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Distributed Energy Addresses Shortfall in Safe Assets

As bonds face mounting interest rate risks and investors look further afield for safe assets, the case for investments in Distributed Energy backed by real assets with index-linked contractual income is building. We look at this trend and the opportunities it presents.

Events since 2008 have served to reduce the supply of safe assets just when demand for them has soared. On the supply side, assets regarded in 2008 as safe (think Italian Government bonds or US subprime mortgage securities) singularly failed to provide the protection they promised. Whilst on the demand side, the events of 2008 served to heighten awareness of downside risks, and fuelled an ever-growing appetite for safe assets. Which raises the question that we ask today – with falling supply and rising demand, where is the best place to find safe assets in 2015?

Defensive investors have historically headed to the bond markets for safe assets. And whilst Government bonds are often referred to as “risk free”, bonds as an asset class are categorically NOT risk-free. We know the value of a bond is negatively impacted by either an interest rate rise, or a counterparty default – so to be truly risk free, neither of these eventualities should be possible under any circumstances. Whilst the default risk for higher grade bonds may be inconsequential, the interest rate risk is anything but. With current 10 year gilts at 2.0%, with further easing channelled through unconventional means, the risk to headline interest rates appears firmly on the upside. Back of the envelope calculations suggest a 1% rise in interest rates on a 20-year bond leads to a 20% capital loss – which is a far cry from risk free.

What about cash? Well, providing the physical cash is suitably secure (rather than stuffed under a mattress), investors are unlikely to face credit risk. But interest rate risk still remains, and investors are almost certain to lose purchasing power holding cash over time. And if you think gold might be a safe asset, think again. Gold delivers zero coupon and has fallen in capital value from $1,800/oz in 2011 to below $1,100/oz. So neither cash nor gold offer a safe asset class.

So, rather than continually searching for a risk-free asset, it would seem more sensible for investors to accept that all assets hold some risk. From that point of reference, the focus can then be redirected away from (unproductively) trying to remove risk, and towards (productively) recognising the inherent risk and seeking to generate a return that at least matches and preferably exceeds the underlying risk. Assets at the lower end of the risk spectrum should have stable costs and longer duration revenue contracts, preferably index-linked.

An asset class in which Oxford Capital invests for the best trade-off between risk and reward is UK Distributed Energy (DE). These are small, grid-connected generation devices, which typically have low maintenance, low pollution and high efficiencies, and built around renewable energy sources including solar, wind, small hydro, biomass, biogas, and geothermal power.

These assets are not risk free, but the risks are considered on a par with numerous higher-yielding bond classes. They offer long-term real assets with contractual inflation-linked revenue streams and low running costs, whilst having the potential to generate returns to investors of 7-9%.

The historic use of Government incentives including Feed in Tariffs and Renewable Obligation Certificates has been paramount to encouraging investment and has provided the visibility required to make long-term capital commitments. Government and investment grade counterparties means default risk is low, whilst the credit risk associated with an upward movement in interest rates is significantly lower than the credit risk associated with investment-grade bonds.

In addition, DE directly addresses the energy “trilemma” of Security, Sustainability, and Affordability. With lower carbon emissions, reduced transmission & distribution losses, short build time, security and diversity of supply and improved resource efficiency (by using both the power and the heat output), DE is not only bringing in new sources of investment, but also engaging end users with the needs of energy efficiency and delaying the need for network upgrades.

In a world where the supply of safe assets is falling whilst demand is rising, investments in UK Distributed Energy look very well placed to benefit from the next wave of infrastructure investment.