McCrone: Don’t Get Euphoric – Risks Yet For World Energy Transition

In the night sky in the Northern Hemisphere this summer, the planets Jupiter and Saturn are edging closer and closer – heading for their tightest ‘great conjunction’ since 1623. Superstition has it that this event will signal the decisive end of one era, and the start of another.

Investors appear to be thinking that way about the energy sector. In the first seven months of 2020, oil company shares on the NYSE Arca Index fell 42%, while clean energy shares on the WilderHill New Energy Global Innovation Index, or NEX, gained 26%.

That is a far cry from the aftermath of the last deep recession, early in the 2010s. On that occasion, the chorus from conventional energy companies, climate change skeptics and many politicians was that the costs of renewables were too high, shale gas was cheap (at least in North America), consumers could not afford relentless increases in energy bills, and neither could governments.

Sure enough, countries in Southern Europe introduced retroactive cuts in feed-in tariffs, putting renewable energy investment there into the deep freeze. Former Australian Prime Minister Tony Abbott closed down the country’s carbon market. Climate change became a political football in the U.S. from early in the decade, culminating in President Donald Trump’s decision in 2017 to withdraw his country from the Paris Agreement.

That backlash did not kill off decarbonization. When one wind or solar market shrunk, another surged, and both technologies achieved spectacular reductions in cost. So – later in the decade – did batteries and electric vehicles. But the clean energy transition had to get through some worrying times first.

The world economy is now trying to begin its recovery from the coronavirus slump, in which (we all hope) GDP hit its rock-bottom in the second quarter of 2020. This time, investors have stayed bullish about low-carbon technologies – or even become more so.

On financial markets, four clean energy stocks tripled in value from the beginning of January to July 23, and another eight doubled. The surge was led by Tesla, which saw its market capitalization touch $300 billion, more than any other car company. Stalwarts such as Orsted and Vestas Wind Systems hit all-time record highs. When U.S. residential solar company Sunrun announced in July an agreed $1.5 billion takeover of rival Vivint Solar, both shares doubled in the ensuing three weeks.

Remarkably, global investment in renewable energy capacity actually increased in the first half of 2020. BloombergNEF’s authoritative figures showed a 5% rise over 1H 2019, to $132.4 billion. Offshore wind was the star sector, with $35 billion invested in projects in Europe and East Asia, up an eye-watering 319% year-on-year.

Companies have continued to make decarbonization commitments – some 22 joined the RE100 group in the first half of this year, only one less than in the same period of 2019. The world’s largest-ever corporate power purchasing agreement, or PPA, was signed by Taiwan Semiconductor Manufacturing Company in July, covering 920MW of output from an offshore wind project off the island’s coast (client link).

No government has responded to the economic crisis by downgrading its efforts to reduce emissions, and some – in the European Union, for example – have promised “green stimulus” spending to create jobs and activity. Overall, BNEF had tracked by July 2 some $54 billion of such commitments (client link), with electric transport and hydrogen the sectors attracting the most.

The zeitgeist of this moment in 2020 also tends to favor the low-carbon cause. Business travel is out (at least for a while), video-conferencing is in, a healthy lifestyle is in, resilience for companies and societies is in, thinking about the nexus between the natural world and human encroachment is in, worrying about the costs of decarbonization is out. The latter seems small beer when the world economy is likely to shrink by 5% this year alone, and world governments are forecast to run deficits equivalent to 14% of GDP this year, according to the International Monetary Fund’s World Economic Outlook, published in June.

However, when the mood is one-way, that is exactly the time to remind ourselves that risks do not disappear – or if they do, they are quickly replaced by new ones.

I see five big hazards facing the low-carbon transition from the second half of 2020 onwards. The first of them concerns the months ahead and into next year, the others are more likely to have an impact in the medium term. Here they are:

1. Long pandemic

Over recent months, BloombergNEF has been analyzing the outlook for the sectors of the low-carbon transition that it covers, using three scenarios: the single-wave, the multi-wave, and the ‘enduring’ pandemic.

The third of these scenarios would be bleak for all our personal circumstances. It would also threaten the momentum in low-carbon energy and transport. The pipeline of deals that passed their preliminary, eyeball-to-eyeball stages pre-Covid would soon be exhausted. Economic damage could be vast, squashing consumer spending on new cars and solar panels. Governments could be under so much pressure that they become unable to address non-virus, non-unemployment issues.

