Is now a good time to invest in renewable energy?

After several years of outperformance, renewable energy indices have been suffering since mid-2023. This is largely due to the macroeconomic environment, with increased interest rates weighing on valuations.

Increased wind equipment costs, supply chain issues and project cancellations have also weighed on sentiment, particularly in the offshore wind segment, making some investors question the attractiveness of renewable energy assets.

In this update, we’ll look beyond the current headwinds to assess the longer-term outlook for the sector.

Rising rates take their toll

The segments of the renewable energy sector that have been most exposed to rising interest rates and equipment costs have seen their share prices decline the most. Within the S&P Clean Energy index, offshore wind developers have been affected by rising costs and project cancellations, while solar rooftop leasing companies’ growth prospects have been heavily impacted by increased rates.   

This turmoil has filtered through to the private markets – albeit to a lesser extent.

Anecdotal evidence from investor and developer surveys[1] suggests investors’ return requirements in private clean energy infrastructure have risen. Listed funds holding European solar and wind assets are reporting higher discount rates being used for asset valuations, suggesting asset prices have come under pressure. Meanwhile, listed clean energy vehicles continue to trade at considerable discounts to their net asset values (NAVs), suggesting investors are demanding higher returns to continue deploying into the sector.

Capital flows data further corroborates this. Preqin data shows that fundraising for private infrastructure funds, including renewable energy, declined substantially in 2023 compared to prior years.

Additionally, transaction volumes of European wind and solar assets declined last year, despite a strong supply of assets – installations rose sharply in 2022 and 2023. This could point to continuing mismatches between buyer and seller expectations, with developers possibly keeping more newly built assets on their balance sheets, rather than selling to infrastructure investors at lower prices compared to historical valuations.

Meanwhile, the supply of assets continues to increase, as annual additions to wind and solar capacity continue to accelerate across Europe. The increased supply of assets is likely to somewhat alleviate the investor competition that contributed to record high asset valuations in the low-interest rate era.

Taken together, we think this indicates that the private renewable energy market is at an inflection point. Higher risk-free rates are pushing up investors’ required returns, while developers have been keeping more assets for longer on their balance sheets to avoid having to sell at a reduced valuation. We do not think this is sustainable over the long run: developers are now having to sell existing assets to recycle capital and develop new assets in their pipeline, and we are already seeing this happen.

In our view, this is opening up attractive entry points for investors into an asset class underpinned by robust fundamentals and supportive regulatory setting over the long term.

What is the path forward for the industry?

After several years of strong price growth, renewable valuations in the public markets have declined towards historical averages over the last 18 months. While private market performance data is sparse, the available evidence indicates that shifts in public market valuations tend to filter through to the private markets after a lag. We believe the private renewable infrastructure market has repriced to an extent, with asset valuations adjusting to the new macroeconomic normal.

Sound fundamentals

It is important to note that, according to our analysis and available market data, the underlying economics of European wind and solar projects remain sound.

For example, solar developer Solaria reports a favourable backdrop for solar assets in Spain, where project returns have improved considerably in the second half of 2023, driven by the sharp decline in solar equipment and shipping costs.

Longer term, the economics of new projects are set to remain resilient as technological improvements increase the efficiency of solar panels and wind turbines and allow for more power to be produced per unit of capacity installed[2].

Healthy project returns are probably the reason behind the strong growth in capacity additions over the past two years. Despite the headwinds, increased volumes of renewable capacity are being installed. Solar capacity additions in 2023 jumped by 35% on 2022 – an extraordinary increase. Forecasters expect capacity additions to accelerate over the coming years as policy support continues to strengthen demand for clean energy.

Policymakers signal long-term support

In the wake of the Ukraine war, energy security concerns drove the EU’s renewable targets to the top of the political agenda. As a result, the EU increased its clean energy deployment target from 32% to 42.5% by 2030,[3].

In the wake of the passing of the Inflation Reduction Act in the US in 2022, the EU has aimed to follow suit. The Green Deal Industrial Plan, approved in early 2023, could offer support to clean energy projects to the tune of hundreds of billions of euros over the coming years. We believe both IRA and GDIP are set to considerably increase the pipeline of clean energy projects in the US and the EU over the long term.

Beyond subsidies, the EU measures are aimed at both simplifying project planning and permitting and accelerating renewable installations across all technologies, including utility and rooftop solar, batteries, and onshore and offshore wind. This is important as bureaucracy around planning has been a significant cause of delays and escalating costs for projects across Europe.

There has already been some progress on this front. The EU’s emergency measures on permitting came into effect in late 2022 and were recently extended. The new measures in essence designate renewables (and ensuing grid connections) as projects of overriding public interest. Member states must now permit new repowering projects within six months, including the Environmental Impact Assessment (EIA) and the grid permits. This is potentially a significant change, especially as growing number of assets approach the end of their lives.

Evidence from Germany, where renewables were designated as projects of overriding public interest in 2022, suggests that this can accelerate deployment, as fewer projects stall due to lengthy complaints resolution and litigation processes.

Timing the market

Despite positive underlying long-term trends, fundraising data suggests that many investors remain hesitant to deploy in private infrastructure assets. Some investors may want to wait to make further decisions until after macroeconomic uncertainty clears and more evidence of asset repricing emerges.

This strategy has been employed in the past: for example, the investor hesitancy around private markets that followed the 2009 financial crisis. However, studies and private market performance data have shown that there appears to be a strong relationship between the maturity of funds during downturns and their subsequent performance.

Evidence from the US and European markets indicates that funds that invest in advance of a recovery, or in its earlier stages, generate superior performance[4][5]. Therefore, skipping fund vintages in times of macroeconomic uncertainty historically could have resulted in portfolio underperformance.

Instead, research indicates that, alongside manager selection, vintage diversification – steady allocation to private market funds across different vintages – is the most effective approach to targeting a robust long-term performance of a private market allocation.

This broadly reflects the difficulties facing investors attempting to time the market to enter assets at the trough of the financial cycle. This is especially difficult in private markets, where fundraising progress, deployment timelines and access to suitable assets are difficult to forecast beyond very short time horizons.

Robust prospects

Despite the current headwinds, in our view the long-term economics of clean energy assets remain robust.

We believe the sector continues to offer resilient long-term cash flows underpinned by favourable regulatory environment across European markets, and that the current pricing correction offers investors opportunities to lock in long-term yields at attractive levels compared to historical averages.

We therefore believe investors should hold course and continue deploying to the sector throughout the macroeconomic cycle.

[1] BNEF, 2023

[2] BNEF, 2023

[3] EU Commission, Renewable Energy Directive, October 2023

[4] Neuberger Berman (2022), The Historical Impact of Economic Downturns on Private Equity

[5] Efront (2020), Private Markets in Downturns