303. Energising portfolios: investing in clean energy income strategies

29 February 2024 (pre-recorded 27 February 2024)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[NTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. We’re focusing on renewable energy infrastructure this week and the impact of rising interest rates on the broader investment trust sector.

Joss Murphy (JM): Hi, I’m Joss Murphy. Today I’ve been joined by Will Argent, investment advisor of the VT Gravis Clean Energy Income Fund. Hi, Will, how are you?

Will Argent (WA): Hi there. Very well, thanks. Thank you for having me.

JM: Great to have you on.

[INTERVIEW]

JM: Let’s kick things off. The fund sits in the IA Infrastructure sector. How does it differ from a typical infrastructure fund?

WA: Well, I think firstly, the clear thematic focus of the strategy which is on infrastructure relating to the energy transition. So, the underlying portfolio has a very large core exposure to renewable energy generation assets, so that’s a clear differentiator against sort of broader infrastructure strategies. I’d also suggest the keen focus on income generation that we have – I’m not so sure that is a key area of focus for other strategies but it is for us: we’re an income-focused vehicle and we are targeting 4.5% net yield.

JM: And Will, this fund invests in investment trusts within the sector; as rates rose, a lot of investment trusts suffered? Do you think we’ll see a strong bounce back when we get more clarity on rate cuts?

WA: Yeah, so, I think just to provide some context around the recent situation, these renewable energy companies, these renewable energy infrastructure assets provide exposure to very long-dated cash flows. Now, as interest rates increased and as a result reference yields, so, things like government bond yields increased, that has hurt our sector and the reasons being the impact of higher rates that has provided a headwind for the present value of these long-dated cash flows that our companies generate.

And then secondly, there’s the relative attraction of, say, investment grade bonds or government gilts or Treasuries in the US for example, which are now yielding higher levels. And, of course, infrastructure –  including our particular area of focus in renewable energy infrastructure – has sort of derated accordingly in order to offer, sort of reacting to those higher reference yields on other traditional fixed-income assets.

So, that’s the backdrop we’ve been in and we’ve seen the strong positive reaction late last year as markets started to think about rate cuts coming down the line in 2024. I think markets got a little bit ahead of themselves and long-dated yields came back quite sharply and they’ve blown out a bit more this year as the market has had to temper its expectations around the timing of rate cuts.

But going back to the question, you know, you saw that reaction late last year, that very strong positive reaction, to the idea of rate cuts coming. We fully expect them to come during 2024 in all our key jurisdictions where we’re exposed. And so, I think it’s reasonable to expect that kind of bounce back, that good performance to reignite as we get greater visibility around those rate cuts. So yes.

JM: That certainly makes a lot of sense. I guess looking at the bigger picture here, how do you expect these underlying trusts and assets to behave through an economic cycle?

WA: Yeah, so, at the asset level, these are companies that have very highly contracted cash flows, right? They’re selling – the companies we own – they are selling electricity, they’re selling the power they produce on a highly contracted basis. So, these are underpinned by very long-term contracts with high quality off-takers, whether those are utilities or other high quality corporates.

The electricity that’s produced is also a critical service. And so, regardless of the stage in the economic cycle, I think, at an asset level, we’d expect the assets to continue generating the power, continue to generate cash flows and those very resilient income streams.

At a trust level, so, at company level, the ratings that are ascribed to these trusts and companies are subject to market sentiment. And that does oscillate through market cycles. I think from where we are at the moment, looking to relatively flat, economic growth – certainly at home in the UK where we’re in a technical recession – if that leads to rate cuts as we expect and lower longer-term yields, I think that would provide a tailwind for ratings. But I’d also suggest that if you are in a period of relatively weak economic activity, the relative security and resilience of the cash flows that these companies generate, I think, may come back to the fore as we’ve seen in the past and they come back onto the radar for more investors, potentially

JM: And Will, more recently and very much all over the news at the start of this year, energy storage and battery trusts have had a horrible time. Why is this? And does the fund have exposure to this area? And how have they performed?

WA: Yeah, so, you are right, the pure play battery energy storage companies – these are mainly listed in London – have had a difficult time, so revenues fell in 2023 versus the prior year. And that decline became far more acute towards the back end of last year. So, a disappointing year-on-year for revenues for these companies. And, at the same time, the underlying cost of debt, for example, has increased. So, they’ve had a bit of a challenging year, and the reasons for that on the revenue level is lower ancillary service revenues from providing services to the grid. That follows very high prices available in 2022, to a degree that reflects greater saturation of batteries in the market.

A second reason for lower revenues would be the lower intraday volatility we’ve seen in electricity prices. And this is partly impacted by the absolute level of power prices coming back, [that’s] one element. But basically, that lower intraday volatility has reduced the opportunities for trading revenues, again, on a year-on-year basis. So, you know, certainly providing some headwinds for that space. And you are right, the companies, the share prices have declined, derated very sharply. We do have some exposure in the VT Gravis Clean Energy Income fund, [it’s] relatively modest.

