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Valuing renewable energy assets: does CAPM work?

Tomas Freyman Tomas Freyman

As the renewable energy investment sector continues to grow, Tomas Freyman explains the advantages and disadvantages of two valuation methods: the CAPM model and the IRR formula. 

While most sectors of the economy contracted in 2020, investment in renewable energy increased by 2%, reached USD 303.5 billion. This total investment, however, was not evenly spread: in Europe, the total increase was 52%, while in India, the United States and China, investments decreased respectively by 36%, 20% and 12%.

As with all segments, the right valuation method is imperative, and there are two principal options: the capital asset pricing model (CAPM) and implied internal rate of return (IRR). Identifying the most appropriate option for renewable energy assets is challenging. 

While renewable energy is a segment of the infrastructure class, we consider these assets to have a different risk-return profile from all other segments.

Why do renewable energy assets differ from other infrastructure segments?

The difference between the risk-return profile and other segments in the infrastructure class is caused by several factors. It's important to understand these differences before deciding on the most appropriate valuation method.

Long-term incentive schemes in the form of subsidies

Renewable energy assets are often subsidised. These assets typically generate a proportion of inflation-linked income for a fixed period, either under a feed-in-tariff (FiT) or via a grandfathered subsidy scheme, such as the renewable obligation certificate (ROC). Although the period of support has been reduced under the new contract-for-difference (CFD) scheme, assets still benefit from a stable cash flow for 15 years, with any residual power generated exposed to merchant power prices. Where government schemes are unavailable, we have observed a rise in corporate power purchase agreements (PPAs). In these instances, investment grade counterparties commit to buying offtake at an agreed price which will also provide a degree of long term revenue certainty.

Lower financial leverage

Core infrastructure assets are often highly geared, comprising as much as 60-70 % debt or even up to 90% in some government-backed sectors. . However, our observation of UK renewable energy funds shows that approaches differ. Some assets are not geared at all. This is especially true in more nascent technologies, where debt financing is typically held at a 'holdco' level rather than at asset level to benefit from cross-collateralisation.

Lower construction risk

Unlike other infrastructure subsectors, such as airports, renewable energy typically exposes developers to limited construction risk as a result of the establishment of the technology over the last ten years and much shorter lead times. In some instances, we have observed little to no construction risk premium for greenfield transactions.

Lower operational cost volatility

Renewable energy assets generally often have lower volume and input price risks compared to other infrastructure assets. For instance, while there are some exceptions: e.g., energy from waste and its increased feedstock risk, the majority of renewable energy assets generate electricity from sources with zero input price with little to no volatility: such as solar, wind or hydropower. This is actually one of the key differentiators between renewable energy assets and other infrastructure segments.

These differences demonstrate why the appropriateness of the two main methodologies for determining discount rates for infrastructure assets: CAPM and IRR, need to be carefully considered when valuing renewable energy assets.

CAPM and IRR: two methods for valuing renewable energy assets

CAPM is the most widely used valuation method for the infrastructure sector, but there are doubts about the relevance of it to this segment. To make these issues clearer, we have deconstructed the basic CAPM formula and compared it to the alternative method: IRR.

Method 1: The capital asset pricing model (CAPM)

Most renewable energy investment is financed by private capital, and, moreover, these investments are often set up as special purpose vehicles, holding either a single asset or a portfolio of assets with a finite lifespan. The scarcity of comparable or available public information for renewable energy assets means that it is difficult to test them against the assumptions of CAPM. These can be divided into four principal components:

Risk-free rate

The time value of money of an investment. This component is supported by historical data and we believe CAPM relies strongly on it.

Beta

This component measures the volatility of a single stock in relation to the overall market and the extent to which it will bring additional risk to the investment compared to a market-like investment (i.e. an index).

Although we observe an increase in listed renewable energy funds and therefore an increase in data points for calculating the volatility of their equity against the overall market, the data pool is still limited. It's also coupled with no sufficiently strong index to compare movements against. This may result in statistically insignificant betas which ultimately result in poor estimates of a stock’s historical sensitivity with regards to the overall equity market (or relevant index).

