Whilst ESG as a label for investments has come in for some recent criticism, it is still at the heart of investing globally, with the “E” for environment perhaps the single most important factor for investors. And one of the biggest environmental questions facing investors has been how to invest in such a way that supports the energy transition from fossil to renewable energy, says Mortimer Menzel, managing partner, Augusta Investment Management.
For very large strategic investors, there has been one straightforward way to do it, which is to buy the assets that produce renewable power, such as wind or solar farms or biomass or biogas plants. But to do that, you have to understand the technology involved and you have to have the operating expertise to run these facilities, which excludes all but a handful of investors.
There has also been the option to invest in these assets through a co-mingled fund which specialises in the space and which then purchases the assets, but there is significant risk involved in this. The fund manager needs to have very specialist, proven knowledge, and the investments create transaction risk, opex, capex and exit risk.
Price risk is also important as the valuation of power assets can be strongly influenced by the market price of the power they generate, which often fluctuates with considerable volatility in response to geopolitical events.
We think there is a different and better way to do it, which is to buy the power produced, literally the electricity itself, not the asset. We are confident that doing this is better for investors, with lower risks and higher returns.
The way to do this is through a long-term power purchase agreement (PPAs). These are typically utilised between the energy producers themselves as a way of assuring continuity of supply and to reduce electricity price risk. A wind farm in the North Sea, for example, might sell the future generation of power to an energy utility through such an agreement.
It is unusual for an asset manager to enter into these agreements, but we are able to do so by virtue of having built deep relationships in the European energy space over the last 20 years as one of the leading M&A advisors in the space.
We are able to enter into PPAs with energy utilities and then to sell the power on the market, while hedging against market risk.
Doing so is lower risk than investing in the core infrastructure itself, for four main reasons.
Firstly, in terms of transaction risk, there is reduced transaction risk as our sole focus is on bi-lateral, exclusive opportunities.
Secondly, in terms of opex or capex risk, there is actually very little. The asset exposure stays with the seller of the power, typically in our case, a state-owned utility.
Thirdly, in terms of price risk, our hedging expertise limits price risk. And these can be adapted to individual investor’s risk appetite.
And fourthly, in terms of exit risk, this is also much reduced because if we do want to exit early, because the power price has gone up, the seller is the most likely buyer as he will want the power back to be able to sell it at a higher price to someone else.
In terms of return profile, this approach yields long-term sustainable income with an immediate cash yield. The return generated is actually higher than investing in core infrastructure and creates a fixed income-like return stream with additional alpha.
The cash yield is immediate because there are already identified opportunities where negotiations are at an advanced stage. All the deals are bilateral and exclusive, reducing deal risk, and deal sizes can be adjusted to fit investor appetite.
We are not critical of the traditional approach of investing in core energy infrastructure. It is important for the energy transition process and it works for very large investors with the right expertise in the space. But we believe that our approach has essentially unlocked a new asset class for investors in renewable energy, the institutional PPA, and this is one that yields higher returns with lower risk.
Not only that, but this approach actually funnels capital into new green capacity, thus delivering an important environmental impact. All the capital which the utility receives from the transaction must be used for green power investments. Each one of our deals in this space has resulted in identifiable additional investments in renewable energy.
A final word about the best renewable sector for this asset class. The broad trend in Europe is towards intermittent renewable sources of power, i.e. energy which is only available at certain times such as when the wind is blowing or the sun is shining. This creates potentially major issues in terms of the reliability and security of power supply in Europe.
Traditionally, intermittent sources of power have been balanced with “dispatchable” capacity, i.e. plants that can be turned on or off, but many of these have been thermal power plants which are now being phased out in Europe, thus reducing capacity.
Hydro power is one of the last remaining dispatchable sources of power in Europe. Because it is generated by reservoirs which are naturally re-filled by water or snow melt, the turbines can be turned on and off when needed. This creates a natural battery which is capable of optimising production volumes to achieve a trading premium above average annual spot price. In other words, the reservoir hydro power can be generated at the most efficient and productive time for investors.
Reservoir hydro power, however, typically requires mountains and lakes which means that it is geologically restricted to certain regions. Nordic reservoir hydropower is the most abundant – there is significant existing capacity and enormous expertise in utilising it.
So not only can Nordic reservoir hydropower play a unique role in Europe’s energy transition, it can also play an important role in investor portfolios as a source of compelling and sustainable alpha with low risk through the unique approach we have pioneered.
By Mortimer Menzel, managing partner, Augusta Investment Management
