July 21, 2014
U.S.

The hidden risk of green energy ‘yieldcos’

Christopher Swann | Reuters Breakingviews | Published Monday, Jul. 21 2014 | www.theglobeandmail.com

The green high-yield craze in the United States is too hot and full of wind. The latest antidote to meagre interest rates is the so-called “yieldco” – collections of wind farms and solar plants. Demand has been strong for the fledgling asset class, with six public offerings in a year. But investor ardour for these securities has driven valuations to unsustainable heights.

To wit, shares in TerraForm Power, the latest yieldco to hit the market, ended their first day of trading a third higher on Friday. This has been typical of investor enthusiasm. The value of another, NRG Yield, for example, has climbed 88 per cent since it went public a year ago – racing past an 18-per-cent rise in the S&P 500 index over the same period.

Part of the frenzy is due to the similarity of these securities to energy master limited partnerships, which are prized by investors because of their steady cash flow, high yields and exemption from corporate income tax.

Because solar and wind producers enjoy multidecade contracts to supply electricity, their revenue is extremely predictable, much like oil and gas pipeline MLPs such as Kinder Morgan Energy Partners.

The new class of yieldcos also enjoys advantageous treatment from Uncle Sam. Renewable energy sources qualify for accelerated depreciation, virtually eliminating taxable income.

And since most projects are financed with tax-deductible borrowing, the bill from the U.S. Treasury is usually zero in the early years.

The drawback is that unlike MLPs or real estate investment trusts, the tax rate for yieldcos will eventually spike up to the U.S. standard 35 per cent – the highest in the industrialized world. To delay this inauspicious day, yieldcos need to keep buying new assets.

This risk is not reflected in the price. With an average dividend yield of just 3.7 per cent, according to UBS, the class compares poorly with more old-fashioned assets. Traditional utility Hawaiian Electric Industries offers 5.1 per cent, while the average MLP delivers 5.2 per cent, according to index-provider Alerian. Other metrics also point to froth. NRG Yield, for example, trades at 15 times 2014 forecast EBITDA, according to UBS, against an average of 8.5 times for regulated utilities.

Rising Treasury yields would be a blow to any of these investments, including old-school utilities.

But yieldcos have the least margin for error: The average security now pays just 50 basis points above the 30-year U.S. Treasury yield. This wafer-thin spread makes them especially vulnerable.