This year has been a very interesting one for infrastructure investors, especially energy infrastructure investors. The war in Ukraine led to massive dislocation in energy markets, this combined with outages in France nuclear power plants and Norwegian hydro has resulted in the price for electricity increasing significantly.

In response, consumers have reduced their demand for electricity, governments in Europe have introduced consumer subsidies ($BBG) to assist consumers and businesses keep the lights on and the cold out this winter. Other responses to reduce electricity prices have included price caps based on fuel types and the introduction of windfall taxes on power producers ($FT).

Now the key question for an infrastructure investors is – “which poison would I prefer?”.

It may be informative to refer to some historical perspectives where similar policies have been implemented in Europe. Luckily, using Inframetrics data it is possible to do so.

Price Caps

First, let’s look at price caps. A good case study where the government capped the revenues of projects is Spain where in short the Government designed a Feed in Tariff (FiT) poorly which resulted in significant government commitments. Given that this was during the end of the GFC and the EU’s sovereign debt crisis, the government sought ways to minimize this burden. As a result, multiple changes to the FiT were made between 2008-2013 with key items being (all details are from this paper):

• Reduce FiT levels retro-actively from 44.0381-22.9764 €Cents/KWH (depending on capacity) to 27.3817-12.497 (depending on capacity) €Cents/KWH
• Set maximum time the subsidy could be paid – 25 years (length of the FiT – previously open ended), subsequently made to 28 years
• Moratorium on new grid connections
• In 2010, set maximum number of hours (amount of time the installation could feed into grid – this was also retroactive)

These changes had the impact of reducing revenue, and as a result, levered projects became riskier. In the following series of charts I summarise the impact on 8 large solar investments with a total capacity of 275.9MW and total investment of €2.4B.

Depressed returns on Solar Assets during FiT changes

Source: Inframetrics

We can see that there was a marked decline in return on assets and profit margin for the solar projects in the years 2009-2013. These are the years where the majority of the changes to the FiT and hence revenues were occurring. These two metrics stayed low for a number of years before recovering in 2018-2019.

Solar Asset Profit Margins rebound post-FiT

Source: Inframetrics

During the same period (2008-2013), shareholder distributions decreased significantly and like return on assets and profit margin, stayed low for several years, only recovering recently.

Shareholder Distributions mirror bounce in Solar Returns

Source: Inframetrics

The results we can conclude that the government capped the revenues to solar PV projects. This has a significant impact on the profitability of the projects. With low profits the ability of the projects to return cash to shareholders was reduced (50% of the projects in this sample pay no distributions). Finally, the key point is that recovery of the economics of the projects took time, patience was a virtue.

Windfall Tax

The introduction of a windfall tax on power producers in the UK follows a long history. First evidence I have found was in the 1980s where bank deposits were charged with a windfall tax. However, the case that most interests me as it relates to infrastructure is the privatization windfall tax introduced in 1997. This was levied on all privatised entities to be paid in 1997 and 1998. Interestingly for us, it was levied on electricity and water utilities.

The tax was levied on the difference between nine times the average net profit after tax for the last four years and the flotation price. With a tax rate of 23%.

As with the Spanish solar example, I can demonstrate the impact on the firms by examining the return on assets, profit margin and shareholder payments. In this case we have 36 companies from that time and their data.

We can observe that there was a one-off hit to profit margins for the utilities, but there was no major long-term impact on the firms after 1998. The underlying trends for return on assets were not changed and the regulated firms had consistent profit margins.

Profit Margins largely stable post-1998 Tax Implementation

Source: Inframetrics

 

Shareholder Distributions resume after short-term dip

Source: Inframetrics

For shareholder distributions there was no long-term impact on the distributions we observe. Firms reduced their distributions in 1998, but it quickly recovered in subsequent years.

As a result, we can conclude the windfall tax had a significant impact on the profitability of utilities in 1998, otherwise ‘normal service’ was resumed quickly, with no longer term impact for investors observed.

The key point to note is that this was a one-off tax impost and hasn’t been repeated since. As a result, for investors this is clearly the preferable option.

The new UK windfall tax being imposed on power producers: taking from profits rather than capping revenues. From the information available the windfall tax involves:

• For power sold above 75GBP/MWh, profits in excess of 10M are taxed at 45%
• Large producers only (100GW/Year)

Whilst the nature of the tax suggests it is temporary, I have yet to be able to identify any firm shut off date. Interestingly, in 1997 was 23% of avg recent profits. Whilst the rate was lower, it was more likely to generate taxation for the UK Government. I have found that some investors have quantified the impact. In their recent half-yearly results JLEN suggests that the windfall tax will have an impact of GBP79m on a portfolio of GBP890.2 – however there are significant other impacts that reverse this negative impact as well, so the net result is GBP7m.

Lessons for Today

The key government interventions that impact on investors is the choice of capping revenues or taxing the profits of energy companies. The results above indicate that temporary windfall taxes may be less disruptive for investors and can create fiscal space for targeted subsidies. The Spanish experience does indicate that revenue caps can change the economics of the sector and may remain in place for longer thus durably impacting the value of investments. However, with the current revenue caps significantly above renewable PPA prices, the impact might be negligible (given the significant majority of projects are non-merchant so do not sell into the spot market).