How to manage the risks of your renewable energy holdings

The aggregate value of global renewable energy infrastructure deals has increased markedly, up from $20bn (£13bn) across 244 deals in 2009, to $28bn in 357 deals in 2013 – and the data for 2014 are expected to show this trend continuing. 

Pension funds are making significant allocations to the sector. Investing in renewable infrastructure diversifies portfolios into an asset class that is relatively uncorrelated to bonds and equities, with attractive return characteristics, given schemes' liabilities. 

As with any asset class, an understanding of risk is critical. In the case of building, owning and operating renewable power generation plants, a thorough understanding of the technological and operational risks is a vital element of the pre-investment due diligence process.  

Construction and operational risk

Project development and construction risk are highest at the early pre-permitted stage. As the project progresses, development and construction risks decrease alongside the expected investment returns. 

The construction risks faced by renewable energy plants are similar to those of other construction projects and can be managed in the same fashion.

Wind and sunshine are variable – this dictates how much electricity a project generates and therefore its revenues.  

To manage this risk, sites are chosen based on extensive historical wind or solar data, and conservative assumptions are made prior to construction.  

However, year-on-year variability can occur, affecting the financial performance of projects. Typically, any variance in the wind or solar resource can be expected to average out over time. 

Portfolios that combine wind and solar projects across geographies improve portfolio resilience.

Regulatory factors

A return on capital investment is driven by long-term power purchase agreements or feed-in tariffs, starting when a plant becomes operational, and typically lasting for 15-25 years.  

In recent years, a number of European Union governments have introduced retroactive tariff cuts that have, to a greater or lesser extent, created challenges for investors.     

Some renewable energy regimes are explicitly protected from inflation. For example, UK green certificate prices are linked to the retail price index

These cuts were the consequence of local economic downturns and poorly designed incentive programmes, which had encouraged booms in new capacity, prompting panicked responses by cash-strapped governments. 

In the EU, directives and individual case precedents help shelter against future unexpected regulatory changes.  

Countries with well-constructed renewable energy support programmes do not carry the same level of risk.  

Better-designed schedules tend to place limits on their potential costs, or become less attractive over time to match falling costs of technology.    

Moreover, well-publicised environmental goals and targets are often imposed at the supra-national level and help to insulate against short-term fluctuations with longer-term demand-side pressure.  

For example, in October 2014 the European Council adopted a target for the EU whereby renewable energy was to account for at least 27 per cent of energy consumption by 2030 – a decision that made a significant contribution to the EU’s action plan in this area.  

This is at the heart of the preparations for the United Nations’ Conference on Climate Change, due to be held in Paris at the end of 2015.  

As with all investments, investors must consider how the assets will perform given the outlook for the macroeconomic environment. 

This is tricky, taking into account the 20-year-plus horizon for most renewable energy projects. However, some renewable energy regimes are explicitly protected from inflation.   

For example, UK green certificate prices are linked to the RPI. French and Italian tariffs also have an inflation hedge. 

The impact on renewables of the recent decline in oil prices is highly complex but largely based on short-term expectation rather than the longer-term reality.  

Only around 5 per cent of electricity generated globally is linked to oil, with coal and gas of greater importance.

Renewable infrastructure projects span a wide risk spectrum: onshore wind and solar projects in OECD countries typically use proven technologies in relatively accessible locations with engineering expertise and repair equipment and therefore have the most controllable risks.  

Ominder Dhillon is managing director, global business development and client service, at Impax Asset Management