Trust Manager – Premier Miton Global Renewables Trust PLC
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Looking back, looking forward
As we look back on 2022, and look forward to 2023, I can identify four major economic influences on the share prices of investments in the Trust’s portfolio. I believe that the two negatives are now largely reflected in share prices, whereas the two positives may not be, but hopefully will be more appreciated as we move through 2023. Let us get the negatives out of the way first.
Negative #1. Higher interest rates
Higher interest rates hurt share prices in two ways. Firstly, to the extent a company has taken on floating rate debt, its finance costs are increased, and its profits will therefore fall. However, most renewable energy companies tend to use long-term fixed rate debt, so this is not a major concern for the time being.
Secondly, as inflation has increased over the year, interest rates have increased to combat it, and this has had a significant effect on the valuations of many renewable energy generators in the year, as future cash flows are discounted to present day values at a higher “discount rate.” The Trust’s US holdings are particularly exposed in that they tend to sell their energy at relatively fixed long-term prices. Therefore, their revenues do not necessarily increase by inflation, but their valuations are hurt by interest rate increases to combat inflation.
On a brighter note, the outlook for higher interest rates appears to be moderating. On this basis, and assuming inflation is approaching its peak, I would contend the future path of interest rates is now largely anticipated, and therefore reflected in share prices.
Negative #2. Political risk
It is difficult to anticipate major political risks in advance, such as the Russian invasion of Ukraine. It is possible that China may take some action over Taiwan, which I view to be unlikely. Perhaps of more pressing concern, is the political intervention in European power markets or windfall taxes, which has affected the Trust’s UK and European holdings, together around two thirds of the portfolio. While this risk has been known about for much of the year, the details have been lacking.
Over recent weeks, these risks have been quantified, with Governments announcing the new tax structures. On balance, these have been set at levels which allow renewable energy companies to capture (post tax) electricity prices substantially above the market prices that existed a few years ago. In any event, these details are now known, so we can safely assume that windfall taxes are now reflected in share prices.
Positive #1. Inflation
While inflation has been a definite negative for the Trust’s North American holdings, European renewable energy companies often have inflation linked tariffs or subsidy regimes. These include the UK’s renewable obligation certificates and the more recent contracts for difference scheme applying to offshore wind. The contracts for difference scheme is the UK government’s main mechanism for supporting low-carbon electricity generation. It incentivises investment in renewable energy by providing developers of projects with fixed inflation linked pricing, thus providing protection from wholesale price volatility, inflation linked tariffs can provide a boost to energy company revenue.
However, the costs of an operational renewable energy asset are mainly fixed, the two largest costs being depreciation of the original capital investment over the life of the asset, and finance costs on debt used to part fund the construction. As noted above, finance costs tend to be fixed rather than variable. The beneficial impact of inflation could therefore have a greater proportionate impact on net profitability than revenues.
Positive #2. Power prices
The rise in the wholesale price of electricity since Jan 2020
Source: Bloomberg, data from 27.12.2019 to 25.11.2022
In the US renewable generators tend to sell power on largely fixed long term prices. However, in Europe many generators retain substantial exposure to electricity prices. Given the sharp increase in the cost of gas, electricity prices have increased as gas generators tend to have relatively high marginal costs of production and as such have an outsized role in influencing power prices for the entire market.
For several years, forecasters have assumed that the falling cost of renewable energy will exert a downward pressure on the electricity price as renewables take an ever-larger share of the market. This remains a common view I hear among investors. However, I believe the factors pushing up electricity prices over the past two years, as show in the chart above, will likely to be with us for a few years yet. Indeed, I can see several reasons why power prices will stay high for several years, including:
- The shift in European gas usage from Russian piped gas to international liquified natural gas (LNG) is a fundamental permanent shift in the market. New LNG infrastructure is expensive and will need to be recovered through the gas price. Further, Europe will be competing for LNG supply against Asian countries, particularly China.
- New nuclear is cost prohibitive and takes many years to build. It is very unlikely to contribute meaningful new electricity supply over anything short of the very long term.
- Europe’s existing nuclear reactors are aging. This is a particular issue for France, where I expect its fleet of aging reactors to generate less power and become more unreliable over time. France, which generates around 70% of its electricity from nuclear, is likely to continue to import power from neighbouring countries, helping to keep power prices elevated across Western Europe.
- European carbon prices have increased over the past couple of years to a level that is now effective in discouraging carbon emissions. The carbon price is paid by coal and gas generators, pushing up the price of electricity, and effectively being a revenue stream for renewable generators. The sale of carbon permits is also a lucrative tax revenue for the EU and the UK authorities who therefore have little incentive to push for a lower carbon price.
The growth story is just getting started
These are fundamental shifts. Should power prices stay at current elevated levels, I believe there is the potential for increases in the share prices of European renewable electricity generators. Over the past decade, the growth of renewable energy has consistently and dramatically outperformed nearly all expectations.
But this growth story is just getting started. As countries aim to reach ambitious decarbonization targets, renewable energy—led by wind and solar—is poised to become the backbone of the world’s power supply.