Lower interest rates spark renewed hope for green energy investments

Clean energy funds, once the darlings of the investment fund landscape, are expected to see a major resurgence as investors rekindle interest in lower interest rates.

After years of rising premiums and growing demand due to environmental, social and governance concerns, the sector has faced headwinds from rising prices and falling energy prices. However, with the Bank of England recently cutting interest rates for the first time in more than four years, and more cuts expected in 2024, optimism is returning.

Clean energy funds were trading at large premiums to their net asset values ​​through 2020, according to data from the Association of Investment Funds. For example, Greencoat UK Wind, the largest clean energy investment fund, raised more than £1bn in equities over 2020 and 2021, nearly a third of its market value. But today, the fund and its peers are trading at discounts, reflecting the broader market’s retreat from the £15.5bn sector amid rising interest rates and falling energy prices.

James Wallace, an analyst at Winterflood, believes the recent rate cuts could help narrow these discounts, though the impact may take some time to fully materialize. “We think these rate cuts will narrow that gap, at least to some extent in terms of discounts, because of the lower required returns that these investors are demanding,” Wallace said. However, he cautioned that significant cuts — perhaps as much as 75 basis points — may be needed to see a meaningful impact on valuations.

But questions remain about whether green energy funds can recapture the high interest premiums of the past without returning to the ultra-low interest rates seen before 2020. “It’s possible that these companies could trade at or near net asset value, but unless we have the prices we saw before 2020, they won’t be trading at a 10-20 per cent premium to book value,” noted Ben Newell, an analyst at Investec.

The challenges are not limited to interest rates. London’s nascent battery storage sector, including funds such as Gresham House Energy Storage and Gore Street Energy Storage, is facing intense scrutiny because of volatile cash flows, with shares trading between 45% and 55% below their net asset value. Unlike wind or solar assets, battery storage returns are dependent on the volatility of wholesale power prices, adding a layer of risk that investors have been reluctant to accept.

Paul Mason, chief investment officer at Harmony Energy, highlighted the unpredictability of battery asset earnings as a key factor in the current market discount. Recent energy price declines have put further pressure on these funds, prompting some, such as Harmony and Gresham, to cancel dividends for the year. “The lesson we’ve learned is that taking an asset class with an unpredictable (commercial) earnings profile and trying to promise a consistent level of dividend is not always feasible,” said Max Slade of Harmony Energy.

In addition, the waning enthusiasm for ESG strategies during economic downturns has had an impact on green infrastructure funds. Last year, ESG funds saw significant withdrawals from UK investors, although flows have improved this year. “During the cost of living crisis and when things are a bit slower in the economy, the focus can be more on the economy and on generating returns,” Wallace noted.

The recent fall in share prices below net asset value has hampered renewable energy investment funds from raising new equity, restricting a vital source of funding for future projects. Renewable Energy Infrastructure Group (Trig), one of the largest funds in the sector, has responded by carefully managing its balance sheet, including selling £210m of assets to reduce debt and fund new developments.

With the UK government setting ambitious targets for expanding wind and solar capacity by the end of the decade, the role of private capital remains crucial. But as Alex O’Cenade, CEO of Gore Street Capital, points out, restricted access to capital poses a significant challenge: “There’s a very big issue around what that means in terms of the new government, and in terms of building renewable energy infrastructure, that the main route for private capital into renewables in the UK is essentially closed.”

As the sector looks to recover, all eyes will be on further interest rate adjustments and their potential to revitalize investor confidence in green energy.