19 February 2020
By David Palmer, Co-Fund Manager DMS Verbatim Portfolio 5 Income Fund
The future of energy will be shaped by how we respond to its central paradox. How can we generate more energy with fewer emissions?
The Paris Climate Agreement signalled a commitment to limit the increase in global average temperature to well below 2°C. Under all energy-system forecasts that keep temperatures below this level, the electricity-generation system must be entirely decarbonised, meaning its emissions should be close to zero.
Yet electricity is only as green as its source. In 2019, the global electricity sector represented approximately a quarter of all global emissions.
Fossil fuels have commanded a consistent 60-70% share of the global power-generation mix since the 1970s. Reducing emissions will require a material restructuring of the historically slow-moving global power-generation system.
Energy-efficiency objectives have not succeeded in stemming the global demand for electricity, which is forecast to grow by 62% between 2019 and 2050. This increased demand is a function of three principal factors: global population growth, economic output increases (particularly in non-OECD countries such as India and across Africa), and the impetus to electrify processes historically based on fossil-fuel use. We are entering a decade of unprecedented disruption in electricity generation and consumption.
The good news is that the electricity-generation cost landscape has already changed dramatically over the last five years. The cheapest way to generate electricity is no longer from coal and gas but via onshore wind and solar power. The primary reason for this dramatic shift has been falling equipment costs. Solar module costs are almost 70% lower than five years ago, while wind turbines are now 40% cheaper than five years ago. Not only are wind turbines cheaper – they can also extract around 20% more energy from the same wind field.
As the world strives to limit temperature increases, more electricity will have to be generated through renewables. Indeed, the International Energy Agency’s Sustainable Development Scenario points towards renewable technologies representing two-thirds of electricity generation globally by 2040.
High investment requirements, yet a small investment universe
There is an increased requirement for investment in renewables, so it’s perhaps surprising to find that the universe of investment opportunities, whilst expanding, is still relatively small at around $1 trillion – less than a 25th of the size of the fossil fuel market it is disrupting. Why is this so?
It’s already been noted that renewable technologies have experienced significant price deflation as technology and materials have evolved. However, the key factor has been economies of scale. Ten years ago, subsidies and tax breaks provided a cash-flow safety net for companies offering renewable solutions to an embryonic market, but these have now largely been withdrawn as adoption accelerates and volumes rise. Renewable company returns are now determined by market forces, which is at the heart of why the sector opportunities are still relatively limited.
Existing utility companies face several challenges in pivoting their generation mix away from fossil fuels. The levelised cost of electricity generation for new investment may be lower for renewables, but they remain higher than those earned from partly or fully depreciated fossil-fuel assets.
Compounding this is the fact that for the past decade electricity demand in most developed markets has been benign. Utilities companies have therefore had little impetus to invest in new capacity. In the absence of subsidies, how to bridge the returns gap and navigate the transition towards renewables is a dilemma faced by many utility companies. Investors have been crowding into the few that have successfully led the transition and have been content to watch from the rest of the pack’s deliberations from the side lines.
Management strategy has made other segments of the renewable supply chain unattractive for investors. Three wind turbine companies consolidating around 70% of a global market expanding at over 12% a year hints at an investment nirvana – one of pricing power and multi-decade, double-digit volume growth. But in reality, the scrum for market share and technical supremacy has effectively capped returns and set in motion a structural price deflation spiral. It’s a similar story in high-voltage electrical cables and perhaps at its worse in solar where there are very limited technical or material barriers to entry. The rush to the bottom has decimated returns and there is scant evidence that this won’t continue through the course of this decade as well.
Where can opportunities be found?
However, there are some bright spots. Carbon-offset prices have risen to the point that current coal-power generation in the EU is now uneconomic. Coupled with inter-governmental leapfrogging to decarbonise economies it suggests utilities will pivot sooner rather than later, forcing investors off the side lines. It also requires regulators to improve the returns that can be earned from monopoly-grid operations to ready the infrastructure for new and distributed capacity as well as rising loads. If costs can be contained and projects executed on time, grid infrastructure is likely to become an increasingly attractive global investment opportunity. We have identified several opportunities in electrical networks across European and North America where the trend of low-carbon power provides a decade or more of increasing returns to investors, almost irrespective of the prevailing economic environment.
Wind farm operators remain in the sweet spot of strong order books and deflationary costs. Although it is a renewable technology which is becoming increasingly crowded, it’s a theme we identified early and the established market leaders, especially in offshore wind, are still able to earn superior returns to the newcomers due to their economies of scale and experience in project execution. Most participants in off- and onshore wind have also succeeded in replacing the largely withdrawn state power price subsidies with Purchasing Power Agreements (PPA) which lock in returns, providing investors with an attractive low-risk annuity income flow.
As we head into another decade of compressing global yields, these characteristics are becoming increasingly rare yet are qualities highly sought by portfolio managers to balance risk. It is likely valuations will remain well supported into the future. However, the ultimate beneficiary of a decarbonised power market is society as a whole, giving the consumer the prospect of enjoying both structurally lower power prices whilst securing tomorrow.
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