The 2019 PLSA Investment Conference in Edinburgh on 6-8 March was attended by over 1,000 pension scheme managers, trustees, consultants and asset managers. Kames Capital’s Nick Edwardson presented on renewable energy, an alternative asset class which has made a significant contribution to the risk-adjusted returns of our multi-asset funds. In this paper we summarise our presentation and discuss how we believe renewables can power your returns.
Environmental concerns have driven significant policy changes in recent years. This, along with technological progress, has delivered a proliferation of energy capabilities, each with their own idiosyncrasies, from traditional hydro-electric schemes through established wind and solar power, to new technologies in tidal, biomass and geothermal power generations.
For investors, this diverse array of power generation capabilities brings a diverse set of investment opportunities and the prospect of attractive returns.
Many of these investments offer the stability of long-term contractual income streams, underpinned by subsidy regimes which lessens the volatility in wholesale power prices. The listed structures we invest in within our multi-asset funds can typically deliver:
- Cash flows to investors with expected internal rates of return of 8-9%;
- Initial full-year dividend yields from 6%; and
- Positive real dividend growth.
When will renewables be cheaper than fossil fuels?
This is a question that we are often asked when discussing renewable energy. The short answer is that they already are. According to the latest annual Lazard Levelized Cost of Energy (LCOE) study, in most parts of the world renewables are already cheaper than fossil fuels without any subsidies. In some areas the most expensive form of solar energy is cheaper than the cheapest form of conventional energy on an LCOE-basis. Chart 1 shows the changing cost of energy since 2009. The message is clear – renewable energy is cheap and getting cheaper, and is becoming a more attractive investment.
Furthermore, fuel-price inflation or volatility is less of a risk for renewables because wind and sunshine is free of input cost and relatively predictable compared to fossil fuel prices. This makes it easier to lock-in long-term prices.
Finally, from an engineering perspective, renewables are a relatively simple undertaking. That means that the projected costs at the start of a renewables project are much more likely to be accurate than for a conventional energy project. This is particularly true of nuclear power, where one study showed that the average construction project over-ran by 117%, while wind and solar project costs over-ran by an average of 8% and 1% respectively *.
*Risk, innovation, electricity infrastructure and construction cost overruns: Testing six hypotheses. Benjamin K. Sovacool, Alex Gilbert, Daniel T. Nugent. 2014.
What is driving these efficiencies?
Although we have harnessed the energy generated by wind for many hundreds of years, modern turbines reflect significant technological advances over early windmills and even over turbines from just a decade ago. One reason has been the steady increase in average turbine size. Whereas new onshore turbines are typically in the range of 1.5-3.5 MW, the largest production models, designed for off-shore use, can generate more than 9 MW, while some models under development are expected to generate 15 MW in offshore projects.
Due to higher costs and technology constraints, off-shore capacity is only a small share of total installed wind-generation capacity. But this is changing. Anyone who has flown into London City Airport cannot fail to have noticed the four wind farms in the Thames Estuary, including the 630 MW London Array, the largest such enterprise in the world when commissioned in 2013 at a build cost of £1.8 billion.
Larger farms have since been built, including the world’s largest, the 659 MW Walney Extension off the Cumbrian coast. Even bigger farms are planned.
The Walney Extension is the world’s largest offshore wind farm.
In aggregate, more than two gigawatts of wind production capacity became operational in the UK in 2018. This is an average of more than one new turbine per day and is enough to power 2.3 million homes for a year. The UK now accounts for more than 60% of Europe’s offshore wind farm capacity.
The UK may lead the world in wind power, but for all the developments in technology there are clearly better places to farm solar. This is why we are investing in developments as far afield as southern Europe and Australia, which have advantages of sunshine and space.
Could we entirely replace fossil fuels with renewable energy?
We believe this is a question of ‘when’, not ‘if’. The reality is that it will take decades to completely wean ourselves off fossil fuels, even if we invest heavily now. But renewables should continue to become cheaper due to their relative technological immaturity and a scaling-up of the industry.
In the future, the areas with the best wind and sunshine will likely export renewable energy, much like they do fossil fuels today.
If we cover 43,000 square miles of the Earth with solar panels, even with moderate efficiencies achievable easily today, it will provide more than 17.4 TW of power. The Sahara Desert in Africa is 3.6 million square miles and is prime for solar power (more than 12 hours per day).
That means 1.2% of the Sahara Desert is sufficient to cover all of the energy needs of the world from solar energy. The cost of the project would be about $5 trillion, a one-time cost at today’s prices without assuming any economy of scale savings*.
* We Could Power The Entire World By Harnessing Solar Energy From 1% Of The Sahara. Forbes.com, 22 September 2016.
There are obvious challenges to this concept, but if US$5 trillion is anywhere near correct, this is very cheap. A recent estimate (see chart 3 below) estimates a capital expenditure spend of US$2.1 trillion on renewables by 2050.
We view this as a conservative estimate. To put it into context:
- An estimated $7.9 trillion of capital expenditure has been spent on the oil and gas sector since 1998;
- An estimated $1.5 trillion was spent on the 2018 US tax cut;
- Global GDP is around $50 trillion annually; and
- The equivalent estimated cost to generate 17.4 TW of nuclear power would be $52 trillion (before any of the potential cost overruns to which we referred earlier).
The International Monetary Fund estimates that we are actually subsidising fossil fuels indirectly to the tune of €300 billion euros per year if environmental damage is taken into account. According to Munich Re, losses from natural disasters are on the rise; they estimate that the cost in 2017 alone was $330 billion. As I said, a $5 trillion one-time cost seems cheap.
Accessing renewable investments
Because pension schemes are long-term investors, they often have the scope to invest in the astonishing potential of renewable energy projects.
Within our multi-asset funds we favour listed vehicles, which provide a diverse array of operational assets that can deliver attractive returns, but with a degree of liquidity and daily pricing.
These assets are also typically lowly-correlated with the more traditional asset classes that we also own in our multi-asset strategies. They help us to dampen volatility and deliver more consistent returns.
Beyond operational assets there are potentially attractive opportunities in equipment manufacturers and the construction of renewable capacity which will benefit from the increased investment spend in this area, driven by lower costs, technological improvement as well as environmental and political pressure
Renewable energy investments are already delivering good risk-adjusted returns in our multi asset portfolios. We believe they can do the same for pension schemes.
About the author
Nick Edwardson is a product specialist in the multi-asset team. His role is to support the team in articulating how the company’s products and investment process add value for clients. Nick joined us in 2016 from his role as the managing director of a successful small business outside of the financial services sector. Prior to that, he worked for Matrix Group in the Pan-Euro equity sales team where he was responsible for sales, marketing and account management for Scottish institutional clients. Nick began his career as a soft commodity futures and options trader, before joining ING Wholesale Banking’s UK Institutional Equity Sales team latterly becoming Head of Edinburgh Office. Nick served in the British Army and studied Russian at the University of Exeter. He has 19 years’ industry experience (as at 30 November 2018).