Interactive Investor

Why our RPI inflation dividend target is sustainable

25th July 2023 10:39

by Kyle Caldwell from interactive investor

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Over the past 10 years, Greencoat UK Wind (LSE:UKW) has managed to increase its dividend in line with RPI inflation each year. In our latest Insider Interview, fund manager Stephen Lilley explains why this dividend aim is sustainable in the coming years, due to how secure and predictable the income is that's being generated.

Lilley explains how the renewable energy infrastructure investment trust strikes a balance between paying the dividend and reinvesting capital. He also gives an overview of the main attractions of investing in wind assets, and plays down the prospect of political risk negatively impacting the way the trust invests.

Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today in the studio I have with me Stephen Lilley, fund manager of Greencoat UK Wind. Stephen, thanks for coming in today.

Stephen Lilley, fund manager of Greencoat UK Wind: You're very welcome.

Kyle Caldwell: Greencoat UK Wind, as the name suggests, invests in UK wind farm assets. Could you summarise the main attractions of this area of renewable energy infrastructure?

Stephen Lilley: In general, people who live in the UK understand that it’s quite a windy place. The most important thing is the regime in this country, not just the wind volume, and that is very stable, and one of the great things about the regulatory regime we operate in is that a lot of the income that we get is inflation-linked. So, coming to this point in time, having inflation protection of a dividend that we've now done 10 times, but also being able to preserve capital on a real basis, i.e., with inflation as well, is a key attraction [for] investors.

On top of that, the UK wind market is a £100 billion market. We have £5.5 billion worth of a £100 billion market, so, we're almost in the FTSE 100 and we own 6% of the UK wind markets. It's a very big market, and that's likely to increase by another £100 billion as a lot of wind capacity is built offshore, which both Labour and the Conservatives are keen on. So, now we produce about 1.6% of UK electricity. We service about 1.8 million homes, and we avoid about 2 million tons of carbon dioxide every year. So, a reasonably sized player, but in a very big market that’s likely to grow substantially.

Kyle Caldwell: You currently have just under 50 UK wind farm assets. So, when the income is being generated, how much of that income is inflation-linked and how much does the trust benefit from rising power prices?

Stephen Lilley: We designed the business with a strapline of simple, low-risk and transparent, so we're meant to be all those things. We only buy operating wind farms, so it’s pretty straightforward what we are. But the income stream, because we have no fuel cost effectively, we don't have a lot of costs, so it's all about production and what we get paid for it. So, wind volume is not particularly volatile year-to-year, so we will produce what we expect over the long term, but the prices that we get for each of those megawatt hours is obviously variable.

Now half of the stack, if you like, as with most of the projects we have, go under what's called the renewable obligation regime. So, we get a certificate, that's RPI-linked. It's about £60 this year. It was £30 twenty years ago, so that's a key component. Because of that stability of production and that certificate, that means we can take exposure to the wholesale power price. So, we have a limited exposure to power prices.

And the nice thing about that is that it gives us enough return to be able to do all that reinvesting, and then pay the dividend that increases with RPI. But [during] the likes of last year when power prices were high, we got paid for it. And so, on average about 50% of our revenue is explicitly linked to RPI because it’s got a contract that increases with RPI. And then the other is the power price, which generally inputs into inflation into the basket, as we obviously saw, and as we've been seeing over the last year.

Kyle Caldwell: And in terms of those cash flows, how do you split it between paying the dividend and reinvesting? I assume that reinvesting is very important for your strategy given that UK wind farm assets don't last forever.

Stephen Lilley: It's the question that when we have half-year results [in late July], we want to get out, because, ultimately, we feel, for nine and a half years out of 10 since listing, we've been trading at a premium. The last six months we haven't. We probably realised that people have been buying that dividend. But a key component, which we thought people understood but they probably haven't, is that we’re not just trying to cover a dividend, we’ve got a lot of reinvesting going on.

At the end of last year - these are the numbers [from the] last time we did it and we're calibrating the half-year results as well - we paid £785 million of dividends. We also reinvested £653 million of extra cash flow. So, it's not just the dividend that is covered, it's that we are designing reinvestment for that very reason, so that as time goes by and wind farms get to the end of life, notionally in 30 years, but probably longer, but let’s assume just 30 years, we want a business that continues, so all that reinvestment goes into buying other wind farms. So, for us, that reinvestment part is crucial.

The thing that I'm going to have to talk [about in] half-year results, and I'm just gagging to do so because it's so important, is that the return on our business to investors is about 10%. Yes, the dividend yield might be 5% to 6%, but with that reinvestment there's a 10% return, which, even in the current environment with high interest rates, is a good return. And the best comparison, if you like, is to an index-linked gilt because our dividend and our net asset value (NAV) increases with RPI in the same way [as] an index-linked bond, the principal and the coupon increase with RPI. So, we're very similar in structure and we trade 500 basis points north of that, and for the risk that we take, that's a very good return.

Kyle Caldwell: So, the investment trust has been going for more than 10 years, and it has a target of delivering dividend increases that are in line with RPI inflation. You've achieved this every single year since launch. Were there any years when achieving that target was difficult?

Stephen Lilley: No is the simple answer. Some years it's been tighter, some years it has been less tight. [I’ll talk about the] two lowest years, one was 2016, when we had 1.4 times cover. The design is normally about 1.7, so 1.4 was because we had slightly lower production and that was the $29 a barrel oil price thing. So, it was a slightly low power price and slightly low production and that was 1.4. And then, in 2020, [which was] Covid effectively, we had decent production, but power prices came off as we saw lack of demand, effectively, in the first part of the year when people were at home into May, [and] power prices were very low.

