Don’t be a fool in the renewable energy market

“In any market, as in any poker game, there is a fool. The astute investor Warren Buffet is fond of saying that any player unaware of the fool in the market probably is the fool in the market,” writes Michael Lewis in his book ‘Liar’s Poker’.

Housing associations and other social landlords are uniquely positioned to benefit from government incentives for the production of renewable energy, the Feed-in Tariff (FIT) and the proposed Renewable Heat Incentive (RHI). The renewable energy market is currently experiencing something of a gold rush and many social landlords are being besieged by companies offering to finance and install renewable technologies such as solar photovoltaic (PV) panels or heat pumps across their estates.

In order to ensure that they do not end up playing the role of Warren Buffett’s fool, finance directors should consider whether any deal they are being offered provides the maximum value for their own company. In particular, they should consider whether “PV for free” deals – which transfer the lion’s share of profits, as well as many of the risks, to third parties – are the best available in the market and best meet the needs of their organisations.

Why social housing is well positioned to benefit

The social housing sector is in a strong position to take advantage of the FIT and RHI. It has control of large property portfolios, allowing landlords to capture economies of scale in deployment. Landlords with in-house maintenance operations can also reduce costs further by training their own staff to fit and maintain equipment, although compliance with the Micro-generation Certification Scheme (MCS) is required.

The size of the housing stock they own means that many housing associations have strong balance sheets and so have very low costs of capital. At the same time, they are able to claim the highest generation tariff rate of 41.3p per kWh for solar PV panels that are installed on individual dwellings, instead of receiving lower rates of 36p or 29p that would be received for larger installations.

Finally, the sector’s strong commitment to reducing fuel poverty and its carbon footprint gives it a direct driver for deploying renewable energy throughout portfolios.

An emerging market

The renewable energy market in the UK is quite immature compared to the market in countries such as Germany and Spain which have had FIT policies for years, but it is now growing fast. The market has many of the typical features of an immature market in its “gold-rush” stage, easily recognisable to anybody who, for example, witnessed the initial stages of the carbon offsetting market. Some industry analysts are predicting that the annual deployment of solar PV in the UK will increase a hundred-fold within the next five years.

In the City of London, people who knew nothing about renewable energy 12 months ago are promising investors market-beating returns based on the FIT. New companies offering to sell renewable energy equipment to consumers are popping up, backed by private equity finance. Even retailers like M&S, Tesco and Sainsbury are getting in on the act.

Social landlords should be careful about selecting the right partners in this market, bearing two primary things in mind. First, making money from renewables requires a long-term commitment. The equipment needs to generate energy for 20-25 years to earn the targeted level of returns. Installed incorrectly, PV panels will generate far less electricity than expected and they can be a fire risk if not correctly mounted and ventilated.

Also, there are policy risks in this area since governments, both here and abroad, have the power, which they sometimes use, to remove environmental policies or reduce incentives. Social landlords need to feel secure that their partners can be trusted to install and maintain equipment for 20-25 years without damaging their property and that they have the financial strength to survive reversals in government policy. This is particularly important in light of recent high profile cases of financial distress of social housing contractors.

PV for free
Much of the running in the renewable energy market is being made by companies offering “PV for free”. In this approach, the social housing provider does not pay for the installation. Instead a third-party provides the finance to a separate company that owns and operates the solar panels. Tenants are then frequently given the electricity generated by the panel for free while the generation and export tariff is paid to the company that owns and operates the panels and hence back through to the investors.

This model has a few advantages. Obviously, it does not require the RSL to provide much of its own financial resources, although some small contribution may be required. Secondly, the process of installation, monitoring, maintaining and repairing the equipment is handled by a specialist organisation removing many associated risks from the RSL. In addition, if tenants receive electricity for free, this can make a contribution to reducing fuel poverty.

There are, however, a number of very significant drawbacks to the model, primarily that there is little or no financial upside to the RSL. Private equity investors will generally aim for a fairly hefty return on their investment, aiming for 9-12 per cent non-leveraged return. Signing up to a “PV for free” deal means that these profits are not available to fund refurbishment or social programmes.

The downside
There are several other disadvantages. A “PV for free” company is likely to focus only on installing solar PV panels rather than looking at how the RSL can benefit from other renewable technologies such as solar thermal and heat pumps. There may be occasions when solar thermal is a better use of roof space from an environmental and financial perspective, with the added benefits related to affordable warmth.

The “PV for free” company is also going to focus on installations that earn its investors the required rate of return, which may be considerably higher than the social landlords’ required returns. This would mean targeting the largest, unshaded properties facing in the optimal direction without reference to social need or other issues. By taking control, social landlords can apply their own targeting policy to tie in with fuel poverty targets, maintenance schedules and carbon reduction targets.

Also, the “PV for free” model involves leasing roof space to an outside company for 25 years. One needs to be sure that the company will not damage the properties and that it is capable of meeting its obligations over such a long period. Finally, there is the issue of equity among tenants. The PV for free model passes all the benefits of the scheme onto the lucky tenants whose homes are suitable, whether or not they face fuel poverty. Finally the operator may seek to sell off its 25 year revenue stream to other perhaps less responsible operators or investment institutions which may have less regard for the social housing provider’s aims and objectives or tenant wellbeing.

Alternative business models
There are numerous other ways of financing renewable energy deployment. Obviously, given housing associations’ low cost of capital, it would be preferable to finance as much as possible on balance sheet (i.e. the loan is secured against the housing associations’ assets) without breeching banking covenants, which may trigger an increase in the cost of capital for all borrowing.

If this is not possible, several other options may be viable. Banks are developing new models whereby housing associations can set up Special Purpose Vehicles (SPVs) which own and operate the equipment. While such a structure would require an initial equity injection from the housing association, it does mean that the profits are ultimately paid back to the housing association.

Other financial institutions are developing lease-based approaches. Under such an approach the housing association would lease the solar panels over a 10-15 year lifetime. The revenue from the panels would pay for the lease over its lifetime. At the end of this time, the RSL makes a small final payment and then owns the panels and collects the final 10-15 years of revenue as free cash-flow.

Both of these approaches are designed to reduce up-front investment required from the social housing provider while retaining the very significant profits that can be earned once the loans are paid off. Their primary disadvantages are that they are more complex to structure and that more of the ongoing operational risk will remain with the social housing provider. They may, therefore, be more suited to larger social housing providers.

There are other approaches that may ultimately be more profitable for social housing providers, such as a shared equity approach that draws on private equity investment but achieves a better balance of returns between the parties in terms of the value that each party brings to the table.

Conclusion
When considering possible business models for installation of renewables across their estate, finance directors of social housing providers should be aware of the massive potential financial value of their estate for renewable investors and the full range of financing options. Any deal to which they sign up should share the risks and rewards equitably with any external finance providers.

This is not simply a matter of avoiding becoming Warren Buffett’s fool in the market. Properly structured, a renewables business strategy can also be a driver of significant strategic importance, helping to strengthen balance sheets and provide profits that can be used to finance core corporate goals such as reducing fuel poverty, improving housing stock and reducing carbon footprints.

BRE Training manages the courses; ‘Introduction to Renewables’, ‘Renewables for Building Designers’ and ‘Sustainable Refurbishment for Homes’. These courses provide key information on how best to use renewables technologies effectively and economically and the opportunities to incorporate renewable technologies during refurbishment works.

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For further details of BRE’s consultancy service, and training please visit www.bre.co.uk

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