Real Assets: Generating returns
Energy and power in Europe is subject to long-term plans to improve the single market, but also buffeted by the short-term vicissitudes of politics, geopolitics and even natural disaster. Daniel Ben-Ami attempts to clarify the investment themes
It is difficult to think of two sectors that are more intimately entwined with national and international politics than energy and power. Asset managers need to consider not just their favoured investment metrics, nor the political backdrop alone, but the interaction between the two.
This politicisation is largely a result of the strategic character of energy. Governments remain anxious to ensure security of their own national supply – despite many years of proclamations of support for a single energy market within the EU. National authorities also typically subject the utilities involved in electricity and gas supply to tight regulation.
The drive to curb greenhouse gas emissions only makes matters more complicated and can have some peculiar unintended consequences. There is a broad consensus that increasing the proportion of energy generated by renewable sources, such as wind and solar, is welcome. It is also widely accepted that it would be beneficial to reduce our dependence on nuclear energy.
Yet, despite the pursuit of these two goals in Germany in recent years, the consumption of coal has increased, including the dirtiest of dirty fuels – lignite or brown coal. The growth of ‘fracking’ in the US, with a resultant boost to its supply of natural gas, has also cheapened the price of coal, boosting exports to Europe.
At a glance
• The fortunes of the energy and power sectors are inextricably bound up with political developments.
• Despite the upbeat rhetoric, the drive to a single European energy market is proving slow.
• Gas and electricity companies are often seen as good sources of dividends.
• There are several strategies to circumvent the many pitfalls of investing in energy and power.
Such interconnections point to another feature of the energy and power sector: its unavoidably international character. For example, the nuclear meltdown at the Fukushima Daiichi reactor in Japan in 2011 had a profound impact on German energy policy. The CDU-led government decided to reverse its previous stance of maintaining a substantial nuclear sector for at least several more years. In so doing, it adopted the Energiewende which, until then, had been the traditional province of the Social Democrats and the Greens.
More recently, the conflict in Ukraine has raised awkward questions about the supply of natural gas from Russia and the possible impact of Western sanctions against Vladimir Putin’s regime. So far, there is little discernible effect on Western European supply but a severe winter could change all that. Interest in the extraction of natural gas and oil from shale has also increased as a result of the tensions.
“Shale is more popular now because people want to be free of Putin,” says James Woudhuysen, the author of Energise! A Future for Energy Innovation. “In Western Europe and Poland it has taken a big upward leap since the Crimea event.”
This article will examine why the EU’s attempts to create a single energy market seem to be progressing so slowly. If this drive were to prove successful it would have an enormous effect on the investment landscape for energy and power. Second, it will examine both sectors from the perspective of investment returns and risk management.
Considering the widespread acceptance that a single energy market would be a desirable goal, it is sobering to recall how long a more integrated set-up has been discussed.
Indeed, the European Coal and Steel Community, arguably the first embryonic form of the EU, was founded under a 1951 treaty with a stated goal of creating a common market for, among other things, coal. When the EU proper was founded under the 1992 Maastricht treaty, it talked explicitly of the need to create a trans-European energy infrastructure.
More recently, energy policy has become tightly bound up with the difficult challenge of climate change. The EU has adopted what have become known as its 20-20-20 targets: reducing greenhouse emissions by 20% from 1990 levels, raising the share of energy consumption accounted for by renewables to 20% and increasing energy efficiency by 20% – all by 2020.
The agreement to set precise legally binding targets dates back to a European Council agreement in 2007.
It is not hard to see why a trans-European energy infrastructure would be desirable. Producing and distributing energy on such a scale would have considerable advantages. For instance, it would help tackle the perennial problem of dealing with oversupply in some countries and insufficient energy in others.
It should be remembered that, while energy shortages clearly constitute a problem, a surfeit of electricity at any given time can damage the grid. A more efficient system of energy production and distribution could also help reduce carbon emissions.
