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How renewable energy investments can help manage the risks facing DC members

2022 highlighted several risks for defined contribution pensions (DC), many of which could have been addressed by renewable energy investments. We explain how.

02/08/2023
Solar plant in Seville, Spain

Authors

Duncan Hale
Private Markets Group
Tim Horne
Head of UK Institutional Defined Contribution

2022 was a difficult year which posed serious challenges for families, individuals and policy makers.

In addition to its profound humanitarian and political consequences, the Russian invasion of Ukraine highlighted issues around energy security and reliance on fossil fuels. It also caused significant volatility in investment markets. Since March 2022, we’ve seen rapidly increasing inflation and interest rates, volatility across public markets and economically-sensitive assets, and significant supply chain disruption.

The impact of these wider macrotrends for DC members - who typically have high allocations to public markets - was negative performance. According to consultancy Lane Clark and Peacock (LCP), default investment strategies for members 30 years away from retirement varied from -3.9% to -12.8% in 2022. The research report “Master Trusts Unpacked” notes this is where equity exposure is typically highest.

For investors with a long-term investment horizon - such as DC members – investing into a broader range of assets could help improve expected risk-adjusted returns.

Indeed, we believe that most DC members would benefit from a meaningful allocation to a broad range of private assets (in the region of 15-20%). In particular, renewable energy and energy transition-aligned infrastructure should be high on the list of assets classes DC decision makers consider.

Here’s why.

Why is renewable energy a good fit for DC members?

The move to net zero and the global transition to low carbon energy production requires significant investment. This provides an opportunity set arguably not been seen since the industrial revolution.

Further, powerful tail winds for these investment opportunities are provided by the affordability of renewables versus other sources of energy generation, as well as an increased focus on energy security. The need for, and investment in, renewable energy continues to grow. Over $500 billion was invested in 2022 alone, according to IRENA data.

We believe it is these investments’ ability to address the key considerations of return, risk and impact that make renewables well-suited to a DC portfolio.

Returns

Proper incentive is required to attract the level of investment detailed above. This can, we believe, be demonstrated by renewables.

Equities are currently the predominant growth investment for DC schemes and this is the benchmark that any new investment should be held against. Schroders’ research suggests equities, subject to market cap and geographical focus, are forecast to deliver a range of 6-9% gross returns per annum (p.a.) over the next 30 years[1].

A typical, operational renewable energy investment in the developed world, run by our team, is expected to deliver returns of 8-10% per annum on a buy and hold basis[2]. This is in line with - or at a premium to - listed equities.

Risk management

While the returns from renewable energy are attractive, it is the way that these returns are generated that makes it so well-aligned to DC members.

Like all assets, investing into renewable energy exposes DC members to risks. Returns are effectively the payment for taking these risks. Renewable energy infrastructure exposes members to risks they otherwise would not have in their portfolio. These different risk ‘premia’ deliver diversification. Below we detail what some of those risks are and how they impact portfolio behaviour.

  • Inflation Renewable energy returns  are often explicitly linked to inflation via payment streams (which are often government backed or supported). They are also implicitly linked to inflation exposure to the power prices (merchant); power prices being one of the drivers of inflation.

Being positively exposed to inflation is a critical benefit for DC members investing into renewables, as it helps to maintain the real purchasing power of their investments.

  • Positive power price risk – Listed equities and corporate bonds are typically negatively impacted by power price rises. This was demonstrated throughout 2022, where high energy prices didn’t just impact the “cost-of-living crisis”, but also negatively impacted businesses. In contrast, renewable energy portfolios benefit from rising power prices through the energy it generates and distributes.
  • Resource/weather risk - Wind and solar radiation are diversifying to other risks in an investor’s portfolio. While predicting the weather today or tomorrow is challenging, over a 30-year asset life this is much more predictable. Our data shows wind to exhibit a 2% standard deviation of outcomes over a 10-year period. Solar’s standard deviation is even lower.
  • Technology - These risks are specific to the technology and deliver another source of risk premium to investors. For example, the operational considerations of a biomass plant vary significantly to a wind farm or hydrogen plant. Again, the key benefit to DC members of this risk premia is the diversification to a wider portfolio.

  • Geography/policy - Energy security concerns globally are driving policy and regulation to support an accelerated energy transition, resulting in a green subsidy race. Significant legislation has been drafted such as the Inflation Reduction Act in the US.

Conceptually, these return drivers and risk premia should deliver robust diversification, particularly for listed equity-heavy investors like DC.   

Renewable energy provided much needed diversification in 2022 for those institutional investors who have already made investments in this area. Our data indicates renewable energy assets delivered robust and positive absolute returns versus the negative returns seen in many other areas.

Meeting the need for positive impact in investment

DC members are growing more aware of the impact their portfolios have on the world and increasingly expect their investments to contribute to solutions rather than just avoiding harm.

Renewable energy and energy transition aligned infrastructures can tangibly be measured in green electrons produced and homes and/or electric vehicles powered. This makes the contribution of these assets towards a net zero economy clear. It is also clear that investing in this sustainable asset class goes beyond the structural environmental benefits of clean energy generation and requires a sustainable approach to the community and local biodiversity.

2022 brought all three of these points into clear focus for investors and DC schemes specifically; public markets provided limited shelter from the market volatility as both inflation and energy prices spiked. There is today, however, thanks in part to long-term asset funds (LTAFs), a broader choice of investment solutions available which can help the member journey and deliver better outcomes while addressing the impacts of climate change.

SOURCES:

[1] Source: Long-run asset class performance: 30-year return forecasts (2023–52)

[2] Source: Schroders Greencoat forecast. There is no guarantee that forecasted figures will be achieved. Buy and hold IRRs assume no exit and zero terminal value for investments over the expected life of the asset (which is generally between 25-40 years).

Authors

Duncan Hale
Private Markets Group
Tim Horne
Head of UK Institutional Defined Contribution

Topics

Infrastructure
Infrastructure Finance
Private Assets
Energy transition
Net Zero
Planet
Defined Contribution
Alternatives
UK
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