Energy Infrastructure: Attractive New Territory for Investors
In general, infrastructure investments offer good visibility on cash flows and frequently also inflation-linked returns that are uncorrelated with equity markets.
Energy infrastructure in focus
Owing to the increase in market volatility and the low interest rate environment, investors now have to consider including new categories of investments. In general, energy infrastructure investments offer good visibility on cash flows and frequently also inflation-linked returns that are uncorrelated with equity markets.
The electricity market needs additional capital
The structural change in the European energy sector is also putting Swiss utility companies under economic pressure. One of the main drivers is the policy of subsidies for renewable energy technologies in Europe and the consequent drop in prices for conventionally produced non-subsidized energy. In this way, many utilities are no longer in a position to fund the necessary investments in maintenance and modernization by themselves. Hence they seek long-term financial investors, offering good entry opportunities in that investors to some extent take over the role of energy providers.
Three investment categories with various opportunities and risks
For most institutional investors, energy infrastructure is a new territory. Economically different, the investment possibilities can roughly be split into three categories – subsidized investments, investments with regulated capital costs and unsubsidized investments.
Subsidized investments benefit from feed-in tariffs and include, for example, small hydroelectric power, wind energy, photovoltaics and biomass investments. Investments with regulated capital costs include, for example, investing in the Swiss transmission grid. Among other things, unsubsidized investments include large hydroelectric plants and (pump) storage facilities.
The essential feature here is financial support. This enables the owner to know the selling price in advance for power produced over a longer period (usually 20–25 years). In this way, the owner is not exposed to price fluctuations in the electricity wholesale market. Thus the investment risks are manageable, which can in turn trigger new investments in this area due to better planning.
However, there is still the uncertainty as to how much power will actually be produced and thus potential fluctuations in revenue. For this reason, hydrological and/or meteorological conditions should be modelled into an investment analysis.
Investments with regulated capital costs
With this type of investment, the regulator fixes the return on capital employed. Among other factors such as eligible costs, the regulatory cost of capital mechanism is the key driver behind the owner’s return on equity. The regulatory cost of capital is especially used when the investment has a monopoly-like characteristic, such as the transmission grid. It is aimed at preventing the owner from earning monopoly profits. Accordingly, the regulatory risk needs to be well considered with this type of investment. A shift in the regulatory environment inevitably has a direct impact on the profitability of an investment. On the one hand, the regulator aims to ensure that the owner does not earn unreasonable returns, but on the other hand aims to create an environment where systems and plants are maintained and expanded if necessary. In this respect, Switzerland has a highly reliable regulator to fall back on. This kind of investment is therefore not dependent on how high prices are or how much energy is produced.
With these investments, the owner is completely exposed to market forces, especially the electricity market and the prices for power produced. While costs can be reasonably well forecast based on the historical costs of the respective technologies, the volatility of revenues due to constantly changing electricity prices is a fundamental problem. Hence it is important that the electricity-price risk is isolated or at least mitigated in an energy infrastructure portfolio.
Long-term purchase agreements can help here and offer a “win-win” situation in many respects. On the one hand, the capital investor receives a steady return because the electricity price can be agreed on for a longer period. On the other hand, the power company benefits from guaranteed access to a set amount of electricity without having to invest as much capital and without being subjected to the volatility of the wholesale market. The risk profile of unsubsidized assets thus depends strongly on the underlying terms of the contract.
Maintain a portfolio view
The inclusion of each of the above-mentioned investment opportunities in an energy infrastructure portfolio is fully justified in terms of risk/reward, in our view. In this context, however, we believe it is important that investors consider the respective features of the investments when putting a portfolio together and seek expert advice during the investment process due to the complexity of the investments.
Credit Suisse Energy Infrastructure Partners (CSEIP)
Credit Suisse Energy Infrastructure Partners is an investment boutique of Credit Suisse Asset Management, focused on investments in the European energy sector and offering various investment possibilities to institutional investors in Switzerland and Europe.
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