For the first half of 2015, the renewable energy sector appeared unstoppable, as costs around the world plunged and installed capacity soared. Ahead of an international climate summit in Paris at the end of the year, rosy projections of solar and wind adoption inspired optimism that the world could replace fossil fuels with zero-carbon energy and prevent catastrophic climate change. Few paid attention to an ironic trend: the same investors holding oil and gas assets had also piled into an obscure but crucial class of renewable energy investment vehicles called “Yieldcos,” stocks for dividend investors that that have helped drive down the financing costs of clean energy.
As it turned out, renewable energy prospects hitched to the conventional energy bandwagon hit a bump in the road. In June and July, the bottom fell out of the oil market (again); the Fed strongly hinted at interest rate increases; and a number of renewable energy firms sought large sums from public capital markets. Together, these three unrelated developments conspired to spook fossil fuel investors, who dumped renewable energy Yieldco shares and plunged prices into a vicious downward spiral.
Now the stakes are high: if Yieldcos fail, renewable energy could lose access to public markets and the low cost of capital necessary to scale up wind and solar. To recover, Yieldcos may have to restructure, seek help from parent developer firms, and hope for constructive public policy to further de-risk renewable energy investments.
A Yieldco is an innovative financial vehicle that enables institutional and retail investors to buy shares of a portfolio of projects, unlocking public capital for renewable energy. In general, a Yieldco will team up with a parent renewable energy project developer to split the low and high-risk aspects of renewable energy deployment. The parent developer undertakes the risky activities of constructing the project and finding a long-term utility buyer for the power. The Yieldco simply purchases and operates a diversified portfolio of projects, offering public markets an attractive low-risk equity investment whose tax-sheltered dividend payout beats the return from other low-risk investments, like U.S. Treasuries.
Initially, Yieldcos performed spectacularly. In the two years leading up to this summer, 15 U.S. and European Yieldcos — most operating in the developed world but some branching out to emerging markets— entered the stock market at a collective $12 billion valuation. Buyers of Yieldco shares were predominantly investors in oil and gas assets through Master-Limited Partnerships (MLPs), which Yieldcos resemble. Having watched MLPs grow to over a half trillion dollars, these buyers forecasted jaw-dropping Yieldco growth and bid up market values to $24 billion.
Unfortunately, for the same reasons that Yieldco valuations spiraled upwards, they could also fall into a vicious downward cycle. Yieldcos are appealing when they can buy projects from a parent developer at a higher return than their cost of capital. When Yieldco share prices are high, the cost of equity, measured by the dividend yield, is low (because yield is the ratio of a fixed dividend to the share price). This means that every new project that a Yieldco acquires is “accretive”—that is, it increases the value of the company, boosting share prices, reducing yields, and enabling the Yieldco to raise even more cheap money on public markets to buy more projects. But this virtuous cycle quickly turns vicious when the share price starts to drop. This drives up yields and closes the gap between the cost of capital and the return on new projects, further depressing share prices.
This is exactly what happened when a freak confluence of events—the perfect storm—knocked sky-high Yieldco shares into a tailspin this summer. Oil prices tumbled 20% in July, deflating investor valuations of both fossil fuel MLPs as well as renewable energy Yieldcos, because the same financial models were doing double duty. Even though there is little fundamental linkage between oil prices and the competitiveness of solar or wind power across the developed world, newly risk-averse Yieldco investors raced to exit positions they suddenly considered overvalued.
Around the same time, Federal Reserve policymakers all but promised that interest rates would rise by the end of this year. Higher interest rates would erode the appeal of Yieldcos as a higher-return alternative to federal bonds, potentially driving down share prices. Moreover, in the months of June and July, four Yieldcos issued new stock to raise $2 billion from public markets, oversupplying the market while investor demand tumbled.
The effect was disastrous for Yieldcos. For example, shares of Terraform Power, a Yieldco subsidiary of SunEdison, the world’s biggest renewable energy developer, have tumbled over 40% in the last two months. The dividend yield has risen correspondingly, making it more difficult to acquire accretive projects. Equity analysts scratched their heads, pointing out the fundamental strengths of YieldCos, the dramatic growth prospects of renewable energy around the world, and the steady underlying cash flows that had not changed.
Analysts are correct that many Yieldcos do comprise low-risk assets and that the renewable energy industry has tremendous growth potential. Moreover, oil price movements should be irrelevant, and interest rates have a long way to go before closing the gap with Yieldco returns. But none of this will matter so long as Yieldcos remain trapped in a vicious cycle of devaluation, unable to fund growth.
Fortunately, there are options for the renewable energy industry to break the vicious cycle. Yieldcos could restructure by increasing their debt load up to responsible credit limits, getting off the treadmill of equity issuances and dividend payouts to reinvest more cash flow into growth. Moreover, parent developers can sell projects to subsidiaries at a discount to prop up Yieldco share prices. After demonstrating several quarters of steady value, Yieldcos can attract a more diverse investor base that is less influenced by unrelated commodity prices.
Public policy can also make it easier to invest in a range of renewable energy assets. For example, distributed generation, like rooftop solar, is an appealing addition to Yieldco portfolios, offering higher returns than large solar and wind farms. Initiatives by state and local governments to de-risk those investments, including programs where homeowners pay off such projects on their property tax bills, can enable Yieldcos to present a diverse, high-value portfolio to the market.
Renewable energy is on the cusp of becoming a mainstream alternative to fossil fuels—getting there requires a mainstream financing tool. Although the Yieldco model must improve after derailing this summer, getting it back on track is in everyone’s best interest.
Varun Sivaram is the Douglas Dillon Fellow at the Council on Foreign Relations (CFR) and a strategic advisor to the Office of New York Governor Andrew Cuomo on energy innovation and regulation. Prior to joining CFR, Sivaram served as Senior Advisor to Los Angeles Mayor Antonio Villaraigosa, and he previously researched next-generation solar technologies as a physicist at Oxford University.