Two ways for income-seeking investors to play the growth in renewable energy

Published Fri, Mar 12 202111:27 AM ESTUpdated Tue, Mar 16 20219:59 AM EDT

Renewable energy stocks had a banner 2020 as momentum behind ESG investing and supportive policy actions pushed the group to new highs. But these stocks do not lend themselves to every type of portfolio. They don't typically return cash to investors, and their valuations depend heavily on projected future cash flows — sometimes many years down the line. For investors looking for a potentially less risky way to capitalize on the renewable energy theme, companies known as yieldcos may fit the bill. At the simplest, a yieldco is an independent power producer that owns and operates up-and-running low carbon energy assets. Unlike other companies in the renewable energy ecosystem, yieldcos return a large portion of their cash to investors in the form of dividends. The model grew out of the desire to separate development risk from operational power assets, while also providing a valuation uplift due to the steady yield and long-term nature of the assets. Within the space two names stand out: NextEra Energy Partners and Atlantica Sustainable Infrastructure . Both companies are focused on dividend expansion, which is supported by attractive assets, long-term contracts and runway for more acquisitions. In the case of NextEra Energy Partners, the company is backstopped by the largest renewable developer in the U.S. Other companies in this specialized area of the market include Brookfield Renewable Partners and Clearway Energy . "Yieldcos are in general a lower-risk way to play the growth in renewables because, relative to renewable project developers or equipment manufacturers, Yieldcos generally have higher cash flows from currently owned assets," Morgan Stanley wrote in a recent note to clients. Of course, not all yieldcos are created equal. It's important for would-be investors to understand the specifics of each company, including the scope and location of held assets. They've also sometimes proved risky in the past because of the group's reliance on raising capital to fuel growth. But the Biden administration's ambitious climate policies — including making the power sector carbon-free by 2035 — as well as corporations' own climate targets and investor interest in ESG strategies — should drive further adoption of renewable energy over a multi-decade investment cycle. "YieldCos remain one of the most efficient ways to play renewable energy, as some of the few publicly-traded vehicles in the space," said analysts at RBC. "Be it increased focus on ESG or the broader structural shifts favoring renewables, we think YieldCos are well-positioned to benefit from these changing tides." How yieldcos work Yieldcos, which is not an official term and therefore doesn't come with any specific regulations, were conceived as a way to unlock value for investors. Ron Silvestri, senior analyst at Neuberger Berman, noted that while traditional utility companies are valued based on P/E. Yieldcos, on the other hand, are valued much more on cash metrics and have assets that are highly cash generative. The way the structure typically works is that a sponsor company, such as a utility, will build the assets. The sponsor will then create a yieldco that can buy and operate those functional assets. Yieldcos can also acquire projects owned by other companies. The yieldco then sells power back to utilities or corporations, typically in fixed-price power purchase agreements that can be 10, 20 or even 30 years in duration. Experts say the most important metric to watch when it comes to yieldcos is cash available for distribution. This measures the cash left over after all expenses have been paid, and is therefore what's available to pay to shareholders or reinvest into the company. High dividend yields and long-term stable cash flow is appealing, but there are also a number of risks. For one, yieldcos rely on stock and debt issuances in order to fund their growth, which means that if access to the capital markets is cut off — which has happened in the past — there can be severe consequences. If a yieldco's share price declines, the company faces a Catch-22 of sorts: a lower price makes it harder to issue new equity, and cash raised from new equity is instrumental for growth. The space is also sensitive to interest rates. As analysts at Raymond James put it, a rising cost of capital is "inherently unhelpful" for companies that rely on deploying capital at scale to finance new projects. The group has benefitted from the low interest rate environment in the wake of Covid-19, but the yield on the U.S. 10-year Treasury has marched higher in recent weeks, sparking a sell-off in growth-oriented areas of the market. "There's a big, big difference in my view between the winners and the losers in the sector," said Silvestri. Management expertise is a key factor. Other important considerations include the location and mix of a company's assets, the duration of its power contracts, as well as the reliability of the power purchaser. NextEra Energy Partners NextEra Energy Partners (NEP) is a top pick among Wall Street analysts and investors, who say the company's prime project portfolio, as well as the backing from its sponsor company, NextEra Energy set it apart. NextEra Energy, the sponsor, has a market cap of $145 billion and is the largest renewable developer in the U.S. The company launched NEP in 2014, and NextEra Energy still owns more than 50% of the yieldco. As of the end of 2020 NEP had operations across 18 states. The majority of NEP's portfolio is focused on renewable energy, although the company does have some interests in natural gas pipelines. NEP has a $13.3 billion market cap, and its yield stands at 3.2%. "It's trading at a substantial discount to the sector and to the broader market," noted Michel Sznajer, portfolio manager at Ecofin, which own