Gresham House Energy Storage Fund — A great year, and better ones ahead?

GRID is the UK’s largest BESS operator, commanding a market share of around 30%, as well as its largest listed energy storage fund. The fund currently has 24 projects plus eight exclusive projects in its portfolio, including 17 operational projects, with the remainder (including one project in the Republic of Ireland) due to come on stream by 2024, more than tripling GRID’s current capacity (see following section and Exhibit 1 for details).

GRID’s Manager, Ben Guest, is ‘very confident’ that opportunities in the UK and Irish BESS market will remain healthy ‘for many years’. He expects the deployment of renewables to continue apace and foresees an increase in UK electricity demand, driven particularly by an increase in electric vehicle uptake and the roll-out of electric heat pumps (which will replace natural gas-fired domestic and commercial boilers). In addition, the Manager notes that the Russian invasion of Ukraine has reminded Western nations of the importance of energy security. In the UK, the government is presently considering a possible easing of planning restrictions for onshore and offshore wind projects, to cut lead times on new renewable projects. And across Europe, the war in Ukraine has sparked a push to reduce reliance on Russian gas and increase the production of energy from renewable sources.

To maintain GRID’s leadership in this burgeoning market, Guest has plans to continue to increase GRID’s scale, by sourcing additional projects to come on stream in late 2023 and beyond. He says he is working on an ‘additional healthy pipeline’, with news to be announced in due course. The Manager’s growth plans now also include expansion beyond the UK and Ireland, to the US, Europe, Australia and Canada. Guest believes that the rapid penetration of renewable energy into these markets represents a significant opportunity for GRID. He argues that the UK represents only 1% of global electricity consumption, while the US and EU markets are among the world’s largest electricity markets, each at least 10x larger than the UK. Some of these target markets are also characterised by high potential volatility in both energy supply and pricing, resulting in strong target returns compared to the UK. ‘There is a lot to do abroad’, Guest says.

The board has therefore published a circular on 22 April 2022, requesting shareholder and lender approval to invest up to 30% of the fund’s gross asset value (GAV) in the United States, the European Union, Australia and Canada. This would replace the existing investment policy rule allowing 10% of GAV to be invested in Ireland and provide shareholders with what Guest believes will be valuable geographical diversity, along with the chance to enter markets at an early stage when entry is most attractive. However, he stresses that any such international expansion will be a gradual process, which he expects will increase EBITDA and NAV growth steadily over time by utilising GRID’s experience, expertise, operational capabilities and advantages of scale. In his statement in the recent annual report, GRID’s chairman, John Leggate CBE, flagged the possibility that potential investments may include solar (photovoltaic) generation equipment.

Guest and his team maintain a constant effort to improve profitability and competitiveness. To this end — at the same time the board seeks approval to expand its international operations — it has also proposed a couple of other investment policy changes intended to reduce costs. These include clearance to invest up to 10% of GAV in shovel-ready projects, which would allow GRID to assume development risk for the first time, via the acquisition of investments in projects at the pre-construction, but ready to build, stage. At present, Gresham House DevCo, an affiliate of the Gresham House Group, acquires and develops projects, and sells the developed projects to GRID. Guest believes the proposed alteration to the fund’s investment policy would simplify and speed up the acquisition process and reduce acquisition costs by 5–10%, by eliminating such related third-party transactions. The change would also provide GRID with the option of a premium listing on the Main Market of the London Stock Exchange, a step that should lower GRID’s cost of equity and improve the liquidity of its shares.

The board is also seeking approval to invest in land under new and existing projects, which will eliminate leasing costs for these projects, and increase operational efficiency by significantly increasing project duration (the amount of time a BESS can take to discharge from full capacity), and hence its potential revenue generation. This is particularly important when trading intraday volatility in power prices and a key consideration for the Manager, given his plans to increase energy trading over time (see discussion below). Owning, rather than leasing, the land used by BESS would increase project duration by providing GRID with full control of the land, rather than being subject to lease length, which is usually around 25 years.

With operational capacity and associated revenues due to rise substantially over the next couple of years, and further pipeline expansion on the agenda, GRID’s Manager and its board are positive about the fund’s outlook, and they expect substantial uplifts to GRID’s NAV over the coming year. In its January 2022 trading update, GRID stated that it expects FY22 NAV growth ‘towards the upper end of the target range of 8–15%’, a healthy pace of growth which would take the NAV to around 134p per share by end FY22. However, developments since the publication of this update and our initiation note, combined with statements in the fund’s annual report, make this target appear conservative.