But what I would say is where we have that exposure, we recognise the revenue uncertainty in these models certainly versus the core of our fund, of our strategy, which is highly contracted renewable energy generation. So, I think we apportion the exposure to that risk, to these companies, accordingly and sort of recognise they sat in our, let’s say, more commercial revenue bucket.

JM: And Will, how do valuations look today on battery storage? And I guess more broadly across the portfolio?

WA: So, in terms of the ratings of these companies, share prices versus the latest asset valuations, the battery storage names are trading at very deep discounts. There has certainly been a reaction to the deterioration in revenues recently. It has surprised the market more broadly. So, I would suggest that things have derated quite significantly, and we were actually looking at – certainly in recent days and weeks – companies in this space trading below replacement costs for their assets. So, I think they are quite depressed. And let’s not forget that battery storage has a key role to play in the future of the electricity grid in the UK and more broadly. So, we understand why they’ve derated recently but I think it’s probably overdone, and we have started to see a bit of a move off the lows.

And you asked more broadly across our universe. I mean, it’s fair to say that the broader sector has derated significantly over the last 12 to 18 months. Now, this has been driven by the sort of macro factors that we were talking about a bit earlier. And I would suggest that, when you look at the yields on offer from these companies, where they trade relative to their asset valuations today, we haven’t really seen the sector trading at such low levels, certainly not in the fund’s lifetime.

JM: And, generally speaking, these assets have greater exposure to power prices, and now that prices have started to come down, what’s your view as we stand today? Does it influence the opportunity available? And, as you just said, its valuations are at incredibly cheap levels versus their long-term average. Does it make that opportunity set more compelling for the fund going forward?

WA: Well, on the point of power prices, I think it’s important to understand, as I noted earlier, a large element of expected revenues are contracted and these are a mix of subsidies that underpin an element of revenues. You’ve got fixed power price sales, so, long-term power purchase agreements that give you great visibility around pricing or more shorter-term hedges which lock in visibility on revenues. And then you may have some market exposure [ie.] wholesale electricity price exposure. So, you know, as power prices have gone up in recent years on the back of – well, largely driven by the conflict in Ukraine, but the energy market was tight going into that anyway, so you’ve had a spike in prices and they’re starting to alleviate considerably now. Just like companies didn’t benefit on a one-for-one basis as prices went higher because of their hedging, forward sales, for example, they’re not coming back on a one-for-one basis either as these power prices fall.

I think the other thing you’ve got to note on power prices is that a lot of the action that we are seeing, the volatility in prices, is at the nearer end, right? So, on a let’s say one to three year view is where prices have spiked up and are now, I mean lower. The very long-term power price curve that a lot of these companies incorporate into their valuations has actually been relatively stable. So, it’s really near years where you’ve seen this big volatility in power prices, but as I say, it is not for … asset valuations or cash flows don’t move one-for-one with those near-term movements. Some companies have benefitted significantly from recent high higher prices and it’s improved their profitability. Those are the companies that have had greater exposure to spot prices.

So, to your question about how does power pricing influence the opportunities available? I think for me, maybe it may influence views on exposures. So, a good example would be, well, let’s just say having a bigger exposure to companies that maybe have more spot exposure in recent years has been beneficial. As power prices are coming down lower, perhaps you might have a more constructive view of companies that have hedged into that higher environment and are therefore perhaps less exposed as these prices have come down.

JM: And Will, the aim of this fund is also to deliver a regular income for investors. How do the underlying companies generate this reliable income?

WA: Yeah, so, in the main, the companies we own are producing power, renewable energy, and these are sold to off-takers like utilities and other corporate entities, for example, on very long-term contracts. As I’ve mentioned, a lot of these companies will also benefit from receiving subsidy payments for the power they produce, further supporting those revenue streams. Now, companies return a lot of, a large element of those cash flows to investors – such as ourselves – via dividends and that’s really what we are focused on. So it’s these companies providing a critical service, right? You need this electricity throughout market cycles. They sell it to various users or off-takers on long term contracts. That cycles back to very visible and reliable cash flow streams that they distribute to shareholders – such as ourselves – via dividends. And that’s how that income stream comes through and it is quite dependable.

JM: And finally, how does this fund fit within a wider portfolio for investors?

WA: Yes, well, I’m probably on the wrong side of the fence perhaps to comment, but from my point of view, in a multi-asset portfolio, I think the strategy can certainly provide a diversifier alongside other traditional asset classes that you would have in there. And, I guess, probably needless to say, it certainly would be useful I believe and naturally fitting in an income-focused, multi-asset portfolio, that’s for sure.

JM: Will, thank you very much for your time today.

SW: The VT Gravis Clean Energy Income fund taps into the expertise of the Gravis group to create a portfolio of renewable energy and energy-efficiency related projects, that are benefiting from the secular move to more sustainable energy demands. For more information on the VT Gravis Clean Energy Income fund visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.