Investing Basics: Investing in renewable energy infrastructure with investment trusts

Closed ended funds are a simple way to access the attractive income and defensive potential of renewables infrastructure…by David Kimberley

 
Climate change, advances in technology and regulatory changes designed to foster the use of green energy have all contributed to increased investment in renewables infrastructure over the last decade.

That investment has been fuelled by demand from investors, who often find the potential for high, comparatively predictable levels of cashflow, which these investments typically produce, appealing.

However, for wealth managers or individual investors, investing in renewables infrastructure directly is close to impossible.

It’s for this reason that investment trusts have emerged as a popular way for investors to get exposure to the asset class.
 

Why invest in renewables infrastructure?

 
Before looking at why that’s the case it’s worth examining what the attractions of renewables infrastructure investment are.

Ultimately the combination of attractive levels of income and the potential for capital growth are what investors like about the sector. However, there are several features of renewables investment that underpin those two factors, which also explain why that’s the case.
 

1. Inelastic demand

 
Renewable infrastructure is ultimately about selling energy. Demand for energy is less sensitive to changes in price or the state of the wider economy.

In other words, the price of energy can rise substantially without a commensurate drop off in demand. Similarly, even if there is an economic downturn, demand for energy is unlikely to subside dramatically.

This means that renewables provide a level of defensiveness to investors. Although the price of energy can fluctuate, the end investor can say with a level of certainty that demand for that energy is not going to subside substantially.
 

2. Stable cash flows

 
Although, as noted, the price of energy is hard to predict and can fluctuate, the point remains that there are comparatively low levels of volatility in renewable infrastructure’s cash flows.

Beyond the fact that this can make the sector more attractive to income investors, for the actual direct investor in the infrastructure, it often means that the leverage used to finance transactions can be acquired at more attractive rates than in other sectors.
 

3. Long-term investment

 
Renewable energy infrastructure assets typically have long economic lives. They are usually capital intensive to set up, but once that is done, you typically have low operating costs, especially compared to hydrocarbons.

Again, this provides a degree of certainty to investors. They know that a given infrastructure asset has a certain useful life, over which time it can generate a fairly predictable amount of energy. This makes forecasting cashflows simpler than it would be compared to other asset classes.
 

4. Inflation-linked cashflows

 
Energy is a significant component that feeds into the inflation calculation. Rising prices boost the revenues of producers, and although this can eventually be counteracted by falling demand, demand is relatively inelastic. As such there is a natural inflation-hedging element to an investment in energy producers.

Additionally, many renewable energy providers also have contracts that contain direct inflation linkage. This means that if inflation does rise, renewable energy infrastructure operators’ cashflows increase in line with it. On the other hand, some renewable energy trusts fix the prices they receive for the energy they produce, so these revenues won’t rise along with wholesale energy prices.

The result is that the income renewable energy infrastructure assets produce can be much more resilient to the negative impact of inflation, and sometimes offer built-in upside sensitivity. A bit of research into each renewable infrastructure investment trust is necessary to understand its individual circumstances.
 

5. Low correlation with other asset classes

 
Renewables energy infrastructure performance has historically had a low correlation with traditional assets.

That is partly due to the stability of the cashflows, which such investments produce. Another factor is that capital valuations are appraisal-based, like private equity. This can ‘smooth’ out returns.

The result is that renewable energy infrastructure assets offer compelling diversification benefits to investors.
 

Why it’s difficult to invest in renewable energy infrastructure directly

 
As noted, investing in renewable energy infrastructure directly is effectively off limits for individual investors and wealth managers.

Fundamentally this is due to cost. If you are a private investor or wealth manager, you simply aren’t going to have the huge sums – potentially hundreds of millions of pounds – needed to make a direct investment in infrastructure.

Even if you could, then the odds are you would not have the time or expertise to manage what is more akin to a company than a ‘normal’ fund management business, investing in traditional assets. You would need to identify and evaluate investment opportunities and then manage the operation of renewables sites once you had invested.

It’s for this reason that investors tend to either invest in the shares of renewable energy companies that provide a level of indirect exposure to the sector or in different types of funds that invest in the sector directly.
 

Why investment trusts are an attractive way to invest in renewable energy infrastructure

 
There are more than 20 different investment trusts listed on the London Stock Exchange today that invest in renewable energy infrastructure, reflecting the fact that closed-ended funds have emerged as a popular and simple way for investors to get exposure to the asset class.

There are several reasons for that, which are largely due to how investment trusts are structured and regulated.
 

1. Easy to access illiquid asset classes

 
Investment trusts are structured as companies that list on the London Stock Exchange. Investors that want to get exposure to a trust’s portfolio simply have to buy its shares.

The important point to remember here is that, even though the value of those shares may reflect the value of the trust’s holdings, the trading of those shares does not necessitate buying or selling assets for the underlying portfolio. The two are separate.

This is obviously a huge benefit for investors in more illiquid assets like renewable energy infrastructure.

Firstly, the shares can be bought and sold easily. The fund managers are not going to have to sell off holdings to facilitate this process.

Share prices are also far more affordable than direct investment. Moreover, investors can customise their order size accordingly, so that their exposure to the asset class fits with the diversification goals of their wider portfolio.
 

2. Dividends

 
Investment trusts are required to pay out 85% of their income to shareholders. This makes them an attractive option for income investors, particularly in a highly cash generative sector like renewable energy infrastructure.

However, this also has another significant upside, namely that the remaining 15% can be kept in a revenue reserve. This can be used to smooth out dividend payments if there is any unexpected drop off in income.
 

3. Gearing

 
Investment trusts are able to use gearing, sometimes known as leverage. This is borrowed money that can be used to enhance returns and deliver a higher yield. However, it must be noted that the converse of this is also true and gearing can exacerbate losses if the fund manager makes the wrong call.

As noted, for renewables investment specifically, leverage can often be used at relatively attractive rates because there is a higher level of certainty with the cashflows that the sector produces.
 

Key points: investment trusts and renewable energy infrastructure

 
To sum that all up, investors tend to want exposure to renewable energy infrastructure because it often offers attractive levels of income, provides a level of defensiveness, and can act as a strong diversifier in a wider portfolio.

Investment trusts make investing in the sector much easier. The liquidity of trust shares mean it is far simpler for investors to buy and sell than it would be via direct holdings.

Moreover, the fact that equities are not ‘lumpy’ assets means order sizes can easily be customised to fit with the level of exposure an end investor wants. Again, this is simply not possible with direct investment.