As we've gone through from 1.3 in 2020 [and] coming into 2021, we saw power prices start to increase. Some of that was a bit of a coming out of Covid, and power prices can be quite volatile in one sense. And so, as you came into 2021, there was a little bit of pent-up demand from stuff that’s happening post-Covid, accelerating. So, power prices go high, and so we were 1.9 covered in 2021.

And then last year we had relatively low production, [and] we were 3.2 covered. We’ve never been in the twos yet. We reckon this year we will be in the twos, that is, two times covered. And at 3.2 times covered, that means we had 2.2 of reinvestment, which was about £360 million. Our IPO was £320 million. So, we had [more] extra cash generated last year than [for] the whole of our IPO. And yes, that says something about power prices last year, but it also says that we're also 15 times bigger. So, we've grown from a relatively small company to something that can move the dial.

Kyle Caldwell: Going forward, how sustainable is the dividend? How sustainable is that RPI target of matching it? In other words, how secure and predictable is the income that's being generated?

Stephen Lilley: Very is the simple answer. So, wind volume, it is just diligence. It is what it's going to be, [so] not a risk, if you like, it's diligence. I think all the politics of 10 years ago has [been] entirely in our favour. I've had meetings in the last six months, I've taken [people] round wind farms on one occasion, Keir Starmer, Jonathan Reynolds, and Jeremy Hunt, and the stability of the regime is quite important. If you want to double the amount of capital in the sector over a seven or eight-year period, the stability of the regime is very important, and I think the political parties get that.

The risk, I guess, is exposure to the power price. We want to be exposed to the power price and it was sort of beneficial last year. For us, one thing that we probably will put in our half-year account, so you've seen it here first, I guess, is that even if the power price over the next five years was zero, we could still pay that dividend. We wouldn't have a lot of reinvesting going on, [but] the dividend would be safe. I don't think people quite understand that the cover is very strong. So, if the power price is zero, we could still pay the dividend. Obviously, power prices can't be zero because none of the energy system would work at that point. For CCGT's (combined-cycle gas turbines), they have to pay for gas, and they have to pay for the carbon they use, so the power price can't be zero. But if it was, we're still covered.

Kyle Caldwell: So, are there any threats at all that could put your dividend aim in jeopardy? You mentioned power prices, and that you think the dividend will still be sustainable even if they declined. Is there anything left field that could happen?

Stephen Lilley: You can never say never in terms of left field, but we scratch our heads to answer that question. Anything other than that is stable [and] safe. And it's why, to some extent, 500 basis points north of a gilt seems quite high. Why are we trading at a discount? It’s probably more about the market and not too much to do with us. And it's why the message I need to get across at the half-year results is that this is all about return. The fact that we decide to pay a particular dividend is kind of arbitrary. We could pay a higher dividend and maybe the share price would go up and we'd have less reinvesting, and that would be illogical. But we could do that, and so the argument about return is hugely important.

Kyle Caldwell: How about political risk? Windfall taxes were introduced, and in the future, the windfall taxes could go up even further.

Stephen Lilley: Yes. So, we're not going to pay a lot of windfall tax. Power prices have come off slightly since last year. We'll pay a bit this year, probably not so much next year.  When we were talking to investors last year, we were involved in conversations with government and the chief executives of major utilities. We were having those conversations throughout the year.

I think government and investors understood that Ukraine was quite a thing, and obviously drove power prices up. You could see that in terms of power price expectations in 2022-23 and beyond. In March, when Vladimir Putin went into the Donbas, you saw the expectation for power prices go up substantially. Obviously, people thought when the supply goes down, costs go up, etc. The world has changed a little bit since then, and we see there is exposure to that. But we're not particularly expecting that to move too much.

The most important thing for us is that we're meant to be straightforward and low risk, and so even if they move around a lot, we're still capable of doing all the stuff we want to do. In terms of politics and the UK, yes, there's the Russian geopolitical stuff, but I think it's been a bit of a wake-up call. And politics is very much behind needing a home-grown industry and the stability of that, and it's based here, and we know where it is. I think that’s important.

In the longer term, you can't have 100% renewable capacity, it's not possible because you will have times, and wind is the big player, obviously, where you don't have wind volume. [There’s] high pressure in the winter, it's cold [and] you don't have wind volume. So, you need storage. Batteries probably aren't the answer because they're very expensive and you'd need to cope with those two weeks, [of] potentially very high pressure.

At low temperatures you would need so much battery storage capacity that it would be so expensive. So, the more relevant thing in the long term is electrolysis for hydrogen. If you do that, it becomes storage itself and then you can burn [it] again. Getting that to work is very helpful for the country and the benefit is that you can use excess wind volume to do that. Hydrogen electrolysis in one sense becomes a bit like a battery, if that makes sense.

In the long term, getting hydrogen to work is hugely important for the country. And you see governments trying to encourage investment in the sector and at Schroders Greencoat we're doing that as well. We're trying to work out what we do. We have a separate private market, an energy transition fund, and that is a business that will work out how to do some of that stuff as well. It's not related to UK wind in one sense, but it's all the know-how we have in the building, we are doing things like that.

Kyle Caldwell: Stephen, thank you for your time today.

Stephen Lilley: Thank you.

Kyle Caldwell: That's it for this episode of our Insider Interview series. You can check out the rest of the series on our YouTube channel, where you can like, comment, and subscribe. Hopefully, see you next time.

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