As the first global agreement to combat global warming that includes both developed and developing countries, the COP21 deal is a truly transformative achievement. The investment implications for the energy sector will become more clear over the next few years as each country formulates its own action plan for combatting climate change.
The COP21 agreement’s stated goal of achieving zero net emissions some time in the second half of the century now hangs like the Sword of Damocles over carbon investments, which are to be amortized over decades. Therefore, companies intending to invest in conventional energy sources such as oil exploration or coal power stations must think twice before making their investments in these areas. Likewise, utilities operating centralized conventional power generation and distributing it to millions of customers will have to adapt their business models to the trend of decentralized clean power generation and storage, or face their demise.
On the other hand, the COP21 agreement is an important tailwind supporting various different clean energy subsectors such as clean power generation, distributed energy systems and energy efficiency – enabling the clean energy industry to finally reap the profits of the improvements to its cost competitiveness over the last 10 years.
"The COP21 agreement's stated goal of achieving zero net emissions in the second half of the century now hangs like the Sword of Damocles over carbon investments."
The ITC/PTC federal tax credit extensions are certainly a boon for the US renewable energies industry, providing much needed transparency for the next 5 years and beyond. The solar ITC extension in particular, is probably the most important policy development for US solar to date. The new ITC schedule links nicely with the state-level investments needed to meet the Clean Power Plan (CPP), and will enable solar to achieve grid parity in nearly all US states by then.
The stay on the Clean Power Plan only has a limited impact on current demand for renewables given that most decisions to deploy renewable energy are made within the context of the relative economic attractiveness of the various energy sources. In fact, the ITC and PTC extensions will give the renewable energy sector the necessary time to move ahead – even without the support from the CPP regulation – subsequently penetrating states that have traditionally relied on coal power generation.
In the meantime, we still need to follow the situation closely, as state level policy changes may counteract federal support for renewables, as we have already witnessed in the recent discussions regarding net energy metering. These decisions will have an impact on the deployment of renewables in the residential sector, but much less so on utility scale renewable deployments.
Intuitively, we would expect stronger support for renewables to come from the Democrats. For example, while on the campaign trail, Hillary Clinton recently called for cumulative solar capacity of 140GW by 2020, which is a very ambitious target, considering that current projections point to a cumulative capacity of around 100GW by then. But it is also worth noting that the most important driving force behind continued penetration of renewable energies lies in attractive financing conditions, and it would not be completely unreasonable to think that the cost of capital for project financing may also remain attractive under a Republican administration.
"The cost of electricity generated from solar has declined by 5–10% per annum over the last ten years, and we expect this trend to continue."
For the COP21 conference in Paris, 188 out of the 196 attending parties submitted a climate pledge. Naturally, the scope and breadth of the pledges vary widely, but this is a clear signal that nations are finally taking the climate change challenge seriously. We also shouldn’t forget that the Paris Agreement is merely a starting point, as the stated contributions will be far from enough to limit the Earth’s temperature increase to 2°C. We therefore expect more and stricter regulations to be implemented in the future. Interestingly enough, the biggest driver for future stricter regulations will come through an increased awareness among countries with limited fossil fuel resources and that therefore have a strong economic incentive to go “clean,” as these countries will be net beneficiaries in a world of cheap, abundant supply of clean energy.
The appeal of the Paris deal is the fact that each country had to submit its own Nationally Determined Contribution (NDC), in which it specifies which measures it plans to implement and how much such measures are expected to reduce greenhouse gas emissions. But this also implies that the implementation of these measures depends on the national governments. However, the Paris agreement is a truly global accord, and the potential for moral outrage from the global community will presumably deter individual countries from walking away from their stated commitments.
On a very long-term perspective, we are confident in our assessment that the entire traditional energy sector is at risk, not necessarily because of stricter regulations, but because of increasingly better economics achievable with future clean energy solutions. As more investors recognize that it is becoming increasingly risky and detrimental to their performance to remain invested in hydrocarbon-heavy industries, we will see more moves to divest out of these sectors.
Still, it is important to remember that we are referring to structural headwinds with most of the impact being felt starting from 2020 and beyond, and that we may still see some short-term cyclical improvements in the oil & gas sector before then.
As of today, we have not observed any decrease in activity in renewable energies as a result of the low oil prices. One of the main reasons for this is that renewable energies essentially compete with coal and natural gas for electricity generation and not oil: only around 3% of the world’s electricity is generated from oil, and in developed countries it is even lower.
Coal and natural gas prices have also been depressed in recent years, but we still haven’t seen any declines in retail electricity prices. In fact, quite the opposite has happened. For example, US residential electricity prices have increased more than 3% per annum over the last 10 years, which is an acceleration of the long-term term increase of around 2% per annum. The reason for the steadily increasing prices is not necessarily linked to the power generation costs, which are just one part of the total electricity bill, but more to the transmission & distribution costs, which account for an increasingly larger share of total electricity costs. Today, transmission & distribution costs typically make up more than 40% of the total cost of electricity, with more increases projected for the future.
Therefore, as long as we don’t see any significant decline in electricity prices – and all projections actually point to continuing slight price increases – the relative competitiveness of renewable power generation will just improve even more over time. For example, the cost of electricity generated from solar has declined by 5–10% per annum over the last 10 years, and it is very likely that we will continue to see to this cost decline trajectory in the foreseeable future.
In the current macro-economic environment, low oil prices are indicative of a sluggish economy and therefore have broader repercussions for the stock markets, with investors becoming more risk averse. Admittedly this also has an impact on the higher beta sectors within our portfolio, notably solar project developers and wind turbine manufacturers. But again, as long as we don’t see a significant deterioration in company fundamentals such as worsening financing conditions, we would use the bad sentiment-induced weakness to increase our positions in selected stocks rather than to trim them.
Natural gas is by far the cleanest energy form compared to other conventional energy sources such as oil and coal. A natural gas power plant emits roughly half of the CO2 compared to a coal power plant of the same size. We view natural gas as an important transitional energy source over the next few decades. The upstream natural gas exploration & production sector is a largely commoditized sector where significant capacity has been built up in recent years, leading to the shale boom in the US. However, from an investor’s perspective, we think that this is not necessarily an interesting sector to be invested in as the companies have considerably increased their leverage over the last few years, and are now suffering from deteriorating fundamentals. If at all, we only had minimal exposure to these companies in the fund within the last three years. As a result, we recently removed the natural gas exploration & production sector from the eligible universe for our strategy. Meanwhile, we still invest in natural gas distribution and transport companies. These are mostly natural gas utilities, which generally profit from higher gas volumes enabled through lower gas prices and show very high earnings predictability.
We always try to find a good balance of sectors addressing different growth and value areas. In the “Renewable Energies” cluster, we are currently focusing on upstream solar companies and wind turbine manufacturers. In the “Energy Management” cluster, we have a decent exposure to the semiconductor power management sector, as companies in this sector enable the efficient conversion of power for consumer electronics, IT, storage and automotive applications. Within the “Energy Distribution” cluster, not only do we own electrical and natural gas utilities, but also equipment companies for smart grid & smart city solutions. And finally, the focus of our “Energy Efficiency” cluster is currently on industrial automation and processes companies.
"Attractive financing is the most important driving force behind the continued penetration of renewable energies."