InvestmentsFeb 27 2012

Does solar still have a bright future?

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Mention investing in the emerging solar photovoltaic (PV) sector in the UK, and the conversation will soon turn to government feed-in tariffs.

The twists and turns in government policy on feed-in tariffs have left a damaging perception of uncertainty. Furthermore, the noise around feed-in tariffs has sparked a larger debate about the affordability of renewable technologies.

Feed-in tariffs were introduced by the then Labour government in April 2010 as a mechanism to boost investment in underfunded renewable energy-generation infrastructure in the UK. This followed similar moves in a number of European countries and offered a guaranteed price to compensate for the high cost of producing units of renewable electricity compared to more conventional power. The response to the introduction of the scheme from the UK solar PV industry was immediate and a number of large-scale projects were developed – so called ‘solar farms’.

In the meantime there was a very technical but very important clarification of the way the feed-in tariff was accounted for in the public accounts. The result was a spending cap applied to the payments made under feed-in tariffs in the government’s comprehensive spending review in the autumn of 2010.

The impact of the spending cap and the rapid roll-out of infrastructure being planned by developers put pressure on the government’s support of solar PV, and in January 2011 the new coalition government issued its Fast Track Review of the scheme. This led to the first of the reductions in the level of the feed-in tariff for larger scale projects, to be followed a few months later by a second review that led to another reduction, this time affecting residential projects as well as larger scale installations.

Clumsiness in executing these tariff reductions led to a well publicised legal challenge, which successfully delayed by three months the implementation of the reduction, although we wait to see whether the government will be able to pursue an appeal through the Supreme Court.

The reality is that feed-in tariff payments are usually intended to be temporary incentives to develop capacity in the industry and should be adjusted downwards as costs in the supply chain reduce, so that consumers do not pay inflated profits to industry participants. In this respect, the government’s reductions in the feed-in tariff were a well intentioned policy.

The failure, however, to communicate a narrative of how the system would work and the long-term plan has created challenges for industry participants as they build capacity in the UK. In addition, it has given confused messages to investors and consumers who are worried that their financial outlay will be vulnerable to a political change of heart.

Myths and misconceptions

The reductions to the UK tariffs announced in 2011 were only in regard to installations completed after a future date, and have not affected installations already ‘plugged in’ to the system.

This has had an impact on developers of solar PV installations, who have had to manage their inventory purchases carefully and adjust their cost model. While disruptive, however, the tariff reductions have not resulted in solar PV becoming uneconomic in the UK. As with many subsidy interventions, there has been an element of cost inflation at all points in the chain and it has been possible to squeeze some very material reductions. For example, panel prices were £2 per watt as recently as early 2011 and are now close to £1 per watt.

Investors who invest in fully operational assets that are feed-in-tariff accredited have not been affected by the tariff reductions. This is essentially an infrastructure investment and investors are seeking a yield commensurate with the liquidity and operating risks.

Solar PV assets continue to represent a very stable and predictable method of generating electricity – they have few moving parts to maintain and the sunshine is not very volatile on an annual basis.

Consequently, acquisition of operating solar PV assets has continued in spite of the tariff reductions: the only difference between investments in projects accredited before 12 December 2011 and those accredited after is the acquisition price – yields have remained relatively stable.

Real returns on investment

In simplistic terms, previously a domestic installation of 4kWp (kilowatt-peak) solar panels cost an investor about £16,000 fully installed when the tariff rate was 43.3p, and will deliver approximately £1,600 per annum of income.

The same installation, built with exactly the same configuration – but which is installed when the lower 21p tariff is applicable – costs in the region of £8,000, and will deliver around £800 per annum of income.

The constant is the yield of approximately 10 per cent per year, with the main difference being the margin or profit for the installer, plus cost reductions in the equipment. The link to inflation – both directly through the tariff, which is index linked, and indirectly through energy prices – means that the investor should generate a real return on their capital.

Private investors have two principal routes to participate in the generation of renewable electricity from solar PV installations. The most direct method is to simply buy panels to put on their roofs. Depending on the available cash they have to spend and, assuming they have the roof space, the returns should compare favourably with other potential uses of their capital, but attention to the costs is key. It is also important to factor in the intermittent use of the power in their homes.

The other option is to invest in solar PV infrastructure through professionally managed funds that should yield cash and can be designed to deliver a capital return through a future sale of the portfolio. Listed specialist funds are available, but can be difficult to find. For UK taxpayers, there is also the option of investing through a wide variety of venture capital trust or enterprise investment scheme funds promoted by reputable investment organisations, which will provide access to this sector in a tax-efficient wrapper.

Most IFAs will be aware of the range of managed investment opportunities in the market. That said, changes to policy are likely to mean that new opportunities will not be available after April 5 2012.

Solar PV continues to provide a very stable and efficient renewable energy technology. The government support, which has been important in building capacity across Europe, has nurtured an industry that is now capable of supplying and installing the infrastructure. The tariff level debate has created something of a distraction to the returns delivered to participants and investors, and this has led to bumpy corrections in the implementation of policy.

However, the tariff support will tail off as costs reduce and the price of energy from conventional sources increases. Solar PV will become more boring, as well as a valuable part of the future energy mix.

Jeremy Milne is investment director responsible for the Ingenious Solar UK EIS