Premier Miton Global Renewables Trust — Are higher power prices here to stay?

Considering that power prices are, arguably, the key factor affecting the profitability of renewable energy generators, the upward shift in the power price curve will be hugely beneficial for the renewable infrastructure industry. According to a number of industry participants (such as Foresight Solar Fund (FSFL) and Bluefield Solar Income Fund (BSIF)) that a combination of fixed-price contracts (with little dependency on power prices expectations and accounting for about two-thirds of renewables’ annualised total revenues) and merchant pricing (direct exposure to power price volatility, approximately one-third of revenues) will exist for decades to come. Merchant revenues would get a boost from a rise in power prices. Moreover, as power prices rise, renewable companies such as wind and solar, which operate at effectively zero marginal cost (as most of their costs are fixed), will gain at the cost of fossil fuel generators, whose costs will be hit by carbon taxes.

BP’s Energy Outlook 2020 suggests three possible scenarios for the energy mix by 2050 compared with 2018. Regardless of which scenario materialises, renewable energy will significantly increase its share of the mix and renewable energy companies will benefit from capturing more business. The scale of this shift varies significantly across the three scenarios, with the share of hydrocarbons in primary energy declining from around 85% in 2018 to 70–20% by 2050 and the share of renewable energy increasing to 20–60%. Considering the UK government’s efforts to achieve Net Zero by 2050, it is plausible that the renewables share will be higher than in the ‘business-as-usual’ scenario, where it hovers around 20%.

The manager’s view of future UK and European power prices is based on three pillars. Firstly, the price of gas has increased to around three times the 2019 average price of c 35p per therm to c 105p per therm at end-July 2021. Secondly, power prices are beginning to be more obviously defined by a combination of gas (c 85%) and emissions permits (CO2) pricing (c 15%), rather than the gas price alone, as it was until recently. Thirdly, Smith believes that electricity demand will grow very quickly from the current level and push power prices up in the mid- and long term.

Smith expects mid- and long-term power prices to be higher than market consensus (provided by independent third-party power forecasting companies) currently suggests. In December 2020, consensus by industry consultants (consensus data from FSFL’s FY20 annual report) was for UK power prices to increase gradually from the near-term level of c 45/MWh to c £50/MWh by 2026 and continue until about 2040. End-July UK power prices have more than doubled subsequently to £105/MWh and continues to climb. Smith believes the market will be tighter this autumn and winter, and contracts will be signed at even higher prices. A more up-to-date report on the forecast curve for power prices (from NextEnergy Solar Fund’s (NESF) FY21 annual report, published on 16 June 2021) shows no changes to long-term power price forecast levels.

The manager believes that the adoption of hydrogen will accelerate within the next few years, particularly within the heavy industry and transport sectors of the economy. This broadened usage of hydrogen and the consequent increase in demand for electricity generation required to manufacture the hydrogen could progress quicker than expected, and lead to materially higher electricity prices than those currently modelled by power price forecasting consultants.

At end-July 2021, the portfolio included 39 holdings (compared to 42 at end-December 2020 and 48 at end-July 2020). As the portfolio was generally restructured by the end of 2020 and sector classification was changed (see our initiation note for details) to fit the new mandate in November 2020, we compare end-July 2021 sectoral and geographical breakdowns with PMGR’s financial year-end data (at 31 December 2020) to gauge the manager’s activity to capture new opportunities.

Exhibits 1 and 2 present sizeable sectoral and geographic changes, with the reshaped portfolio representing Smith’s views and stock performance dynamics. The manager categorises listed renewable energy companies into two broad groups: ‘yieldcos’ and developers. The former invest in built or construction-ready assets that pay out the majority of cash flow to investors and raise capital through new equity (PMGR’s yieldcos & funds sector).

Developers are integrated companies, which develop projects from first inception, retaining some assets but raising capital through a combination of retained earnings and project sales (whole or in part, to yieldcos and financial investors). These two sectors remain the largest within the portfolio, accounting for c 55% of portfolio assets at end-July 2021, up from c 51.5% at end-December 2020.

The main area of portfolio activity in the half was a reduction in some of the North American holdings (North American allocation down 9.7pp to 16.2% at end July 2021). Smith believes these are likely to underperform in the scenario of a material rise in interest rates, which would curb inflation, he explains. North American holdings performed well in 2020, and the manager envisages lower potential returns than historically. He reduced the position in Atlantica Sustainable Infrastructure (formerly Atlantica Yield), the portfolio’s largest holding at end-2020, to 3.8% of the portfolio at end-June 2021 (the latest date for full portfolio disclosure) following the 2.0pp share price decline over the previous six months. He also reduced the position in TransAlta Renewables (3.1%) and Clearway Energy (‘A’ Class share, 2.8%), as their share prices had declined by 4.3pp and 14.7pp, respectively. He retains holdings in all three as he views of the continuing combination of long-term growth and revenue visibility attractive.

Smith partially reallocated the proceeds into UK yieldcos (UK allocation up 5.5pp to 26%, the top position). Having fallen during 2020, the share prices of UK renewable investment companies now look more attractive to the manager. He points out that in contrast to their US counterparts, UK companies have a greater level of inflation linkage (through the indexation of renewable obligation certificates), together with higher exposure to power prices. US renewables tend to sell power on long-term contracts with fixed, predefined prices. The manager believes that this additional risk to UK names is compensated by potentially higher returns when electricity prices rise.

