Jolly Green Giant

There could be a solution to economic problems on the horizon, and one where the UK is a world leader…

 
In a June article we discussed the difficulties in maintaining the right balance between the need for traditional energy companies and the push towards renewables, and the importance of this issue has only been heightened in the second half of this year. The natural gas price has become the macro factor of the past few months, dominating both the economic and political agenda.

In our June note we highlighted how the transition to green energy would take time, and that while it presented a huge opportunity for investors, in the short to medium term fossil fuels would remain critical and potentially lucrative investments.

However, this is not to say the transition won’t happen. In fact, strides are being made in tackling the problem, leading to numerous investment opportunities, particularly in the investment trust space.

The natural gas price has become a major contributor to the sharply rising rate of inflation and emerging cost-of-living crisis. In the short term it is easy to be bearish: restricted supply and low levels of capex in recent years mean the prices of gas and other fossil fuels look likely to remain elevated, and so they will remain a critical input into the cost of electricity and industrial production. However, we think there are reasons to be optimistic, and in the long run there are solutions on the horizon, one of which the UK is a world leader in – offshore wind.

At the end of 2020, the UK had the largest offshore wind capacity in the world – not just relative to its size, but in absolute terms – with 29% of the entire world’s offshore capacity. China is fast catching up, though, and installed more capacity than the rest of the world combined in 2021, taking it ahead of Germany to reach second place as it vies for the lead as the world’s biggest producer.

Conversely, the UK had a relatively quiet year last year due to some timing and technical factors. However, the UK’s pipeline for new capacity is huge and will comfortably consolidate its lead position into the near future. In terms of numbers, the UK has 91GW either in active operation or in the pipeline for completion by the end of the decade, according to figures from GlobalData.

This is enough output to power over 60 million households, or fast charge over 800,000 electric cars. The equivalent figure from China is 87.2GW either active or in the pipeline, with Brazil and the US at 72.2GW and 44.6GW respectively (though both of these are coming from a standing start).

To put into context how ambitious the plans for the UK are, the new plant at Dogger Bank (yes, the same one as the shipping forecast) is set to start coming online in 2023. When all three phases are complete, it will be the world’s largest individual farm with a capacity of 3.6GW and will add nearly a third to the UK’s capacity. If the plant itself were a country today, it would be the world’s fourth-largest producer, ahead of the likes of wind pioneers such as the Netherlands and Denmark.

There are a number of investment trusts that are set to capture this explosive growth.

Greencoat UK Wind (UKW) has a range of wind farms across the UK, thus offering pure exposure to the theme. It was the first trust in the AIC’s Renewable Energy Infrastructure sector and has amassed a portfolio of 44 wind farms generating 1,460MW of power. Around a third of these assets are based in offshore wind, including sites in the North Sea as well as the Irish Sea.

The managers of the trust have recently acquired a stake in the Hornsea One offshore wind farm, one of the largest active offshore wind farms in the world. The manager has taken the approach of being unhedged to power prices, meaning the trust can benefit from times of rising markets rather than fixing in on long-term deals.

In normal times the management team manage this exposure very diligently, ensuring they pay a sensible dividend whilst reinvesting cash flows back into the business to sustain themselves going forward. Over the past year this approach has been very beneficial to cash flows, with the elevated power price nearly doubling the excess cash flows available to the business and adding considerably to the NAV prospects.

Jupiter Green (JGC) is another trust that has exposure to this space, albeit from a slightly different angle. Manager Jon Wallace looks for a combination of fast-growing, innovative companies and those with proven and scalable solutions that can accelerate their growth. These will all be companies developing exciting solutions to a range of environmental issues.

The rapid expansion of wind turbines across the globe clearly fits this philosophy, and Jon holds positions in two key global players: Vestas and Ørsted. Vestas develops and manufactures wind turbines itself, as well as installing them and performing ongoing maintenance.

Ørsted works on the development, construction and operation of specifically offshore wind farms, as well as a number of related technologies. We think this speaks to Jon’s experience of being able to identify and capture this growing theme without taking direct exposure to the variability of factors such as power prices.

Renewables Infrastructure Group (TRIG) is another trust with plenty of exposure to wind power, albeit within a more diversified overall portfolio. As well as offshore wind, which makes up around a third of the trust (as at 30/06/2022), its management team also invest in onshore wind, solar parks and battery storage.

This diversification also extends to the income structure, with the management team looking to take a mixture of fixed rate and market rate electricity price exposure and a balance of revenue sources such as open market or government subsidies.

The aim of this is to create a sustainable, income-based return for investors which offers a level of inflation protection due to the linkage of inflation to the underlying cash flows within projects. This has led to very smooth total returns for investors, with an annualised NAV return of over 8% since IPO and a stable, progressive dividend of 6.76p over the past financial year offering a yield close to 5% and slightly above the peer group average.

We think this expansion in wind capacity offers a light at the end of the tunnel for the UK because as we increase our capability to produce our own electricity, we become less reliant on sources such as gas and oil.

This offers the UK much better energy security, at much better economics than traditional fossil fuels can offer. Whilst construction prices for new wind farms are above those of the most efficient new gas plants, the cost of fuelling those gas turbines makes wind considerably more cost-effective over the long term. In 2020, the UK government estimated an average lifetime cost of £57MW/h to install and operate a new offshore wind project in 2025, versus £85MW/h for an equivalent gas-fuelled power plant.

