the infrastructure was not being built at scale; so renewables operators were incentivised with subsidies from the government.” The majority of operational renewables projects – solar farms, onshore wind farms, rooftop solar – operate under this system. But the past eight years have seen the introduction of different systems for new projects. Under these (known as contracts for difference or power price agreements – PPAs), the government goes to the renewables market to secure infrastructure for a certain amount of capacity, and the successful provider gets a long-term guarantee that it will receive the price at which it’s undertaking to provide energy. Any extra revenues from electricity sales at a price over and above that guaranteed level go back to the administrator (the low carbon contracts company) and any surpluses are then transferred to energy suppliers. The energy watchdog Ofgem takes these transfers into account when setting the retail price cap.
The upshot under this system is that the renewables operator receives a secure revenue, regardless of what happens to energy prices; and that certainty also means it can also borrow more cheaply from lenders, helping to bring the price down for renewable energy. When the gas price rocketed in response to the invasion of Ukraine, it impacted differently on different parts of the energy market. Thus the businesses buying gas to produce electricity have seen little gain because their costs rocketed. But as New observes, the renewables companies operating under the old credit scheme are enjoying huge profits. “If you’re, say, an offshore wind farm built 10 years ago under the old scheme, not only are you getting all of the gas price spike, but you’re probably getting the government subsidy as well.” Businesses operating newer assets under the more recent fixed-price arrangements, meanwhile, are making just what they expected to at the outset. What does all this mean for investors in renewables trusts? Clearly, different trusts have differing levels of exposure to projects operating under the old system, with revenues dictated by short-term power prices but also subsidies, and those in the new system where prices are fixed.
It’s the level of exposure to marginal power prices that has been so significant for their fortunes this year, of course. As a note from broker Stifel explains: “Some [companies] have over 80% of their revenues fixed – for example, Bluefield Solar and Foresight Solar. In contrast, Greencoat UK Wind only has around half its
revenues fixed in 2022, with exposure to merchant power prices high – this being helpful for returns over the past year.
Looking ahead, the concern for investors is that a decline in gas prices and a reversion to more normal market conditions – which would be terrific news for most people – could stall or damage NAV growth for the sector. However, Stifel points to the various ways in which renewables’ revenues are protected from market volatility: “While the recent H1 NAV total returns of +10% to +15% are likely to be an anomaly, the high levels of subsidy income and PPAs should provide significant insulation in a scenario of lower power prices,” it argues. Overall, it estimates that around 80% of revenues are relatively stable as a result of subsidies and PPAs. That could be taken a significant step further in due course too. Stifel reports that the government is currently discussing with the renewables industry ideas to decouple the price of the electricity it produces from the gas price and broader power price. “One idea is for wind and solar producers to be offered a 'fixed' price for electricity over a 15-year period. We assume this would include inflation indexation, and it could be organised as a 'special' contracts for difference round,” says the broker. “We think there would be some merits for the listed funds in having more certainty on their revenues, and dividend cover for the next 15 years.” As New explains, that could be a good thing for consumers too. By getting all the non-fossil generators onto long-term fixed price contracts, the extra revenues between the gas price (which dictates the price of electricity) and the long-term price to which they have contracted can be recycled back into the system, diluting the impact of the kind of gas price volatility we’ve seen this year. “The higher the gas price, the higher the rebate will be, effectively taking the sting out of it,” he says.