In the UK, the manager has increased the position in NESF (4.8% of the portfolio at end-June 2021), whose shares fell by 4.9pp, and initiated a position in FSFL (2.5%), whose shares fell 7.9pp in the half. Both have been weak as lower long-term electricity price forecasts were incorporated into their net asset values. He believes that longer-term pricing may be higher than currently assumed (see The renewables opportunity section above), and that their recent share price movements are inconsistent with the increase in UK electricity prices seen in H121.

Renewable energy developers sector exposure grew by 6.5pp. Developers tend to have higher returns that yieldcos, to compensate for development and construction risk, and the manager has bought several at attractive prices. Smith added to the positions in RWE (4.4% at end-July 2021, top 10 holding), which is building a sizable renewables business and is now one of the world’s largest investors in offshore wind projects. He also added to global renewables developer Acciona (2.7% of the portfolio at end-June 2021), listed in Spain. The company has three divisions: renewables, construction and infrastructure, with renewables accounting for the bulk of its earnings. PMGR established a new position in another Spanish solar developer, Grenergy Renewables (2.6% of the portfolio), which has an extensive solar growth pipeline with a particularly strong position in Latin America. These two holdings have made considerable contributions to the increase in Europe-ex UK exposure of 4.0pp by end-July 2021.

The manager believes that several of the portfolio’s top 10 holdings (Exhibit 3), including Drax, SSE, RWE, plus the UK renewable funds, look set to benefit from increased electricity pricing over the short to medium term. Smith has been selling Indian power company OPG Power Ventures – the only Indian holding and the only stock in the liquidation portfolio. It no longer conforms to the new investment policy, (still 2.1% of the portfolio at end-July 2021 on low liquidity, but this will be sold in due course).

PMGR’s shift from a broad global infrastructure portfolio to a narrower focus on renewable energy stocks has paid off. Over the past 12 months (Exhibits 4 and 5), the trust’s performance has recovered well from the March 2020 market sell-off, driven by pandemic fears. Both the trust’s NAV and share price outperformed the blended benchmark, as well as both the infrastructure and utilities indices over the 12 months to end-July 2021. Most notably, PMGR’s stronger performance (33.7% and 36.6% for NAV and share price total return (TR), respectively) versus the MSCI AC World Index (26.3% TR) over the period demonstrated the considerable recovery in portfolio stocks bought during the March 2020 market sell-off over 2020.

The fortunes of renewables equities have changed somewhat during the past six months.

The renewable and clean energy sector has weakened following a very strong performance in 2020. Expectations of rising inflation have weighed on renewable and other energy infrastructure companies. However. the precise make-up of revenues from renewable energy assets varies across the world. For instance, US renewable assets tend to sell power on long-term, predefined prices and could be expected to underperform in an inflationary environment. By contrast, UK renewable assets have a combination of inflation-linked subsidy revenues plus market price exposures. Smith currently favours those renewable energy operators with higher inflation and market price linkages and believes that the higher electricity price environment is, in many cases, yet to be adequately reflected in share prices. Despite a weakening sector performance in the first half of the current year, PMGR’s NAV generated a positive TR. This was partly due to very strong performances in PMGR’s Chinese investments.

In Exhibit 6 we show PMGR’s performance relative to peers. Apart from the only other peer listed in the Association of Investment Companies’ (AIC) Sector Specialist: Infrastructure Securities sector, Ecofin Global Utilities & Infrastructure (EGL), we note that PMGR is the only pure-play listed renewable energy investment trust in the UK market. EGL has limited crossover with PMGR as it is currently only c 26% invested in renewable energy. In Exhibit 6 we have also included funds from the AIC Sector Specialist: Environmental peer group (although these tend to be more focused on the technology underlying sustainable solutions), as well as the renewable energy infrastructure sector, whose constituents mainly invest directly in operating assets, and Utilico Emerging Markets, which focuses on utilities and infrastructure but comes under the global emerging markets sector.

Given the narrowing of the mandate from broader infrastructure to renewable energy sector during 2020, PMGR’s most relevant peer performance comparison is over the past 12 months. The trust ranks second on NAV TR over the past 12 months, following Impax Environmental Markets - a highly technology exposed mandate. This period demonstrates that the strategy shift has so far paid off, and the manager looks into future returns with optimism.

We note that it is difficult to directly compare the level of gearing for the peer group like-for-like, as companies can either carry debt at parent or project companies’ level, and this is not always consolidated. PMGR’s level of gearing, the second highest in the group, is a result of the trust’s capital structure. The fund is relatively small (the second smallest in the peer group) and as typical with smaller funds, the discount to NAV is relatively wide (third widest among the peer group). The 5.5% dividend yield is 0.3pp above the mean.

On 22 July, the company announced the second interim dividend for FY21 of 1.75p per ordinary share, to be paid on 30 September. This is in line with the board’s target of paying an annual dividend of at least 7.00p per share for FY21 (see Exhibit 7).

In November 2020, following the refinancing of and reduction in the ZDP liability, funded through the sale of investments from the portfolio and the board’s announcement of an expected consequent reduction in income generation, the expected annual dividend per share has been reduced by c 3.2p from 10.2p. This is compensated by a reduction in finance costs of c 3.6p per share. Gross gearing (as reported by PMGR, excluding current period revenue) was down from 52.5% at end-December 2019 to 31.1% at end-June 2021.