Re-pricing renewable equity and debt returns – “Sunny” optimism vs “normal” distributions

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As sources of carbon-free electricity, wind and solar generation assets are critical to achieving long-term net-zero objectives.

Conversion of “sunshine,” “wind” or other renewable resources via new technologies into electrons that compete and trade with other sources of energy (oil, natural gas, coal) is one of the most transformative developments in the last decade in the US and globally.

Renewables are long-lived, capital intensive assets with zero “input” costs. Yet forecasting their long term cashflow assets remains subject to “modeling” biases, judgements and errors which have material implications for their long term valuation. Implicit assumptions around “normality” and “correlation” on the underlying cashflow variables make valuations of such assets complex. Independent consultants and experts who make such forecasts don’t have the same incentives as those putting capital at risk.   

Modeling long and short term weather variability, equipment performance and market prices – the main drivers of cashflow from such assets, remains inherently challenging – is both an art and a science, requiring robust stress-testing as we are learning as investors.
The notion that sun always shines and wind always blows – making modeled “production” or “volume” risk very small – may appear to be optimistic.

A recent study from well-regarded industry participants points out that operational solar assets in the US continue to underperform relative to their original pro forma for production risk.  Such a “delta” over the long term can be significant – ~10 – 20% – significantly eroding equity valuation, and making debt, supporting such projects, in our view,  as being “highly speculative.”

While asset “underperformance” via lower production is only one side of the cashflow risk, price risk remains a far more challenging risk to model over 35- to 40 year economic lives, as equity investor time horizons far exceed the contracted revenue periods for such assets. Thus, it raises the question whether such assets qualify as core infra assets.

The solution in our view is better risk management, including data analytics that rely on actual operational and relevant weather data, stress testing, and importantly, balanced risk-sharing between project participants through “aligned” commercial structures, ultimately leading to a “fair” allocation of risks between debt and equity. This in our view will not only contribute to a more accurate pricing of risk and returns from renewables, but also to a far better alignment with capital providers and their investment strategies, avoiding what many see as a “green bubble.”