In late February 2022, GRID announced that National Grid (the UK electricity system’s operator) had awarded it several high-value, one-year and 15-year energy supply contracts. The fund estimates that these contracts will add 5p per share to GRID’s Q122 NAV and a further 10p per share over the longer term. The NAV is also expected to benefit from project revaluations as some of its pipeline projects become operational in the coming months (see our initiation note for details of GRID’s valuation policy).

GRID publishes its NAV on a quarterly basis and the Manager expects that when the Q122 NAV is published on 4 May 2022, it will show an increase to at least 124p per share. He foresees a further rise to ‘140–145p’ per share by end June 2022, 20–24% above its level at end FY21. Further NAV increases will follow as the remainder of GRID’s existing portfolio projects come on stream over H222 and beyond. Also, as Guest executes his plan to add further to GRID’s project pipeline via developments in the UK, Ireland and further afield, the commissioning of these projects will drive its NAV even higher over the longer term.

At end December 2021, GRID was invested in 24 BESS projects plus eight exclusive projects across England, Scotland and Ireland, of which 17, totalling 425MW of capacity (FY20: 315MW), are operational and generating multiple revenue streams (Exhibit 1) and 15 are under construction. These numbers are unchanged from our initiation note published in February 2022, although in some cases the expected commissioning dates of projects currently under construction have been delayed a few months, due to COVID-related supply chain constraints.

GRID’s FY21 annual report confirmed that of the 15 pipeline projects under construction, eight are due to be commissioned during 2022, including four in the next three months. These eight projects have a total capacity of 415MW and will almost double GRID’s operational capacity to 840MW by end FY22. Additional commissions in 2023 and 2024 will lift total operational capacity to more than 1,500MW, more than triple current capacity. These figures exclude any new projects GRID is yet to announce (see previous section for discussion of GRID’s expansion plans).

When we published our initiation report in February 2022, details of the capacity of most of GRID’s pipeline projects was not publicly available. However, information provided in the FY21 annual report, and included in our updated table above, shows that GRID has significantly increased the average size of its most recently acquired projects. According to Guest, larger projects are more cost effective, and an efficient way to drive scale and cut costs once projects are operational.

Following the fund’s equity and debt raisings in 2021 (discussed in our initiation note), the fund had £122m cash on hand at end FY21. According to the Manager, these funds, combined with GRID’s £180m debt facility, will be sufficient to finance the completion of the pipeline projects numbered 18–26 in Exhibit 1. Beyond that, he has the option of drawing down an additional £200m line of credit (an uncommitted accordion), which was part of the 2021 debt raising, to finance the completion of GRID’s existing pipeline and any further acquisitions. Otherwise, he will need to seek additional sources of funding.

GRID’s NAV and share price performance has been strong over FY21 and since its inception in November 2018. Its NAV rose 42.6% to £511.7m over the year (FY20: £358.9m), while its end-FY21 NAV per share of 116.86p was up 13.5% from 102.96p at end FY20 and 19.2% higher than at inception. (GRID’s unaudited Q122 NAV will be published on 4 May 2022.)

The increase in GRID’s NAV per share over the 12 months to end December 2021 was due to several factors, the most significant of which was the revaluation of three of its eight projects previously held at cost. (The fund values projects at book value and only increases their valuations as they become operational.) The NAV also received a notable boost from a net improvement in its budgeting forecasts, driven by a rise in revenue assumptions, as well as significant cash generation from underlying asset performance. A small reduction in the discount rate applied to most revenues (from 11.1% to 10.85%) had a more modest positive impact on NAV per share. These supportive influences were only partially offset by the payment of dividends, transaction fees and debt charges.

As discussed in the Fund Manager section on page 2, GRID’s Manager expects further substantial increases in the fund’s NAV in the near term and beyond. NAV per share is expected to reach ‘140–145p’ by June 2022, a rise of around 20–24% from the level at end FY21, with additional uplifts driven by the revaluation of GRID’s construction pipeline as each project becomes operational.

GRID’s share price has performed even more strongly that its NAV over the last financial year, widening the premium at which its shares trade above cum-income NAV. GRID’s shares delivered a total return of 23.0% over FY21 versus a UK market return of 18.3% (represented here by the CBOE UK All Companies Index) and 51.5% since IPO, more than 2.5x the UK market return of 19.1%. The fund’s share price has risen a further 8.3% in the most recent three months to end March 2022, compared to a UK market return of just 1.0%.

