Power Prices: Are renewable energy funds their own worst enemy?

While few dispute the need for the rapid build-out of renewable energy in the UK, the debate over how profitable investing in the sector could be is still raging.

In the last 18 months declining power price forecasts have hit London’s renewables infrastructure investment companies amid growing concerns about the long-term threat of ‘cannibalisation’.  

The grisly-sounding thesis is that green energy could become essentially a victim of its own success as the proliferation of solar parks and wind farms drives down electricity prices in coming decades, reducing income for the owners of these assets.  

Among the small group of independent forecasters which renewables closed-end funds use to assess the outlook and value their portfolios, Bloomberg New Energy Finance (BNEF) has shot to prominence for its bearish forecasts, which show power prices crashing as the low-carbon transition gathers pace.

However, BNEF’s more optimistic rivals have criticised its stance as unrealistic. In fact, power prices have spiked as the global economy recovers after the Covid-19 pandemic, one sign that concerns could be overdone as natural gas continues to play a major role.

Other forecasters including Baringa and Aurora Energy Research whose views have received less coverage paint a less bleak picture for the renewables sector, with long-run prices projected to decline gently rather than sharply, supported by new sources of electricity demand from areas like transportation.

Shares of renewables trusts were sent sliding in January 2020 by a bearish JPMorgan Cazenove note which dug into BNEF’s latest forecasts. The dangers of a pullback were significant given established names in the sector had seen their shares pushed to large premiums above their actual net asset values (NAV) by enthusiastic income investors.

According to Association of Investment Companies data, the average premium in the Renewable Energy Infrastructure sector has narrowed from nearly 20% at the end of 2019 to just under 10% today.

Most investment trusts have also seen their NAVs cut over that time, largely due to declining forecasts. JLEN Environmental Assets (JLEN), for example, has seen a steep drop over 18 months, from 104.7p per share at the end of September 2019 to 92.2p at the end of March.

In April, BNEF delivered an even more pessimistic set of figures, while JPMorgan Cazenove analyst Christopher Brown in turn released another note highlighting ‘further downside risks to UK power prices’.

The forecast sees a huge ramp-up of wind generation, taking us close to hitting the UK government’s target of 40GW of offshore wind capacity by the end of decade. With that, BNEF predicts that by the end of 2030 baseload UK power prices will fall to £16/MWh in real terms, accounting for inflation. That is 36% lower than the £25/MWh figure published a year before which spooked investors.

For renewable generation specifically, the predictions are more acute due to the cannibalisation issue. When the wind blows, for example, wind assets effectively eat into their own revenue base by trying to generate all at once, thereby pushing down the electricity price.

BNEF expects wind and solar assets to realise materially lower prices than the baseload. For onshore wind, that ‘capture discount’ is forecast to be 21% by 2030, rising to 30% by 2050.

While renewables have historically derived significant income from subsidies, merchant power price exposure has been increasing across the sector as new subsidy-free projects are built, leaving funds more exposed to that predicted drop in cash flows.

In his latest notes, investment companies analyst Brown has reiterated his concerns. He estimates the six trusts his team cover across the sector, including the £2.7bn Renewables Infrastructure Group (TRIG), base their NAV calculation on a flat real term average power price of £45MWh until 2050.

Applying the BNEF forecast to a theoretical renewables portfolio, Brown extrapolates a 34% reduction in average NAVs across the sector with share prices tumbling 41% as funds’ 11% share price premiums are eroded.

Brown said the simplified model he used was not a proxy for any renewable fund but was an illustration of what the impact might be of a sudden shift in future power prices and to use the more conservative BNEF forecasts.

However, the analyst also noted that BNEF’s predicted 2030 offshore wind capacity of 39GW effectively assumes that ‘every project in the current planning and development pipeline goes ahead’, something BNEF itself accepts is ‘ambitious’.

TRIG’s current forecasts incorporate an assumption of 30GW of offshore wind capacity by the same point, according to its 2020 results, noting that faster deployment would put downward pressure on power prices.

Brown argued that funds investing in batteries, such as the £414m Gresham House Energy Storage (GRID), are a ‘hedge’ against these risks during the energy transition, as they benefit from increasing arbitrage and grid balancing opportunities created by intermittent nature of renewable generation.

Richard Howard, research director at Aurora, questioned both the magnitude of the power price fall and the speed with which BNEF had changed its forecasts.

'How much would you trust a forecast that has moved that much in one year? What have you learnt in the last year that you've put in?’ he asked.  