Even if the outcome is not as bad as that, there is a high chance that the Covid-19 emergency will get stuck in a stubbornly inconclusive phase. If the disease proves impossible to marginalize, and the world economy inhabits a halfway house between lockdown and recovery well into 2021, business and investor confidence may slide further.

So far, it has been investment in oil fields, and the longevity of coal-fired power stations, that have taken the brunt of the economic impact on the energy sector. But clean power and transport could expect to suffer too, if electricity demand (and prices) undershoot expectations for a long period, and if policy-makers lose focus on emission goals.

2. The unsubsidized era

The next risk is of something resembling the blow that subsidy-enriched renewable energy projects in Southern Europe suffered in the early 2010s – namely that the revenue support investors thought they could rely on, suddenly disappeared. This time, the problem might come from the private sector rather than from governments reneging on their commitments.

An increasing number of wind and solar projects are going ahead on the basis of five-, 10-, 20-year PPAs with utilities or corporate electricity buyers, and a few even on a pure merchant footing (where the power is traded short-term or the price is fixed for only 1, 2, 3 years at a time).

There is a great deal of entrepreneurial activity going on in this area. New models for financing wind and solar projects are being hatched – clients can read here about some big new deals of this sort in Europe. Banks are increasingly willing to finance them, albeit at much lower debt-equity ratios than the old 80:20 figure from the feed-in tariff era.

I wish this trend well. However, there are clearly risks. Market electricity prices could fall sharply in the 2020s (we saw a glimpse of this in some countries in March to May this year, when power demand slumped). Weak economies, and/or hectic renewable energy build-out, could result in chronically low power prices this decade.

If so, counter-party risk would loom large. Some corporate buyers could feel pressure to renegotiate, or even default, on their PPAs. Some might even go bankrupt, effectively canceling previously agreed power purchase deals. And utilities that backed PPAs could also be under financial pressure, and struggling to honor them.

There is a related concern, which is that a prolonged period of depressed electricity power prices – even if it does not cause counterparties to choke on deals that have been done – could simply deter corporate and utility buyers from agreeing PPAs at prices high enough to make new projects viable.

Meanwhile, the pure merchant model could fizzle out if the few projects already built on that basis are struggling to get prices for traded electricity that are high enough to cover debt interest or deliver returns to equity investors.

3. More expensive capital

Number three is certainly not an August 2020 risk. But it could be a 2022 or 2023 or 2024 danger. Right now, the cost of capital for renewable energy projects is about as low as it has ever been. For instance, BNEF estimates are that new wind and solar farms in core Europe can be financed at an all-in debt cost of 2% to 2.5%, and even lower in Germany (client link).

This reflects narrow margins on project finance loans, but also rock-bottom central bank interest rates and interest rate swap costs (driven in turn by government bond yields that are down at 10-year figures of 0.5% for the U.S., and minus 0.6% for Germany).

This low cost of borrowing has two effects. One is ensuring that many new projects make sense that might not have been economically viable at higher debt costs. The other is underpinning the cost-competitiveness of new wind and solar (where most of the lifetime cost is upfront and therefore has to be financed upfront), against feedstock-dependent generation options such as gas and coal.

Could the interest rate trend turn, and spoil this party? Admittedly, I have been wary of this happening several times over the last decade, and it still has not happened. Maybe the 2020s will continue with the rock-bottom interest rates of the 2010s, but it is at least worth considering the possibility that they might not.

One possible reason is the colossal budget deficits that governments are now running. These have to be financed by greatly increased issuance of government bonds. To make further heavy bond issuance palatable to investors once recovery is fully underway may require treasuries to offer higher yields (interest rates). Alternatively, central banks could print money to buy the bonds and cancel them, but that might generate inflation, and in turn higher borrowing costs.

In the U.S., there is another question mark over capital for renewable energy. That comes from its tax equity market, which has been key to financing countless solar and wind projects while the Production Tax Credit and Investment Tax Credit have existed. Corporations choose to invest in renewable energy project tax credits to shelter their profits.

The PTC and ITC still have a few years to run, until their phase-downs are complete – and it is possible they could be extended yet again, by a post-election Congress. But many corporations are seeing their profits hammered by the Covid recession. Will enough of them still have appetite for tax credits, or will renewable energy projects suddenly run into a shortage of this type of capital?

