Blowin’ in the wind: the role of renewable energy in portfolio diversification

By Frederik Bruns

Over the last 10 years, renewable energy has been the fastest growing industry segment in the energy sector, reaching a global investment volume of over $200bn in 2010 (1). One might think that this substantial volume mainly stems from the utility sector. However, more than half of the wind farms in Europe, for instance, are currently owned by financial investors (2), a large group of whom are either pension funds or insurance companies. They invest in this new asset class due to several attractive characteristics such as stable cash flows and independence from capital markets.

As institutional investors get more attracted to renewable energies, they are trying to find out how these investments generally fit into the rest of their portfolio. An academic approach to evaluate potential benefits of renewables would be to make use of the well-known concepts from modern portfolio theory (MPT) as of Markowitz (3). This theory states that in a reasonably sized portfolio, the risk from volatile returns does not exclusively depend on the risk of the individual assets but is dominated by covariance risk, the so-called “diversification effect”.

Applying this theory to renewables, there are two areas of diversification that can be considered. The first area concerns the benefits from diversification when wind and solar parks are added to an existing institutional portfolio. Secondly, the question of how an investor can diversify away risk within the renewables asset class itself can be addressed.

This article summarises the main findings from an intensive research study that tried to explore the diversification potential of renewables from the perspective of a financial investor. The study thereby used an exclusive data set from one of the largest institutional investors in renewable energies in Europe.

Renewable energy as an alternative asset class

The main characteristics of renewable energy investment are generally in line with broader infrastructure investments (4). Economically, due to natural monopolies, government regulations and concessions, these investments tend to operate under limited competition. Both solar and wind power, for instance, receive substantial political support in terms of subsidies. Financially, low correlations with other asset classes, predictable cashflows and inflation-hedge benefits should make these investments resilient against financial crises.

Probably the most important characteristic of renewable energy investment lies in its cashflow profile. Wind and solar investments tend to have a high cash generation with operating margins of around 80%. A major component for the revenues of these investments is the price, or the so-called “tariff ”, for any electricity produced from a wind or solar park. Some countries, such as Germany or France, guarantee a fixed feed-in tariff for almost the whole lifetime of the projects. Other countries, such as Italy, China or the US, implement a “market” solution, where government support is granted, but prices can fluctuate during the holding period of the asset.

In case of a fixed feed-in tariff regime, production risk seems to be the major leftover risk for the asset class. For wind farms, this risk should not be underestimated since average annual wind-speeds can fluctuate quite substantially.

For solar parks, the risk appears to be lower since irradiation, which is the main input for energy creation from solar parks, tends to be more stable.

The last favourable characteristic of renewable energy investment relates to correlations. There is no logical reason for any correlation with stock or bond markets. Both annual wind speeds and irradiation are assumed to be randomly distributed. Therefore, investors should expect fairly high diversification potential when investing into renewables alongside other asset classes.

Diversification potential in a multi-asset portfolio

Following these initial thoughts, the first quest for diversification has been approached by applying the main concepts from modern portfolio theory to renewables, and thereby making them comparable to other asset classes.

The first input factor that had to be determined was a measure for the expected return. Wind and solar parks are usually evaluated via discounted cashflow (DCF) models since the parks are assumed to have no residual value in the end. Hence the right measure for the expected return should have been the project internal rate of return (IRR). However, actual performance data cannot easily be included in these models, unless there is available data for the whole lifetime of the project. This is why a proxy had to be found, which came sufficiently close to a DCF valuation. Returns in the study were therefore defined according to the return on investment (ROI) figure which simply divided the earnings before interest and tax (EBIT) in a respective month by the initial invested capital.

The second input factor that had to be determined for the Markowitz framework was an appropriate estimator for risk. Both wind and solar irradiation are highly seasonal inputs. Since the inherent seasonality however is known in advance, it cannot be regarded as a real “risk”. In order to remove seasonality of the input resource, the monthly returns in this study were therefore transformed into seasonally adjusted annual rates (SAAR), which simply scaled the ROI figure according to a pre-defined seasonality ratio.

Having found a proxy for the two main input factors for the Markowitz framework, the asset class renewables could then be integrated into a typical asset allocation problem. The corresponding investment universe consisted of traditional and alternative assets, measured by standard proxy indices. Renewables were represented by a single wind farm (due to data limitations). The asset allocation problem considered monthly returns from August 2006 until August 2011.

Although this time frame was heavily distorted by the recent financial crises, it seemed plausible to choose a historical period of turbulence if one wanted to exemplify the benefits of “uncorrelated” renewables investments. The underlying risk-free rate has been determined to be 2.34%, which was equal to the average of the one-month EURIBOR during the five-year horizon. All data (apart from the wind farm) have been taken from the Bloomberg database. Stocks were further divided into European and emerging markets in order to account for international diversification.