Afry, Aurora and Baringa are among the main forecasters used by renewables trusts to judge the income-generating potential of their assets, feeding into their NAVs, while BNEF is a relatively new entrant to the space.

Though BNEF’s nearer-term forecasts show a decline in power prices, in some scenarios they then show a long-term upward trend from 2030 to 2050. Howard said one new factor included is the potential for green hydrogen produced via electrolysis to become a driver of electricity demand.

In BNEF’s most favourable scenario that could drive baseload power prices to £27/MWh in real terms in 2050, versus its £23/MWh base case.

Howard questioned how BNEF had arrived at that forecast, nearly double the £15/MWh base case made a year ago, and whether its outlook amounts to a working system. He suggested scenarios relying heavily on wind, like BNEF’s, would simply not function during week-long lulls in wind which happen about once a year.

Phil Grant, a partner in Baringa's Energy Advisory practice, said it was important to ground any discussion in recent trends. 'At the moment, power prices for the next year or so are as high as they've been for a very long time,’ he said.

Baseload power prices are getting close to £80/MWh for next winter, according to Grant, rebounding sharply from averages for day-ahead baseload contracts below £25 last April and May. That has been sparked by the growing gas demand during the global economic recovery, led by China.

Grant explained that power prices in the UK remained heavily driven by gas prices, which still largely set the cost of generating electricity. He estimated that over a three-year period, the gas price is still responsible for setting about 60% of the baseload power price, while 25-30% is accounted for by the price of carbon allowances and related taxes.

Grant said he expected gas and carbon prices – which have recently hit record highs in Europe – to continue to drive power prices across most European markets including the UK for the next 10-15 years.

‘When you look at risks, a lot of the price risk that people are currently facing, it's nothing to do with European power markets. It's all to do with Asian gas demand,’ said Grant.

For its part, BNEF’s bearish outlook seems to rest on wind displacing gas as the price-setting technology more quickly, given wind turbines have near zero marginal cost of generation and are the cheapest power generation technology.

Grant emphasised that future modelled scenarios have to be ‘consistent’. Baringa assumes developers will demand a certain level of return on low-carbon projects. Otherwise, they will not be built.

'Investors are going to have to see a degree of price stability, a degree of revenue certainty,’ said Grant. He listed possible government intervention including further Contracts for Difference subsidy auctions, with the next round scheduled later this year, or direct subsidisation of new technologies.

Cazenove’s Brown suggested that environment could equally prioritise returns on new projects over existing assets, as the government shoots to hit its targets.

‘Our takeaway is that there are big risks over the next few years on both the supply and demand side and that while BNEF is likely too bearish, equally the existing forecasts used by the renewables funds are probably too optimistic,’ he said.

The other forecasters’ predictions are more closely guarded than BNEF’s, while the trusts also do not disclose exactly which they use.

Baringa’s own forecast is for a 2030 UK baseload power price of £48/MWh in real terms, with Grant saying the trend was 'slightly up in the near term and slightly down in the long-term'. Aurora forecasts a £56/MWh average over the second half of the 2020s, before what Howard calls a ‘slow…but not a very scary decline’.

Both certainly buy into cannibalisation, but also argue this will be somewhat offset by a massive increase in demand for electricity.

The electrification of transport is a key area, underscored by the UK government’s commitment to banning sales of new petrol and diesel cars by 2030. Heating is another, as we move away from gas boilers to some combination of electric heating and hydrogen, which may also find wider industrial usages.  

Vehicle charging and electrolysis will require more electricity, but Howard emphasises that it will also provide ‘super flexible demand’ which can easily be switched on and off to take advantage of lower prices. That provides some solution to the cannibalisation issue on very sunny or windy days when there is surplus renewable generation.

Battery storage is another flexible source of demand, propping up prices by charging up when they are low. There is only about 1GW of capacity in the UK currently, but Aurora forecasts this rising to 10GW by 2040.

Grant thinks more renewables funds will look to diversify through energy storage or broadening their generation portfolios, while taking advantage of the potential for capacity provision contracts.

'That's where we'd expect a lot of the investment funds now to be thinking of. How do I reduce my exposure to pure energy but also monetise against the growing forms of revenue streams in capacity and flexibility?’ he said.

That trend is already underway, with the likes of Foresight Solar (FSFL) broadening their mandates. The £599m trust made its first battery storage investment recently alongside JLEN, also relatively new to the technology. TRIG, which currently owns one battery project in Scotland, said it was ‘actively reviewing’ further opportunities in the space.