Yet there is widespread agreement among asset managers that progress is proving extremely slow. “This has been a project since the European Union was launched but the reality is that countries have been reluctant to give up their power on decisions regarding energy,” says Juan Cruz, CIO of Cygnus Asset Management, a Madrid-based investment firm specialising in the sector.
Christian Pecher, a research analyst at JPMorgan Asset Management, says there is integration in the market for energy commodities but not in the physical grid.
“There’s a lot of talk about it but the cross-border activity that would really turn this into a fully integrated physical market is just not there yet,” he observes, estimating that it will probably become a reality in the next decade.
Risk and returns
Energy and power together make up a substantial part of the equity market. Energy companies make up about 9.5% of the MSCI Europe index with electricity and gas utilities constituting another 4.0%.
Although often lumped together, the two sectors are, in some respects, quite different. Energy includes such international giants as BP, Royal Dutch Shell and Total. Many of the larger power companies originated as nationalised corporations, but a large number have since spread well beyond their original national borders. The largest players include E.ON, GDF-Suez, Iberdrola and National Grid.
The power utilities tend to be tightly regulated by national governments in the countries in which they operate. This means that asset managers monitor closely what regulators are doing and often meet with them. Utilities have also traditionally been valued for their cash generative characteristics.
Joseph Titmus, a portfolio manager, in AMP Capital’s global listed infrastructure investment team, says: “For pension funds they provide a reasonably reliable flow of cash and dividends.” In his view, dividend yield is quite attractive compared with the broader market. Income levels are certainly attractive compared with the current low yields on European government bonds.
Cygnus’s Cruz says many utilities have experienced a decline in cash-flow generation in the past few years. They have suffered a double hit from the combined impact of the economic crisis and regulatory changes from hostile government policies. Fortunately, the situation is improving. “Prospects for the European sector in the coming years are definitely more positive,” he says.
Unlisted assets provide an alternative source of income for investors. “A lot of pension funds have invested directly in renewable portfolios,” says Thomas Guennegues, a senior analyst at RobecoSAM. This includes wind farms, which are in many respects akin to traditional utility investments, producing power at a price at least partly set by a regulator, and distributing most of the cash that they generate back to investors.
Yield companies (‘yield cos’) are a more recent innovation. These are publically traded entities that are structured to provide income for investors. They are particularly prevalent within alternative energy.
Successful investors in the power and energy sectors are likely to take a highly selective approach overall. This means considering both conventional valuation metrics and the effects of government intervention. The effects of the latter can be particularly perverse.
For example, heavy German subsidies for the development of wind farms and photovoltaic cells have cost its domestic consumers dearly. But underwriting the price of such technologies has helped create opportunities for companies elsewhere.
Perhaps the closest there is to a sure thing within this area, given the EU’s energy policy and widespread concerns about climate change, is that the emphasis on renewables will increase further. Recent research commissioned by Aquila Capital, an alternative investment company, found that 83% of institutional investors in Europe expect to raise their holdings in renewable energy in the next three years.
Asset managers have also often proved adept at managing risk within the area. Steven Ho, a research analyst at JPMorgan Asset Management, points out that companies such as BP
and Shell are highly diversified both inter-nationally and in businesses in which they operate. “You therefore take out the risk of operational failure of one significant asset or moving of the goal posts because the government wants more money.”
Pecher takes a similar view on the utilities side. He is wary of investing in companies which are wedded to a single technology.
Guennegues of RobecoSAM is particularly keen on companies that are involved in the electricity transmission. In his view, such firms, including National Grid in the UK, are subject to fewer regulatory pitfalls than the generators. “These are very attractive,” he says. “They usually have very stable regulations. Countries have no incentive to be too harsh towards them.”
Institutional investors can generate good returns from the European energy and power sectors by investing selectively. But to succeed they need to negotiate more potential pitfalls, including sometimes perverse unintended consequences, than most.