Yet this forecast was made with a long-term average gas price of £40MW/h, whereas due to the ongoing crisis, the current spot rate is over ten times this estimate at £420MW/h. Conversely, the equivalent ‘fuel cost’ for wind is zero. This not only offers considerable relief to UK consumers and businesses, but is also supportive of the UK government’s plans for the electrification of the country through its so-called ‘Green Industrial Revolution’.

However, whilst this new capacity offers many opportunities for the country, there is a major issue with wind power which needs to be resolved and means the energy transition will take time: the intermittency of the source. Wind is not available on demand, and this can cause issues.

On a cold but still winter’s night, there will be a lack of wind power but soaring energy requirements from the demand for heating and lighting. Expanding capacity makes no difference if the wind simply doesn’t blow.

On the other hand, when demand is low – such as on a mild summer’s day – wind has been known to generate excess capacity which can’t be used, leading to the controversial practice of wind turbines being paid to disconnect from the grid and not generate electricity. This then leads to other sources – the main one being natural gas – providing almost all our energy needs despite the billions of pounds of investment made in wind power.

However, we note that there are solutions being worked on which could resolve these issues, and investment trusts offer opportunities to invest in them. Regarding oversupply, the UK has five interconnectors with Europe with enough capacity to power 6.4 million homes.

Three of these have been built in the past three years, while a sixth cable, with capacity to power an additional 1.4 million homes, is due to be completed in 2023. These are effectively giant undersea power cables, meaning we can buy and sell electricity across the Continent, depending on how our own supply-and-demand dynamics are working.

This enables offshore wind farms and other electricity generators to sell their excess power to the Continent when countries are suffering from shortages, and also lets them import energy should the UK’s systems not generate power as expected.

The countries that are part of this system are Norway, Denmark, Belgium, France and the Netherlands, and 90% of the electricity that flows through these cables is forecast to come from clean sources. This also offers a weather diversification of sorts with the Continent.

Researchers at ETH Zurich have delineated seven prevailing weather regimes across Europe, implying that at least somewhere on the Continent, the wind will always be likely to be blowing. Regardless of this, the North Sea is one of the best sites in the world for wind consistency. Wind speed of seven knots (the approximate minimum wind speed needed for a turbine to generate electricity) is reported at North Sea weather stations at least two-thirds of the time, even in the calmest months of July and August, with this same figure reported over 90% of the time during the windiest months of January and December.

The UK is not alone in harnessing this, and other countries with coasts on the North Sea, including the Netherlands, Denmark and Germany, also have ambitious plans for new installations, including floating wind turbines and artificial islands. With all of this in the works, it is easy to see why the North Sea has been dubbed the world’s largest power plant.

Of course, the more important issue is undersupply; it is critical to find means of storing energy for when the wind doesn’t blow. This is where batteries come in. Large-scale battery storage is a rapidly expanding area and has multiple purposes.

The most obvious is supporting the grid with back-up power in the event of the sun not shining or the wind not blowing. When the energy supply from the sun and wind is plentiful, these large-scale batteries can be recharged for times when supply isn’t so plentiful. Yet if the issue of low generation persists, the interconnectors can be called upon to assist.

There are a number of investment trusts operating in this space. TRIG has a foothold in the battery storage market and has recently announced plans to expand this considerably, though there are also pure-play trusts such as the Gore Street Energy Storage Fund (GSF).

This was the first London-listed trust dedicated to energy storage, and it has a range of sites housing lithium-ion batteries spread across four different electrical grids: those of the UK, Ireland, Germany and the US. Not only do the trust’s sites provide back-up power for these grids, but they provide other services too, including frequency response, which balances the electrical frequency of the grid to around 50Hz, creating extra capacity during peak demand periods.

Another service they offer is wholesale trading, allowing countries to buy cheap electricity from other sources as and when demand and supply allow. The trust was launched in 2018 and has grown rapidly since, through a number of oversubscribed capital raises which have taken the trust to over £500m in size. This capital has been deployed in a number of operational and under-construction assets, from which the trust aims to generate a 7p dividend, which would yield over 5.5% currently.

However, battery storage does have its drawbacks. The current technology used – lithium ion – needs a considerable supply of rare minerals that are often located in areas of geopolitical instability. Cobalt, for example, is currently a key part of this battery technology, and between 50% and 70% of the world’s known supply is mined in the Democratic Republic of Congo, where safety practices are lax and child labour is widespread.

Furthermore, even when these minerals are found, the manufacturing process behind batteries is highly pollutive, somewhat undercutting the environmental argument of renewable energy. The lifespan of large-scale batteries is also uncertain. The best estimate is that it takes around five years for standard lithium-ion batteries to no longer be economically viable, though this can vary depending on how they are used and how regularly energy is dispelled.

The process of recycling the materials at this point also brings challenges. Bringing through new technologies is a big focus for the scientific community at the moment, whether that be in using more sustainable materials or in using entirely new styles of batteries (molten sand, solid state, etc.); however, these technologies remain a number of years away from economic viability. At present lithium ion remains the best available option, and the UK is expanding its capacity for battery storage, though this is not without its challenges.

In conclusion, we believe the UK is well placed to capitalise on the new, low-carbon future, and there are numerous investment trusts that allow investors to benefit from developments in this area. In an environment of increasingly difficult headlines, we think the pipeline and prospects for offshore wind are a genuine bright spot on the horizon, while there are a number of trusts investing in the battery technology necessary for the transition to a clean grid.
 

 

Disclaimer

This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.