Equity risk premium (ERP)

The expected return above the risk-free rate which represents the incremental return required by investors over the risk-free rate, to invest in equities of listed companies. For many reasons, the risk and return profile of a renewable energy asset is different to that of a company. Indeed, some of the risks associated with equities are not present in renewable assets; such as input price variability and product price variations (due to competition and market conditions), which are not as prevalent to impact the return of renewable assets in a similar way. It is arguable that an ERP is indicative of the actual risk supported by an investor when investing in a renewable energy asset, and as such, this component is difficult to support. Finally, most renewable energy projects have a finite economic life which would be inconsistent with the indefinite economic life of the most listed equities.

Capital structure

It is necessary to determine an optimal capital structure to have a relevant re-levered beta to account for a market participant basis gearing level in the determination of a relevant discount rate. Financing structures are very diverse: some funds are highly levered while others are predominantly financed through equity. The fact that most project finance is not transparent in the financing structure may lead to a distortion of an efficient market gearing level, especially when defining a cost of capital for a single asset.

A broader point in relation to CAPM is that the 'portfolio effect' arising from synergies and efficiencies of assets with large portfolios of renewables may be inherently factored into the publicly available data. As such, the impact of the portfolio effect should be considered, as this tends to smooth out returns. It may also be ignoring idiosyncratic risk of a single renewable energy asset under consideration (for example, an offshore wind farm).

This highlights the pitfalls of using public data in the CAPM method. Investors and valuers should consider these points when determining the cost of capital appropriate for a renewable energy asset. Hence, CAPM should only be used as a cross-check of the implied internal rate of return method presented below.

Method 2: implied internal rate of return (IRR)

The limitations of CAPM for valuing renewable energy assets indicate that it is more appropriate to use the IRR implied by comparable transactions as a proxy for cost of capital. As the pricing is competitive and changes based on the specifications of the asset and market conditions, the implied IRR is a more reliable measure of required return than that calculated using the CAPM.

A renewable energy asset’s implied IRR comprises the risk-free rate plus the required return for technology, geography, incentive scheme and any other asset-specific risks. It is also impacted by the level of supply and demand in the investment market.

The required return used for valuations, however, should only account for the asset’s risks, and not include any variations caused by market conditions. It is therefore important to look at the components to an asset’s IRR when calculating a suitable cost of capital.

Risk free rate

Risk free rate is typically determined by long-term bond yields. However, given the current low interest rate environment, investors are seeking opportunities that do not reflect long-term yields, for example, investment in renewable assets with IRRs below 4%.

Return for technology risks

This return compensates investors for a technology’s maturity, production reliability and maintenance costs. For example, solar power production relies on the level of solar irradiation, which exhibits lower variability than wind and would generate less risky cash flows, whereas wind assets also need to consider the impact of cannibalisation.

Return for incentive scheme risk

The various incentive schemes in the UK each expose the asset cash flows to certain risks. While renewable energy projects under the ROC incentive scheme have exposure to wholesale electricity price variations, the new CFD scheme has removed this exposure by providing payouts to fill the gap between the actual electricity price and the contractual strike price. The risk of changing the support level has also been reduced under the CFD regime. Unlike under previous schemes, there is no mechanism to change the strike price set in the contract. Investors, therefore, expect a lower return for CFD projects than those under ROC and FiT schemes.

Return for asset specific risks

The implied IRR of newly acquired assets may include a premium for factors such as size, counterparty risk, stage of completion, and track record.

Residual

The IRR can change due to market conditions, such as high demand from investors and increased sentiment (for example, the recent push towards environmental, social and governance (ESG)-friendly investments). Therefore, acquisition prices that investors are willing to purchase renewable energy assets could vary significantly due to the reflective market sentiment and internal views adopted. Temporary variations should not impact the long term required return applied to asset cash flows but rather captured in the implied asset IRR.

Finally, IRRs implied by transactions are widely used by market participants in opining on the appropriate cost of capital as part of valuing renewable energy assets. As valuers of dozens of gigawatts of renewable energy projects on a quarterly basis, we track this data very closely by technology on a global basis.

As is the case with any valuation, the more angles or perspectives you are able to approach an asset or company valuation from, the better. Academic theory (i.e., the CAPM) can be useful, but the resulting value must make sense in the wider market context where assets are exchanging hands. There is no better indicator for value than what someone is willing to pay for it.

To discuss any aspect of renewable energy asset finance, get in touch with Tomas Freyman.