Green Energy for green investors

There’s a lot of turmoil in the energy markets at the moment. I don’t mean just among the variety of different energy market operators and suppliers. I mean among investors – about ‘clean’ or ‘green’ energy – and how to invest in it. There are also pitfalls that greener investors might not notice.

There are renewables funds like the Gresham House VCT’s predominantly investing in solar farms, and more recently the Gore Street Energy Storage Fund (LON:GSF) describing itself as ‘London’s first listed energy storage fund supporting the transition to low carbon power’, currently raising funds at 107p.

And there is The Renewables Infrastructure Group (LSE:TRIG), part of the FTSE250, which has a portfolio of 77 mostly wind and solar plants, and has also raised funds recently.

These are specialised funds, but there are more general global ETFs like the Invesco GBC Clean Energy ETF (LON:GCLX) and the Black Rock iShares Global Clean Energy Fund, which include shares in many companies whose ‘green’ credentials, to my mind, are not entirely ‘pure’. In order to supply investor demand they seem to have trawled far and wide among energy suppliers of one sort or another, all of whom, of course, claim to be ‘going green’.

For example, the iShares (Black Rock) Global Clean Energy ETF includes such disparate elements as wind farms, the UK energy provider SSE, Solar Farms, manufacturer Siemens, and China Longyuan Power.

And their performance accordingly has been mixed. Although the Gresham solar farm VCTs did well, GSF started three years ago at 100p and only now has recovered from a 90p low to 115p, while the larger global funds have also been mixed. All however spurted to all time highs last January on the then spike in LNG prices. But all have subsequently fallen back.

Such investors will like to know of The London Stock Exchange’s Green Economy Mark, which purports to recognise London-listed companies and funds that derive more than 50% of their revenues from products and services that “contribute to environmental objectives, such as climate change mitigation and adaptation, waste and pollution reduction and the circular economy.”

What with almost all companies today clamouring that they fit the bill, such an endorsement is obviously desirable, but the current list which can be seen on londonstockexchange.com shows only around 100 companies. Maybe that is because some of those on the list have only a remote connection with truly ‘green’ activities but are merely taking steps to decarbonise their operations, such as one gold mining company listed there and a travel company introducing electric buses.

Balancing the Power

So small investors might be tempted to look at what they think are more direct ways to invest and there are companies coming onto the UK, mostly AIM, market which seem to fit the bill. But in my view, they too only have a remote connection.

A popular sector is the ‘Reserve Power’ market, where small – up to 50MW, generating companies – initially using diesel, and increasingly now, gas generators and battery storage – are being built to supply short term power shortfalls in the grid – ie to balance it.

Claiming that as a ‘green’ activity and therefore as a long term investment opportunity, again doesn’t stack up in my view because the process merely rolls out numbers of similar plants generating revenues that won’t grow organically.

Meanwhile some developers make a living from developing a project rather than building and operating it, taking a profit when they sell it on instead. One large such is Renewable Energy Systems, owned by civil engineers Robert McAlpine, who claims to have developed over 19 GW of green energy projects, mostly wind farms in Europe and the Americas.

That, to my mind, indicates that investors should take the same approach – finding developers rather than operators, because for example UK Power Reserve with over 50 sites, was reported last year to be threatening to withdraw completely from the market, while AIM listed minnow Plutus Power went bust because its 8 in number 20MW generating sites were not able to repay their lenders, let alone pass any income up to its parent Plutus. It was, admittedly, using diesel, which became less economic than gas, but nevertheless illustrates how the playing field can become tilted.

What is common to these companies is their claim to ‘growth’ through rolling out more and more sites, along with which they claim shareholders will see a big growth in their income.

But that is misleading. Another common characteristic of these companies is a lack of transparency in regard to their financial structures and the information shown to investors. While all make big claims for the revenues they will generate, very few disclose how their plants are to be financed, and how much that will cost.

Most companies have an incentive to hide information from investors and lenders because the larger the borrowing the larger the risk, and promising investors ‘profits’ is easy to do, even though they might not be coming their way but are going to lenders or partners instead.

So it was that ‘off-balance-sheet’ borrowing came into fashion, only to be misused by the likes of Enron, and a crack-down by the regulators which still hasn’t eliminated similar accounting tricks.

Enron didn’t disclose to investors that many of its businesses were partnerships or joint ventures with other entities who borrowed the funds but whose accounts didn’t need to be disclosed as part of its own. Only when those partnerships couldn’t repay their loans, did Enron have to disclose that it itself was responsible.

