Renewable energy infrastructure struggles creating attractive entry opportunities

The year so far has not been kind to funds supporting the transition to lower-carbon energy. In their monthly review of the AIC Infrastructure and Renewable Energy Infrastructure (REI) sectors published this week, analysts at Winterflood highlighted a negative total shareholder return of 5.6% for REI funds in the first quarter of 2023, underperforming UK equities (+3.1%), gilts (+2.0%) and even the beleaguered property sector (-1.4%).

Within the sector, energy efficiency trusts performed worst (-7.4% for the quarter), followed by battery storage (-5.3%) and broader renewables strategies (-4.5%). It is worth highlighting that with only three funds each in the battery storage and energy efficiency subsectors, the average returns of the 16 more diversified funds mask a broad range of outcomes. In March alone, top-performing fund Downing Renewables & Infrastructure produced a total shareholder return of 6.6%, while HydrogenOne Capital Growth saw a decline of 29.5%.

As shown in the table below, REI is a ‘young’ sector, with only one of the 22 funds (just) having a 10-year record and a further six having been around for at least five years. However, the combination of a high yield with an ESG-friendly asset class has found favour with investors, and REI funds have consistently topped the AIC’s table for new and/or secondary fundraising in recent years.

Looking at the launch dates of the funds, there have been three clear waves: first in 2013/14 (with all the funds having a track record of more than five years seeing their 10^th anniversary in the next 12 months), then in 2018/19, and then from late 2020 into 2021, after COVID-19 put a brake on new listings for much of 2020.

The more recent launches have tended to be more specialised, with all of the six battery storage and energy efficiency funds having launched in the past five years. However, youth is no guarantee of success: Aquila Energy Efficiency Trust has not yet reached its second anniversary but has already put forward proposals for a voluntary liquidation, evidently having failed to convince investors that it offered a compelling alternative to the £1.2bn SDCL Energy Efficiency Income Trust, launched in December 2018.

With many of the trusts having traded at substantial premiums to NAV in recent years, the current 11.7% average discount – combined with an average 5.8% dividend yield – arguably offers an attractive entry point. In many cases the funds’ revenues have explicit inflation linkage, and Winterflood points out that with many of them having posted their full-year results over the past month, dividend growth as well as yields remains high. Greencoat UK Wind – the longest-established fund in the sector – has raised its dividend by 13.4%, matching RPI inflation in December 2022, while Octopus Renewables Infrastructure has provided a CPI-busting 10.5% increase.

Returns during 2022 were generally supported by higher actual and forecasted inflation, higher power prices and increases in forecast power prices, offsetting increases in discount rates and the impact of levies and windfall taxes in the UK and Europe, according to Winterflood analyst Shayan Ratnasingam.

While many may view REI funds as a bond proxy, owing to the duration sensitivity of the underlying cash flows and the fact that most of the return comes through dividend payments, Winterflood points out that yields are materially higher, historically having offered a yield pick-up over the 10-year UK gilt of between 350 and 420 basis points, and also offering a yield premium of around 30bp over UK corporate bonds, with the added ability to increase dividends, which corporate bonds – as fixed income instruments – cannot do.

However, fundamentally these funds are a yield play, and investors seeking more of a total return strategy may wish to consider gaining exposure to the energy transition through funds investing in in the renewables supply chain, for example through natural resources (lithium is vital for the development of battery storage, and copper is used in electrification) or a more equity-focused environmental fund.

That said, the negative capital returns experienced in the past year by the REI funds are uncharacteristic of a sector that often boasts relatively low volatility alongside its high income, and any sustained rerating could see attractive total returns from these funds too.

*In process of liquidation. Source: AIC/Morningstar, at 18 April 2023