How do renewables perform in a stagflationary environment?
Renewable assets could show themselves to be more resilient to a high inflation-low growth backdrop than more traditional assets. Here's why.
Renewable energy assets such as wind farms and solar parks generate long-term, stable, inflation-linked, revenues on relatively low operating costs. In the UK, contractual links bind returns particularly tightly to inflation. Many of these assets are also financed with limited or no debt. As a result, they stand to perform much better in a stagflationary environment than many other assets.
Inflation-linked revenues and predictable costs
The precise nature of the cashflows from renewables varies by country.
In the UK, the most common structures used to support renewables include a contractual link to inflation. The contracts for difference (CFDs) used on most new projects allow producers to effectively sell their electricity at an inflation-linked (CPI) contractual price for 15 years. Payments are guaranteed by a UK government-backed entity. After 15 years, electricity is sold on the open market so revenue depends on future electricity prices. However, the link between energy prices and inflation means that an implicit connection is maintained.
Older UK contracts (Renewables Obligation Certificates, or ROCs) were structured differently but also have a long-term (originally 20-year but nowadays none have more than 15 years left to run) contractual link with inflation, through the RPI-inflating ROC payments.
Even where UK wind farms or solar parks are built without any form of government support, they enter into long-term and (often) inflation-linked contracts with creditworthy counterparties as diverse as ABInBev, Unilever and McDonalds, as well as energy utilities.
To put this all into perspective, by our estimates, a 1% a year increase in inflation is expected to boost returns by 0.8% a year in the UK.
In Europe, support schemes vary across countries. As in the UK, these have evolved over time. Both inflation-linked and fixed-prices can be observed amongst the various support schemes, although most countries have moved to fixed-price schemes.
Some support schemes include upside potential, where assets benefit from high price environments such as we are experiencing now. And corporate power purchase agreements can have an inflation-linked element. This was not common in the past but there are signs that this is changing. Existing, fixed-support contracts struck in the past will lose some appeal if inflation shoots up, like what happens with a fixed interest bond. Existing, inflation-linked support contracts or contracts with upside potential will offer similar protection to UK assets. For new contracts, pricing will reflect the prevailing market environment for both the length of contract and price.
For example, in Germany, prices are mainly fixed but, for new contracts, these have shifted up a lot over the past year. German contracts tend to be for less than 10 years, but this too is evolving and there have been some recent, high profile, corporate power purchase agreements of 10 years.
Both in the UK and in Europe, some assets will produce power that is not covered by long-term contracts with governments or corporates, and that will be sold into the market at the prevailing market price.
Of course, revenues equal price times volume. And renewables’ volumes depend on how much the wind blows or the sun shines, and how much “down-time” is needed for things like maintenance. These are relatively predictable, particularly over medium to longer horizons.
In terms of availability, wind turbines are usually available to generate more than 95% of the time. They generally require fewer than 20 days a year for regular servicing and maintenance, which can often be scheduled for less windy periods. Manufacturers are so confident of this reliability that they usually guarantee this level of “availability” over the first 15 years of a turbine’s life. And even beyond that, the performance remains excellent, with the expected level of availability only falling by a few percent over the remaining operating life.
The amount of wind or sunshine does fluctuate from year to year. However, this has nothing to do with the economic cycle, so is independent of whether we go into stagflation. There is also no reason to believe that it will become a lot less windy or a lot less sunny in future.
Over the long-term, the fluctuations tend to even out, resulting in a relatively low standard deviation over the asset life.
On the cost side, an important differentiator for renewables compared with other assets is that the price of many of the main inputs is zero. Sunshine or wind doesn’t cost anything. And what costs there are (such as maintenance and land leases) represent a relatively small percentage of the revenue and are usually fixed or inflation-linked over the medium to long term. Contrast this with a manufacturing company which is highly exposed to labour and energy costs.
As a result, renewable cashflows are highly predictable and relatively insensitive to the economic cycle, and usually positively exposed to inflationary risks. That security can be very valuable in an economic slowdown.
In other markets like the Nordics and Southern Europe, and occasionally in the UK, revenues follow a fully merchant model. Under this, 100% of revenues depend on the spot price in the market – although, as explained earlier, this has a link with inflation. This leads to a more variable revenue profile but has the same predictable cost profile.
For unlevered projects, the degree of uncertainty in an asset’s revenues is largely determined by the degree of contractual revenues vs merchant revenues, as shown in Figure 1 below. More contractual revenues mean a lower but more certain return profile. More merchant revenues mean a higher but more variable return profile.
While the shape of this revenue model will be similar for different renewable energy assets, the actual returns expected for different projects will be driven by a myriad of factors. These include the current level of interest rates, regulatory regime, level of inflation linkages and level of resource (i.e. weather), and risk.
As a general rule of thumb, real returns from assets with fully contracted revenues offer a comfortable spread over the relevant local government bond (e.g. index-linked gilts in the UK, or bunds in Germany). Fully merchant returns are materially higher and tend towards the low double-digits in nominal terms in the UK, high single digits in Europe.
There is a need for material investment in renewable energy capacity around the world if we are to transition to a low carbon future. It should not, therefore, be any surprise that the pricing structures that underpin them have been designed to incentivise investment. Long-dated, inflation-linked, resilient, secure cashflows meet the criteria of many investors.