While GRID does not have a formal benchmark and its assets are very different from conventional financial instruments, Exhibit 4 uses the CBOE UK All Companies Index as a proxy for the UK market, and the MSCI AC World Index as a broad international comparator. Exhibit 4 also includes the MSCI World High Dividend Yield Index, given GRID’s focus on providing investors with an attractive dividend. As can be seen from Exhibits 3 (right-hand side) and 4, GRID outperformed the UK market, the World Index and World High Dividend Index in the year to end March 2022, and since inception on a share price basis. (As the Q122 NAV is not yet available, the NAV performance calculations in Exhibits 3 and 4 use the end-FY22 NAV, which accounts for the lag in performance on a NAV basis over all periods shown.)

GRID’s revenue generation and EBITDA rose very strongly in FY21, significantly exceeding budget estimates. Operational revenues were up 170% to £51.4m (FY20: £19.0m) and EBITDA increased 172% to £42.5m (FY20: £15.6m). As shown in Exhibit 5, revenues at end December 2021 continued to be dominated by the provision of various Frequency Response Services (FRS), which are governed by commercial contracts to provide energy to National Grid. Together, Dynamic Containment (DC), Enhanced Frequency Response (EFR) and Firm Frequency Response (FFR) contributed 83% of revenues (see initiation note for definitions). National Grid’s demand for these services remains strong, given the structural shortage of BESS capacity to meet demand across the grid. Capacity market contracts comprised a further 6% of revenues. These contracts are awarded to dispatchable energy sources, such as gas-fired power plants, which can be switched on and off in response to demand. Renewables are therefore not eligible for these contracts. Trading income accounted for the remaining 11% of total revenues, driven mainly by opportunities early in the year when energy price volatility reached extreme levels for a brief period.

Energy trading has been a core element of GRID’s strategy since inception, on the basis that it is inherently profitable. Like other commodities, energy can be acquired during periods of low energy prices, stored, and sold at times when volatility and prices are high. The Manager has previously indicated that he expected trading to generate around 50% of income by 2022. However, while FY21 trading revenues were lower than forecast, Guest is not disappointed by this outcome. As he observes, the UK energy market continues to evolve, and the extent of trading opportunities is determined by National Grid’s use of the system. As events transpired in 2021, high wholesale energy prices meant that providing power to National Grid was a more lucrative use of GRID’s battery capacity than trading, as National Grid was prepared to pay record prices for DC supplies when needed. Also, the Manager is keen to stress that he will continue to ‘go where the value is, to realise GRID’s goal of maximising returns’, and is not wedded to any given trading target if more profitable sources of revenue present themselves. Given current market conditions and despite several bouts of extreme power price volatility in Q122, Guest now expects income from trading to be lower than DC revenues again during FY22.

GRID has paid a dividend of 7.0p per share for the past two financial years, and the board has confirmed a target dividend of 7.0p per share dividend again in FY22 (Exhibit 6). Dividends are paid in four quarterly payments covering the periods to end June, September, December and March, in the form of interim dividends. No final dividend is paid. The first quarterly dividend payment in respect of the current fiscal year will be paid in July 2022. The fund offers a current dividend yield of 4.7%.

GRID’s dividend cover is a key focus for the board. In FY21, the portfolio generated earnings sufficient to provide operational dividend cover of 1.32x, up from 0.78x for FY20, and the board expects full operational dividend cover from underlying portfolio earnings in 2022 and ‘ongoing calendar years’. Looking further ahead, the board expects dividend cover to improve in the medium term, as further projects are commissioned and revenues rise accordingly, and it has stated its aim to ‘balance’ future dividend targets with increases in operational dividend cover. We believe this is a clear indication that dividend payments are likely to increase over time, as dividend cover rises.

GRID’s shares have traded at a premium to cum-income NAV since its launch in 2018. However, in recent months the premium has increased quite sharply and is currently 28.2%, compared to its average of around 10% since inception. The trust’s current premium is no doubt due in part to its strong performance, the prospect of additional NAV uplifts and the Manager’s plans to increase the scale of GRID’s operations. The fund’s attractive and regular dividend, together with the possibility of dividend increases over time, as well as its position as the largest participant in the BESS market, are other factors likely to be adding to GRID’s attraction for investors.

Despite its current, wider than average premium, GRID’s chairman believes that its shares ‘still demonstrate good value’. In support of this statement, he cites, the growth in value anticipated through 2023 from the increase in operational projects in particular, and the longer-term NAV benefit expected from additional contracts awarded in February (discussed above). However, the premium may narrow over time as these NAV uplifts are realised.