And that’s where investors in the new ‘energy conglomerates’ need to be wary. Because ‘off-balance-sheet’ financing is still necessary where a small company which ‘sponsors’ (ie plans and organises) large building or engineering projects has a legitimate need to protect itself should the project – though no fault of its own – fail.

In those cases legal structures called ‘project finance’ and ‘non-recourse’ financing are used, and protection is obtained by encasing the whole project – its capital assets, the lenders funding them and the equity shareholders who the lenders demand put up the financial ‘buffer’ which takes the risk – inside a ‘Special Purpose Vehicle’ (SPV).

These act as an autonomous entity entirely disconnected from its owning (or ‘sponsor’) company and their key feature is that, like Enron but for more honest reasons, their financial details do not have to be shown along with those of their owner. So investors are denied knowledge of the SPV’s assets, income and borrowings, and while this can lead them to misunderstand the true value of their company, it also gives an opportunity to the parent company to pull the wool over their eyes.

I’m not intending to discuss any particular company, but to suggest to investors what to look for, so as to properly understand exactly the ‘structure’ of the company they invest in (which is always the ‘parent’ company and not the SPVs) and therefore the flow of money between it and its SPVs.

This is where wool can be pulled, because whether or not its project has been built and is operating, it is good publicity for a company to tell its investors about its project’s overall size and revenue, rather than to tell them where that revenue is going and who else might have a claim to it.

As said, an SPV is merely a ‘shell’ which contains the project but has no relation to the value of the assets and liabilities inside the project. Before funds are raised to build the project, the SPV will contain the rights to build and the value of the planning that will have been done, and this is the value that will appear in the parent company’s accounts. As such therefore, an SPV can itself be bought and sold and often is between companies.

But the information which it is important to know in order to evaluate a project is always inside the SPV and is therefore hidden from investors unless the company deigns to tell them. Very few of them do.

To take an example, one of the typical 20MW gas ‘peaking’ plants that a company might be rolling out will likely cost between £12m and £15m, and the cost of an equivalent battery plant is probably 3-4 times higher, while that of a waste to energy plant will be higher still.

But this heavy cost won’t appear in the parent company’s balance sheet and neither will any loans which finance it, or other investors. While the parent company will tell its own shareholders what share it has in the equity of the SPV, and will also tell them what revenue and cash flow the project will generate, that is of little use without knowing how much of it will go to repay the loans or to other shareholders and partners in the SPV.

As things are, shareholders in the parent can be left thinking that all those revenues will belong to them and as a result will accord a value to their shares which can be very inflated.

To show this, take the typical 20MW generating plant. To meet the build cost, the SPV will have to raise £12m, of which the SPV’s ‘owner’ (ie the parent company) might contribute (or obtain free as a fee for developing it) £2.4m for a 100% equity share, with the remaining 80% raised as a bank or asset loan, which typically is repaid over 10 years at a 9% interest rate.

Typically also, companies sponsoring these plants will quote a 12-15% irr return (or about £1.2m pa) ‘gross profit’ – and sometimes £1.5-£2.0m. (although no similar plants among those on Companies House seem to have earned more than £1m pa recently)

Due the lack of transparency, shareholders might think this gross profit flows through to their company. But it won’t, because repaying the SPV’s bank loan will in this case take practically all of it for the first ten years. Over that period therefore the SPV will have little value, and only 10 years later will it start to receive that £1.2m pa income. Assuming a 10 year life thereafter at a 5% discount rate, that will be worth around £6m today compared with the total build cost of twice that.

In other words, after the £2.4m cost of its equity share, the company and its shareholders will have made a total profit of £3.6m. But you will find one particular company today persuading investors that they should pay, now, £15m for a 5MW project. And you will find a ‘research firm’ predicting that another company’s pipeline of 170MW makes the company ‘worth’ some £100m, even before any funds have been raised and compared with a current market value for the shares of less than £10m.

If its return is better than 12%, the SPV’s net income after repaying the loan will of course be geared up substantially and it would be able to pay a dividend to the parent company. And if instead of a loan, the company puts up all the £12m cost itself, its net income will be a lot higher but will have to be shared with whatever method has been used to raise the £12m, probably by issuing shares and diluting shareholders accordingly.

It was by getting these sums wrong that Plutus Powergen went bust, even though it was much more transparent to its shareholders about its real structure than many newer companies today. It might be why most such are vague about how their projects will be financed. Until that is disclosed, along with clearer information about their project revenues and costs including loan repayments, investors will be completely in the dark as to the real value of their investment. Be sure you know.