With unprecedented growth in interest in renewables as an asset class amongst institutional investors, AltAssets asked Rosheen McGuckian, CEO of specialist European renewables investment manager NTR, to reveal the key questions LPs should be asking prospective managers in the space.
You’ve been investing in renewables for two decades now across Europe and the US. Are things very different today from what you might have expected even five years ago?
Absolutely. Over that time we have seen exponential growth in appetite for renewables and the transformation from a niche asset class to the largest sector within infrastructure, ahead of telecoms and transportation. This is of course hugely encouraging, but the growth of the class and addition of many new entrants has meant that making returns from the sector is becoming a lot more complex.
Where then, do you believe LPs should be focusing their diligence efforts?
I think the primary focus should be to understand how much allocation the manager intends putting into proven versus emerging technologies. The LP will want to assess whether the manager can articulate the relative risk reward of each technology and demonstrate its team has the capability to deliver them.
The cheapest, fastest method of replacing fossil fuel continues to be solar and onshore wind and that’s reflected in the expected growth of these technologies across all markets. The returns available from these are a good deal lower than you might have achieved even three years’ ago. So as a result, many managers are taking on deeper technology risk. That’s a perfectly valid strategy to follow. But the LP will want to understand whether they have got to grips with their selected technology risks. Do they understand the revenue profile of energy storage? What is their view on cabling degradation for offshore wind? What are their back-up plans if feed-stock for biomass fails?
The LP will want to probe whether the managers are going a little too niche in their strategies. Battery storage, floating offshore and hydrogen get a lot of attention, but at the end of the day, they are only part of the mix. To meet climate goals in Europe for example, we need to be installing onshore wind and solar at a rate of 2.8 times that of the last five years. That’s where the majority of capital will have to be deployed.
LPs tend to think about renewables as a split between brownfield or greenfield strategies. Is that still the case?
Traditionally, the renewables life-cycle was seen as comprising three phases- development, construction and operations, with clear difference in expected returns before and after operations, and further returns expected again for taking on development risk.
More recently, we’ve seen certain capital willing to blend expected rates of return before and after the date of going into operations and a migration to earlier-stage cycle has seen a further compression on development risk returns. There has been a move by some to equate “in construction” assets as having the same risk as operational assets, and while an expert manager can mitigate construction risk, it doesn’t get away from the fact that the underlying energy source forecasts are still unproven.
But I’d also add that returns compression is not the only matter to consider in lifecycle. Those three stages that I mentioned aren’t so clear cut anymore. You can find that the characteristics of one stage can seep into next phase of the cycle. In many markets, we are seeing a phenomenon whereby you might think you have full planning, but you could end up dealing with appeals right the way through construction and even beyond. The LP will want to assess whether the manager understands how to deal with this.
Grid is possibly one of the most complex pieces of the jigsaw at each stage of the cycle. First of all getting access to the grid on time and on budget, even if you already have a grid offer. Secondly, the more renewables are added, the more you are likely to be constrained – is that fully understood? And thirdly, some markets are considering downgrading existing firm priority rights for projects already built – is that built into their model?
So there are a myriad of lifecycle matters that require experienced specialist expertise to navigate and it is well worth your while questioning the manager on their understanding of these issues.
We carried out a poll during our recent webinar where we asked LPs what they least understand about renewables, and power price and government supports came out at the top. Does that surprise you?
Not at all! The world of feed in tariffs is shifting and for most markets today, where there is government support in place, it comes by way of an auction-based feed in premium or contract for difference. Every auction system has its own nuances and you’ll want to ensure that the manager understands how it works in their selected jurisdictions and if they are investing at development stage, that they have the expertise to be successful in the auctions. Ask the manager to articulate how they address the potential risk of a government retroactively changing a tariff and if they are deploying capital in a market without government supports, do they have proven expertise in putting in place corporate PPAs.
We also know that with government supports gradually pulling back, that merchant power exposure will inevitably make up a larger proportion of a renewables portfolio. One question the LP will want to put to their prospective renewables manager is what is their position on the relative mix of equity and debt in the project and aligned with that, the relative mix of merchant power or fixed PPA prices. It’s really beneficial to ask to see the manager’s stress tests on a merchant project under different scenarios of fixed PPAs and levels of debt to understand what is their approach to returns. Are they seeking higher target returns with potential for more volatility or lower returns with more risk mitigation in a stress scenario. Each approach is valid, but you’ll want to understand their philosophy.
‘Value add’ appears to be the mantra of the sector. How does an LP know that they are actually getting value add from their renewables manager?
Optimising the performance and value of a renewables fleet requires constant, expert attention and the LP will want to get to grips with how the manager is geared up to deliver value optimising initiatives. What engineering expertise is in-house to design and construct assets, to manage power
trading, or to set out strategies to optimise production output? Value add is as much down to hard graft and a combination of continuous improvement engineering backed by statistical process controls as well as the one-off “big ticket” actions.
For example, lengthening the life of an asset has become a favoured value add strategy, but that involves a bunch of work not without risk. It involves seeking planning extensions, re-opening land lease agreements, reassessing the useful life of your equipment and so on. So the LP will want to see can the manager demonstrate how they would actually go about delivering the value-add items that they might list in their marketing?
And finally, does renewables tick the box for ESG?
Well as we know, renewables is attracting a lot of ESG money because of its impact on the climate emergency. But it’s quite possible to invest in renewables and still perform very poorly when it comes to long-term sustainability from an E, S and G perspective. Many LPs will rely on third party frameworks to assess a manager’s ESG capabilities. And while that is a good starting position, I would suggest that the LP will want to get under the bonnet of the E, S and G practices a manager has in place at each of their investment diligence, development, construction and operational phases. Areas as diverse as supply chain, community engagement, health and safety, habitat management and end of life strategies are factors that can affect the long-term viability of your renewables projects. The LP will need to know whether the renewables fund manager has a handle on these issues, clear policies in place and the ability to monitor and act on vulnerabilities?
Is there anything else you would want to say to LPs to help them in their selection process?
I hope the points I’ve made here in this interview underscore one thing, which is that the sector is evolving fast and the LP will want to ensure that the prospective manager has what we call an “engineering mindset”, with specialist operational experience to optimise yield but also protect the value of the investments on the LP’s behalf.
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