The past four years have been a period of extraordinary progress for clean energy related technologies. The sector has attracted close to $US1 billion in new investment, and a number of technologies have reached a point of cost competitiveness with conventional technologies, well ahead of expectations.
Yet the performance of international clean energy related listed equities has lagged most major equity indices by a substantial margin, such as the WilderHill New Energy Innovation Index (NEX Index), comprising the leading 90-100 global clean energy stocks, which has declined a staggering 75 per cent since 2008. Nanuk Asset Management see this disconnect as a cyclical phenomenon rather than an ongoing trend. The fundamental drivers of clean energy remain intact, and with valuations for global listed clean energy companies at historic trough levels, the sector stands at a very interesting point from an investment point of view.
Outperformance for clean energy technologies
Investment in new renewable energy power supply reached $US240 billion in 2011, accounting for 44 per cent of the over $US540 billion of new power generation capacity investment in that year. Renewables such as wind and solar have reached material levels in many power markets and are recognised, along with gas, as the key alternative power source to replace retiring nuclear and coal capacity in the coming years.Article continues below…
Investment in demand-side applications such as energy efficiency, energy storage and grid infrastructure has been just as strong. Venture capital and private equity investors remain very active in these areas, as do large mainstream energy companies looking to position themselves for changes to power markets brought about by increased renewable penetration and greater focus on demand side efficiency. Recent intelligent grid related acquisitions by power market leaders Siemens AG, Schneider Electric SA and ABB Limited prove this point.
The substantial investment in clean energy has led to rapid advances in performance efficiency and significant cost reductions. Technologies such as wind, solar, LED lighting and large-scale energy storage, to name a few, are now at a point of unsubsidised competitiveness with existing technologies in a growing number of markets. The growth in new investment and the rapid improvements in economics have occurred well ahead of expectations.
Share market under performance
Despite close to $US1 trillion of new investment, rapid adoption of new technologies and extraordinary cost declines, the NEX Index has lost over 75 per cent of its value since 2008 and close to 50 per cent since 2010. There are two key reasons for this.
Firstly, disappointing negotiations at the Copenhagen Climate Change Conference and some highly publicised technology failures have weighed heavily on sentiment in the sector, removing much of the hype from the clean energy valuations, but generally not changing industry fundamentals.
The second and far more critical reason relates to individual industry dynamics. In establishing subsidies to stimulate the adoption of clean energy technologies, policy-makers around the world generally underestimated how quickly prices would fall and how rapidly they would be deployed.
Excessive subsidies, declining costs and a low cost of capital led to a substantial new project boom, distorting markets for equipment and components and driving margins to unsustainably high levels across the entire supply chain. This in turn attracted intense competition, particularly from new Chinese low-cost entrants fuelled by low-cost stimulus-related finance.
It’s estimated that over 200 new solar module manufacturers and 50 new wind turbine manufacturers entered the market in the last 5 years alone. As incumbent producers re-invested to maintain market share, overall production capacity pushed well above any reasonable estimate of potential demand. Similar subsidy-led over-capacity plagued other large sectors like light-emitting diodes used in energy efficient lighting. Prices fell dramatically and profits collapsed.
The impact of this over-capacity was particularly acute among early technology leaders, whereby companies such as Vestas Wind Systems AS, Suntech Power Inc., Q-Cells AG and First Solar Inc. all declined well over 50 per cent from their peak prices. Wind, solar and LED stocks became some of the most heavily shorted across all markets by hedge funds during 2011.
Outlook for listed equities
It is ironic that as clean technologies are on the verge of unlocking the huge potential of unsubsidised markets, stock valuations and sentiment are at historical lows. Picking the timing of a market recovery in so complex an area is not easy, but the outlook is good for many of the industries that make up our clean energy investment universe.
Increasing integration of renewable energy requires a smarter and more interconnected power grid. There are billions of dollars of large-scale power transmission projects on foot globally and less than 20 per cent of the world’s one billion electricity meters have ‘smart’ communication capabilities, the first step towards a more consumer driven power market.
We are seeing the very start of LED adoption in the $US90 billion per year general lighting market. Biofuels still account for less than 5 per cent of the $US1.5 trillion global fuels market and policies to drive the next generation of technology are in place. Utilities are assessing the feasibility of large-scale storage as an alternative to adding new generation and grid capacity.
In the wind and solar equipment industries, further rationalisation is needed in the short term before they find a profitable balance. But demand remains very strong and we see opportunities in other parts of the supply chain. The longer-term outlook for these sectors is positive, particularly for solar. Representing less than 1 per cent of global power supply but with almost limitless potential, the proliferation of distributed solar will have profound effects on the existing centralised power generation and distribution model.
The steep declines in clean energy equities reflect today’s challenging industry dynamics, and we see this as a cyclical phenomenon rather than a long-term trend. Technologies continue to improve at a surprising pace and the circumstances driving economies to seek greater diversity in energy supply and greater efficiency in energy usage have not changed.
Challenges remain and the transition away from subsidy driven markets will add further complexity. But with the NEX Index trading at below 1 times book value, clean energy-related equities can provide an interesting area for investors with a selective approach and good understanding of the technology, policy and industry dynamics at play.
Christian Jensen is a founding member and portfolio manager with Nanuk Asset Management, an Australian-based global equities fund manager focussing on clean energy-related investment.