The UK’s listed renewables fund sector has faced a challenging decade, with the most aggressive interest rate hiking cycle in 40 years and record average discounts to net asset value (NAV) of 20%.
According to research by RBC Capital Markets, the sector has now reached a critical juncture, where an approach towards terminal rates—the target benchmark for long-term interest rates—and low valuations, offer “attractive potential upside” for investors.
One of the key valuation metrics that RBC uses to assess the renewable energy fund sector is the “implied risk premium”, which reflects the expected return for investors over gilts, with adjustments for share price discounts to NAV.
The average implied risk premium for the renewable energy fund sector is around 550 basis points (bps), which is 300bps higher than 12 months ago and higher than the five-year average, RBC analysts said in a research note on Wednesday.
This implies that the market has fully repriced for the new rate environment and that the sector now offers “upside risk to valuation”, according to analysts.
Mind the ‘valuation gap’
Analysts at RBC Capital Markets said robust private market activity, where private equity buyers are buying assets such as those held by listed renewable energy funds at attractive premiums to NAV, supports the underlying value of those funds.
They said this is an indication that the discount rates applied to NAVs in these investment trusts are “reasonable”, as well as being indicative that there is excess spare cash, known as ‘dry powder’, in the private markets.
“There is market evidence to support NAVs given private markets have excess dry powder, but discounts to NAV are justifiably reflecting relative value across financial markets,” said the bank's capital markets analysts Joseph Pepper, Alexander Wheeler and Fernando Garcia.
The analysts said the market has “lost sight of the positive wider market environment for renewable generators”.
UK inflation remains elevated and pricing of certificates under the Renewables Obligation scheme, which accounts for about 50% of revenue for UK-focused funds, will increase by about 9% in April 2024, they said.
Moreover, power prices are expected to remain about 60% higher than long-term averages, and although the Electricity Generator Levy will impact upside risk until April 2028, analysts said windfall tax burdens are reducing overall in European markets.
RBC said on Wednesday that it has expanded its coverage of renewables funds, rating two funds, The Renewables Infrastructure Group Limited (LSE:TRIG) and the NextEnergy Solar Fund Ltd (LSE:NESF), as ‘outperform’, indicating its analysts expect those funds to outperform the market.