Globally, there may also be a bigger issue out there. There is an increasing buzz in policy circles about restricting the deductibility of interest payments from taxable profits, partly as a way to raise government revenues and partly to discourage high leverage in the corporate world. The EU is pursuing this already, as is the OECD as part of its BEPS (base erosion and profit shifting) initiative. Some jurisdictions have already started to move on this. If change happens in a decisive way, the implications for private equity and company share buy-backs could be immense. It could even impact the on-balance-sheet and project finance methods of funding energy projects.

4. Geopolitics

The danger here is partly to international efforts on decarbonization, and partly to the relatively liberal international trade regime that has delivered sharp cuts in costs of low-carbon technologies over recent years. Relationships between the West and China have become more strained than they were in, say, 2010. The Trump administration has contributed to this, but across the political spectrum there is now much more skepticism than before about Chinese intentions generally, and about the reach into Western infrastructure of its technology leaders such as Huawei. India, meanwhile, has clashed with China in the Himalayas.

This strain between these main players in climate change negotiations will only make international agreements, from the delayed COP26 next year onwards, more difficult to achieve. Policy targets to cut emissions are only one driver of decarbonization nowadays – the raw economics are even more powerful – but when G20 governments set the long-term direction of travel, it does help corral reluctant smaller economies and corporations to make their own moves.

On trade, the advance of renewable energy and electric vehicles through international markets has benefited from fierce competition, and specifically the ability of Chinese manufacturers to undercut developed-economy rivals. PV panels have been a lousy market for manufacturing profit margins, but they have been a great one for price-conscious solar developers. Something similar has been happening with batteries, and may happen with basic EVs.

The Trump administration took a protectionist step with its tariffs on Chinese crystalline PV modules, a move that kept costs higher for U.S. solar investors than they would have been otherwise. A much wider and decisive shift toward trade barriers and away from globalization could lead to industries breaking up established supply chains and ending up with a lot more local manufacture. The resulting upward pressure on costs would be to the detriment of the rapid spread of low-carbon technologies.

5. Technologies can disappoint

The 2010s were the decade when technologies such as solar PV, electric cars, lithium-ion batteries and offshore wind made huge strides on reliability and cost-competitiveness.  (Onshore wind had made perhaps half of its journey in the previous decade.)

Some other technologies have not quite made it. Solar thermal generation has struggled with cost-competitiveness against PV. Despite the occasional big project in the Middle East or at either end of Africa, it remains a relatively small sideshow. Second-generation biofuels, based on non-food plant materials, were promising – but that is where they remain (promising). Wave energy technology foundered. Tidal stream energy showed viability, but is up against it on cost terms against offshore wind. Carbon capture and storage has remained (almost entirely) on the drawing board.

Some technologies that currently look fresh and shiny may not look so clever in 2030. A lot of investor and corporate excitement now surrounds hydrogen, and its possible role as a replacement for coal and gas in industrial heat, the domestic heat network, in heavy transport and in seasonal electricity storage.

BNEF has led the way on understanding the dynamics with a stream of research over the past 12 months. However, hydrogen – particularly ‘green’ hydrogen made via electrolysis – has an enormous amount still to prove, particularly on cost reduction potential. Transport and safety also remain question marks.

Such is the bullishness in the EV market at present that a shake-out seems inevitable at some point. Making high-quality vehicles is still difficult, and many of the new manufacturers raising money are chasing the same segments. The market is looking increasingly crowded just as direct purchase subsidies are starting to be phased out.  Fossil fuel cars are not finished yet, and may be able to fight back with ultra-efficient petrol models, helped by depressed oil prices. The attitude of mass-market consumers is still an unknown – early adopters may love EVs, but that does not mean that average buyers will too, even if they are bombarded with figures on relative costs. Right now, EVs are less than 1% of the global vehicle fleet.

I started this article off with Jupiter and Saturn. Planetary conjunctions like the one that will reach its climax in December come around every so often. So do economic recoveries. But every economic upturn I can remember – and there have been a few – has seemed like hard grind at the time. They are often described as “joyless” by the media. It would break with precedent if the coming recovery was all Champagne and chocolates, even for the clean energy sector.