Investor view: Bruce Huber and Gerard Reid

“Utilities cannot buy renewable assets at prices that enable them to generate sufficient returns to keep their shareholders happy”

One of the greatest challenges facing utilities is the rising cost of capital, as highlighted in Alexa Capital’s recent report: UK Energy Perspective – Is there a Better Way Forward? Higher costs compound pressures on management at a time when utilities are facing imperatives to lower prices and move towards cleaner fuel sources. The pressures are becoming extreme in Europe where policy change has been significant and we are seeing most of the major European utilities cost-cutting and restructuring, leading to asset sales and portfolio repositioning.
On the positive side, feed-in tariffs (FITs) and increasingly prevalent long-term power purchase offtake contracts are revolutionising the power landscape. These offtake structures are facilitating massive capital investment into the energy sector, especially in renewables which, with their zero marginal costs and priority grid access, have pushed down wholesale prices across the region. In the case of Germany, the vast majority of the 70GW renewable capacity developed over the past decade has been financed by private individuals or institutional investors (either directly or indirectly through funds), with less than 10 per cent owned by Germany’s “big four” utilities. How did this come about?
The answer is simple and gets to the core of the “FIT revolution”. Utilities could not buy renewable assets at prices that enabled them to generate sufficient returns to keep their shareholders happy. These returns are around 10 per cent, while the average FIT investor will take 7 per cent or less. Currently, there are pension funds and investment trusts buying German, French and UK assets at equity return levels of between 4 and 7 per cent. Meanwhile, utilities across Europe are required to pay dividends often above these levels to retain shareholder support. What does this mean? If a megawatt of power capacity costs €1 million, a pension fund requires only €40,000 a year in returns, while the utility requires €100,000. So why should the public pay a utility so much to invest in generation, and is there a solution?
A few months ago NRG Energy, the largest independent generator in the US, took a notable step by spinning out certain assets into a unit called NRG Yield. NGR Yield comprises 2.5GW of generation assets (including 414MW of solar and wind) supported by long-term power purchase agreements. Investor demand drove a 20 per cent share price increase, implying that new investors will receive a yield below 4 per cent. And what does NRG get out of the transaction? Capital, plus continued control and management fees. The maths are compelling.
Bruce Huber and Gerard Reid, Alexa Capital LLP