James Smith
Premier Miton Global Renewables Trust Manager
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Pressing the sell button
For investors in UK renewable energy investment companies, recent performance has been disappointing to say the least. An over-riding factor behind the weakness has been the sharp increase in interest rates and bond yields.
When yields rise many investors press the sell button on stocks they consider to be “bond-proxies,” these being companies having a high level of visible and recurring revenues, with a high proportion of total investment return expected to come through dividends. After all, if you can achieve over 5% yield on short-dated gilts, why take the risk on owning an equity? Property companies are often considered to fall into this category, along with utilities and renewable energy.
To illustrate the point, I will use Greencoat UK Wind Plc (“Greencoat”) as an example. There is nothing particularly scientific about choosing this company, only that it is currently Premier Miton Global Renewables Trust’s (PMGR’s) largest holding, has one of the sector’s longest trading histories, is entirely focused on the UK (making comparisons to Gilts more valid), and is one of the larger renewable investment companies, often seen as a bellwether for the sector. Considering its share price and the yield on 10-year Gilts over the first half of 2023:
Greencoat UK Wind plc performance vs UK 10-year Gilt Yields 30.12.2022 to 10.07.2023
Source: Bloomberg data from 30.12.2022 to 10.07.2023. The performance information presented on this page relates to the past. Past performance is not a reliable indicator of future returns.
Looking at the chart above, you do not need to be a trained statistician to see there has been a high correlation between Greencoat’s share price and the increasing yields on UK government debt over the first half of 2023. Essentially, increased yields (plotted inversely above) have been matched by a falling share price. The market is clearly trading Greencoat’s shares as though they are government debt. The question is – is this valid? First, let us see if the relationship holds good over the longer term, taking the past 5 years:
Greencoat UK Wind PLC total return performance vs Gilts
Source: Bloomberg data from 29.06.2018 to 30.06.2023. The performance information presented on this page relates to the past. Past performance is not a reliable indicator of future returns.
Making a contrast
In sharp contrast to the first half of 2023, over the longer term Greencoat has outperformed Gilts (here the FTSE Actuaries 5–15-year Gilt Index). In fact, despite the recent fall in its share price, over the five years to June 2023 Greencoat has returned 48.8% or 8.3% per year. In contrast the 5–15-year Gilt index has performed poorly, losing 15.0% in total return over the period, a loss of 3.2% per year on average.
It can be said therefore, that while there may be strong correlation between Greencoat and the Gilt market over the short term, the relationship breaks down over the medium term. There are clearly other factors at play.
As an investment company, Greencoat revalues its assets, quarterly in this case, using a long-term discounted cash flow model to calculate a current net asset value (“NAV”). The main components of the model are a) interest rates and bond yields which determine the cost of capital used to discount future cash flows to current values, b) inflation, which increases both the payments under historic renewable incentive mechanisms, and the UK Government-issued contracts for difference schemes under which offshore wind is remunerated, and c) power price assumptions. The first of these is a mathematical component of the model, the second two are the major drivers of achieved revenue.
So far in 2023, the market looks to have been focused on the first of these three factors, perhaps forgetting to consider the second two. There are of course other components to the calculation, such as cost assumptions, wind speeds, assumed asset lives, and tax, but these are less material than the three components above, and also less volatile. Turning to Greencoat’s NAV per share, in comparison to its share price:
Greencoat UK Wind Plc, NAV per share vs share price
Source: Bloomberg / company reports and accounts from 29.12.2017 to 30.06.2023. The performance information presented on this page relates to the past. Past performance is not a reliable indicator of future returns.
Rising steadily?
Greencoat’s NAV has risen steadily, showing particularly strong momentum since the start of 2022. The positives of higher power prices and inflation have more than offset the negative of higher interest rates. Despite this, the share price currently trades at similar levels to late 2019, when the NAV was over 40p per share lower than where it stands today. The shares have gone from trading at a premium to NAV to a substantial discount since the start of 2023 as the share price has tracked bond yields.
My belief is that the market is discounting the impact of higher interest rates but is forgetting to factor in the benefits of higher inflation. Higher inflation and interest rates are essentially two sides of the same coin: the high inflation is the reason for the high interest rates. Greencoat is long the former and short the latter, but over the long term, the two will naturally offset each other. Indeed, given that inflation continues to run ahead of interest rates, Greencoat should be benefitting from the existing inflationary environment.
Such is Greencoat’s positive inflation capture, the Company’s policy is to increase its dividend in line with the Retail Prices Index, which can be seen by looking at the company’s recent dividend record, and targeted dividend for 2023:
Greencoat UK Wind dividend per share (historic declared per year, plus 2023 company target)
Source: Greencoat company reports and accounts. The performance information presented on this page relates to the past. Past performance is not a reliable indicator of future returns.
The inflationary environment has manifested itself into sharply increasing dividend payments to shareholders. The company’s target dividend for 2023 of 8.76 pence per share, represents an increase of 13.5% on the 7.72 pence paid for 2022.
I have discussed some of the other factors which may be impacting valuations and market sentiment in an article written earlier this year. Perhaps the most important is that power prices remain relatively high despite having fallen back from the elevated levels seen in 2022. Greencoat incorporates third party power price forecasts into its NAV calculation. These assume power prices falling back toward £60 / MWh by the end of this decade. It is worth noting that in the first half of 2023, the UK wholesale baseload (i.e., constant power) price averaged almost twice that level, at £116 / MWh. To anyone who believes that power prices will stay at current levels or higher, Greencoat’s NAV calculation must look conservative.
What conclusions to draw
None of what I have written above should be seen as an investment recommendation (which I am neither qualified nor allowed to give). Much could go wrong with an investment into a UK based renewable energy producer. Power prices could fall, there could be further political intervention and new taxes, turbines can fail, the wind may not blow at speeds it has in the past, costs might increase, and management may make poor decisions.
However, coming back to our original question, there does appear to be far more to the longer-term performance of a renewable energy investment company than interest rates, and the sector should not be dismissed solely as a bond proxy.