Rising yields are not such a worry for valuations
Under the popular discounted cashflow valuation model, higher bond yields increase the discount rate, lowering the present value of an asset’s future cash flows, lowering its valuation – all else being equal. The longer the asset’s duration, the greater the valuation shock from a rise in government bond yields.
This might make you think that renewables’ valuations are vulnerable in a stagflationary environment – where inflation is sending bond yields higher. But the risk is lower than you might think, supporting the asset class from both a diversification and resilience standpoint. There are two main mitigating factors.
First, and foremost, in a higher inflation environment, increased cashflows in the numerator of a renewable asset’s discounted cashflow calculation will at least partially offset any inflation-driven change in the discount rate.
For example, the value of an asset paying a guaranteed 30 years of 100% inflation-linked cashflows would hardly change at all if inflation and discount rates were both assumed to be 2% higher, all else being equal. If the pass-through of inflation to revenues was 80%, the valuation would only fall by around 5%. Assets with a weaker pass-through would suffer a lot more. Renewables’ strong revenue link with inflation puts them in a strong position on this front versus other assets.
These figures are for illustrative purposes only.
While an inflation-driven rise in bond yields is of less concern for renewables’ valuations, a bigger risk is if it is rising real yields which are pushing bond yields higher. But here too, the risk is less than you might think for an asset which pays several decades of cashflows.
In technical terms, renewables’ duration is shorter. This is for two reasons. First, because the residual value assumed for a renewable asset at the end of its useful life (around 30 years for solar and wind) is zero. Its value is derived entirely from the projected cashflows over that life, not any sale value. And the vast majority of this value comes from the first 15 years of cashflows.
In contrast, for a 30-year bond, a big part of its value is driven by a principal repayment in 30 years, whose present value is very sensitive to changes in real yields. Renewables have a shorter duration than you’d think based on their 30-year life, as they “amortise” their value over that period.
Second, the discount rates used to value renewable energy assets incorporate a significant ‘spread’ over government bond yields. This spread reflects things like operational risk, supply/demand dynamics, illiquidity, and other risk preferences. Historically the spread has made up the majority of the discount rate. In effect, the yield, or expected return, on renewables is much higher than government bonds. And bond maths tells us that the higher a bond’s yield, the shorter its duration, all else being equal – reducing its sensitivity to movements in government bond yields.
Furthermore, as the other risk premia making up the spread are driven by diverse factors that are not all related to bond yields, this leads to smoother discount rates during times of bond market stress, such as has been experienced recently.
There is also a final consideration. Renewables are often bought on a buy-and-hold basis; they are held by investors for the cashflow generated over their life. While inflation will impact the level of cashflows received, changes in the discount rates due to yield changes only impact how those cashflows are valued, not expectations of how the asset will perform (it is the same situation for a bond which an investor plans to hold to maturity). Given this, short term volatility in valuations has less bearing on the long-term returns earned by investors.
All in all, while renewables’ valuations are not immune from risks arising from higher bond yields, their features put them on a stronger footing to weather stagflationary storms, certainly relative to other asset classes which will find the going tougher.
An imperfect but reassuring insight from public markets
The renewables industry we know today did not exist the last time there was a serious problem with stagflation. However, as well as their cashflow characteristics, investors can take additional comfort from the long-term track record of the stock market’s utilities sector during times of high inflation and slowing growth. This is not a perfect match for renewable energy assets today, but they do share some similarities.
For example, in the UK, there is a long track record of regulated pricing in the utilities sector having a strong link with inflation. This is not the case everywhere. The US is different, for example.
Reassuringly, using UK data since 1987, utilities have generated a positive real return in 79% of the 12-month periods when RPI inflation has been above 4% (RPI inflation chosen as it was the main UK inflation measure for most of this period. RPI has averaged 0.8% more than CPI over the period when they coincided, so this is approximately the same as CPI inflation of 3.2% or more). UK utilities have outperformed the broader UK stock market in 73% of these environments.
As Figure 3 shows, the degree of outperformance has been strongest in those environments where inflation has been high and economic growth slowing (based on the OECD’s Leading Composite Indicator for the UK being below its 12-month moving average). The reverse is also true, with performance lagging more cyclical peers during periods of stronger growth and lower inflation.
This strong performance is not just indicative of utilities’ revenue link with inflation but also how the market views and values essential real assets during period of stress. When we analyse the US utilities market there is also a high degree of outperformance during these environments, even without the same strong revenue link with inflation.
Ballast in a storm
Renewables provide secure income streams, with limited exposure to the economic cycle. Performance should be resilient to any economic slowdown. They benefit further from having strong linkages to inflation; in some areas this is explicit, while in others it is more of an implicit linkage through energy prices.
And that is before we even consider the tremendous need to build out renewables capacity. It is the cheapest form of new power generation. It improves energy security - the European Union’s RePowerEU plan puts an accelerated transition to renewables at the centre of its plan to wean itself off Russian fossil fuels. Net Zero pledges are also dead in the water without a material expansion of renewable capacity. Pricing regimes need to remain attractive enough to incentivise large amounts of capital to be allocated to this area.
They stand to perform much better in a stagflationary environment than many other assets.
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