This in-depth analysis explores the financial dynamics of the UK power sector between 2018 and 2022, unveiling infraMetrics’ extensive analytical possibilities. The research meticulously compares the performance of renewable and conventional power sources across key metrics like revenue, profit margins, returns, and cost of capital, providing a comprehensive view of the industry landscape. Our research is supported by dynamic visualizations derived from inframetric’s data and thorough market analysis.
Market Overview
During the last decade, the UK’s energy system has undergone a major transformation, towards low carbon generation sources.
Specifically, looking into the last 5 years, gas-powered generation fell by 5%, coal-fired generation got squeezed to less than 2% of the total mix, while total renewables generation increased by 30%.
During the same period the average power price in the UK surged from £58 to £210 per MWh driven mainly by geopolitical tensions and fear of disruption of gas supplies in Europe. Also, low reactor availability in France due to maintenance works and low reservoir levels in Norway hydro plants added pressure on import prices.
The above conditions created a favorable environment, in 2022, for power generators which saw their earnings skyrocket, although with increasing challenges due to high volatility and surging feedstock costs.
Main Analysis
Generally, renewables performed significantly better than conventional power in terms of profit over the period 2018-2021, as shown in the chart below, their profits fell slightly behind though in 2022 due to abnormal market conditions.
The various government support schemes or price guarantees (i.e. CfD, ROCs, FiTs, private PPAs) which offer revenue stability and a price premium compared to merchant market were a significant driver of this performance, but not the sole one.
Looking closer into each technology’s profit margin profile, in the graphs below, we notice that performance is more stable for renewable assets, especially for the period 2018-2021, while conventional power assets profit margins have wider fluctuations.
The main difference between renewables and conventionals comes from the difference in revenue generation and costs profile. As mentioned above, most renewable energy sources have some type of price guarantee which protects them from market price fluctuations. Although there is a small number of plants (or parts of them) that are in the merchant market allowing firms to ‘steal’ some of the cream of high power prices. Additionally, renewables’ operating costs profile is stable, comparatively low, and largely uncorrelated to their production profile.
On the contrary, conventional power assets are heavily exposed to market forces regarding both price and feedstock costs. Furthermore, operating costs are directly correlated to their production profile. As a result, their profit margin fluctuates more frequently and wildly than renewables.
Besides profit, other useful metrics to assess the total financial performance of power generation assets are realized and expected returns.
Realized returns for renewables soared during 2022, according to inframetrics, driven mainly by high profit margins. However, in previous years conventional power sources indicated consistently higher realized returns than renewables.
Historically, the higher realized return rates for conventional power assets are explained by the fact that these assets have been operating for longer periods than renewable assets as shown below. The longer operating period provided these assets more time to pay back the initial capital invested and pay off debt in early years, while allowing now for higher amount of free cashflow to be returned to shareholders. Also, in some cases, the operational lifetime of some of these assets has been extended. Going forward, we expect that renewables realized returns will keep rising as the initial capital expenditures are being repaid and debt levels are declining.
Moving into expected returns, the median expected return in 2022 from inframetrics for conventional operating power sources stands at 9% while for renewables is at 6%.
Looking closer into the historic time series of expected returns, we notice that there is a sustained spread of 3% between conventional power and renewable energy. The elevated expected IRR required by conventional projects is related to the risk profile of these assets and is derived from certain parameters.
Primarily, conventional projects have a higher cost of capital, due to their exposure to merchant markets which directly impacts their revenue streams. As these assets are considered inherently risky due to their business model, equity providers require a higher return for these investments, as shown in the chart below.
Additionally, conventional power plants are usually negatively impacted by changes to environmental policies and public perception. These factors add to the existing risks as new regulations and sometimes local public sentiment might impact an asset’s ability to generate cash in the future or even lead to early abandonment.
infraMetric’s data support the above view, as shown below, coal-fired power plants in the UK currently require the highest expected returns from investors to compensate for the elevated risks, primarily related to the environmental profile of the asset. The next higher return is required by gas-fired plants for similar reasons.
On the other hand, renewables mainly showcase a lower expected return, as the presence of contracted revenues (in most cases) reassure investors cashflows and the current policy environment tends to be generally supportive of such investments. Additionally, some risks related to the maturity of the technologies have been downgraded, at least for the generation sources presented on the chart, as they are currently considered established technologies.
In terms of cost of debt, the differences between the two types of technologies are much lower than on the equity side. Here, the financing costs are similar for both generation types, and the overall cost of debt is mostly driven by macroeconomic factors. Increases in cost of debt for certain technologies in some years might be attributed to certain technology risks.
Finally, when digging even deeper into the infraMetrics universe we can look into the equity and debt returns generated by the UK’s power assets during the period both in terms of cash and price.
Focusing on the equity returns, the spike during the 2018-2019 financial year is driven by strong combined cash returns in both types of assets (renewables are slightly stronger in 2018), although post-2019 conventional assets are generating stronger cash returns. This trend is expected as conventional assets are more mature, hence paying higher dividends, while renewable projects, still on their early years, are using most of their free cash flows to repay debt.
As a result, since cash returns for conventional assets have been higher than renewables, mostly, during the period, mean price returns have been higher as well.
Conclusion
Overall, the strong financial performance of both types of power generating assets seen in 2022 is expected to be less impressive in 2023 and the coming year as power prices have come down to lower levels, although still higher than the historical average.
Focusing on renewables assets, their resilience to turbulent market conditions compared to other power generation sources make them a safe choice for infrastructure investors seeking steady cashflows with low risk profile. However, challenges are emerging, especially in the current market conditions. While these assets achieved impressive returns in 2022, the current price environment combined with grid’s technical constraints and rising operating costs is expected to put pressure on earnings.
This doesn’t necessarily signify a decline in expected returns for renewables, on the contrary, we expect that operating projects will start returning higher levels of free cashflows to shareholders, as projects mature and their debt levels subside.
For new built projects, things are more complicated, although the UK government’s announcement in November 2023 to increase the price of CfDs in the upcoming allocation round, should enforce the level of returns in the sector. Additionally, a move into more innovative business models like corporate PPAs coupled with partial merchant market exposure can have better risk/return profiles than assets with revenue support for certain investors.
