Wealth Insights | Weekly Market Analysis | Sustainable Investing | Asset Allocation
Weekly Market Analysis - Renewed Interest in Renewable Energy
Posted on3 Things to Know
It Will Get Easier Being Green
Due to its heavy use of leverage, the Renewable Energy sector is especially rate sensitive. It also could have a higher level of intrinsic growth than other equity bond proxies.
As central banks around the world normalize rates, financing cost reductions will boost the profitability of many renewable energy companies. We expect as rates normalize and governments improve policies, the industry can enter a more sustainably profitable phase beginning in the second half of 2024.
Solar Powers Ahead
Solar and wind power are in a phase of exponential growth where the likelihood of disruption is real. Solar installations in 2022 accounted for 56% of all new electricity generation worldwide, despite only accounting for 5% of the installed base.
Renewables Could Threaten Fossil Fuels in the Decade Ahead
Asset risk has already become a reality for coal-powered electricity production in the developed world. As prices for new renewable power continue to fall, that threat will likely grow for other fossil fuels.
Summary
We believe that green assets, including renewable energy, are preparing to recover from 2023’s setbacks. In the Wealth Outlook 2024, we highlighted the attractiveness of renewables and the headwinds they faced due to a business model that is dependent on debt.
High interest rates have crushed renewable energy valuations bringing down forward price-to-earnings (PE) 70x to and estimated 22x. Lower rates will create an opportunity for renewables. For the sector to mount a sustainable recovery, however, a rebound in profitability along with sustained government support will be essential.
In our Wealth Outlook 2024, we did not include renewables as an unstoppable trend for portfolios, but highlighted how a turn to lower rates would drive a reversal of fate for the beleaguered segment. As we move closer to a start of easing by both the Fed and the ECB, entry points for this highly rate sensitive segment look increasingly attractive and have the potential to drive value in portfolios.
Portfolio considerations
Renewable energy investments are more impacted by interest rates and debt levels than market cycles. We believe this sector is poised to grow – and become a potential portfolio opportunity – as interest rates and inflation normalize. Over time, this will present a competitive challenge for fossil fuel energy production. Policy support from governments, scalability and unsubsidized price advantages are all firmly in the renewables’ corner. For the sector to mount a sustainable recovery in markets, however, evidence of profitability improvements across the solar, wind, and battery landscape will also be necessary.
Source: FactSet, March 13, 2024.
It Will Get Easier Being Green
Government policy support is essential for a sustained recovery in renewables. Government policies create financial incentives that will power the growth of renewable energy. These incentives take multiple forms, including subsidies, direct research and development funding, tax benefits associated with R&D, faster grid integrations and net metering (allowing customers to sell excess electricity back to the grid). In developed markets for fiscal years 2016 through 2022, the Energy Information Administration (EIA), an independent agency of the U.S. Department of Energy, found that traditional fuels (coal, natural gas, oil and nuclear) received 15% of all subsidies, while renewables, conservation and end use received 85%.
Policies including the US Inflation Reduction Act (IRA) and EU Green Deal have also increased the rate of adoption of renewable energy. In addition, Power Purchase Agreements (PPAs) can boost renewable energy deployment by providing renewable energy producers with a predictable revenue stream by securing a pre agreed price for the consumer. Renewable energy still dominates energy subsidies in FY 2022. In response to the market impact of higher interest rates, interest rate guarantees and subsidies may be added to the list of renewable policies. Giving manufacturers and producers access to lower cost financing can create wide benefits relative to direct subsidies.
Solar Powers Ahead
Over the last 10 years, solar power production has grown at a 30% annual rate, while wind has grown at a 15% rate. While the increases in renewable capacity in Europe, the United States and Brazil reached record levels, China added as much new solar PV in 2023 as the entire world did in 2022, while its wind capacity grew by 66% year-on-year.
For investors to potentially benefit from the exponential growth of renewables, they need to stay invested. This requires that the growth story be understood. Every year, the International Energy Agency (IEA) makes a forecast for the growth rate of new annual solar photovoltaic (PV) additions, and they typically assume linear growth from the prior year. Yet, the actual history of additions has shown exponential growth. And this puts the world’s targets for renewable electricity within reach.
Renewables Could Threaten Fossil Fuels in the Decade Ahead
The renewables sector is experiencing exponential growth in size as the world’s electricity system is undergoing an accelerated rate of transformation. While PV power accounted for 56% of new global electricity installations, it still only accounted for 5% of total power production in 2023. Demand for energy is on the rise, too. Greater onshoring of manufacturing capacity and Artificial Intelligence server farms, coupled with the electrification of heat and transportation, have dramatically increased forecasts for electricity demand in the developed world after years of stagnation.
While the greening of the global electricity grid continues to be an unstoppable trend, brutal competition and rate sensitivity have weighed on renewable energy shares. We see value being restored in this sector. We continue to see output growth for this sector beyond what is typical in the rest of the market, with solar installations having grown for example at 30% annually on average for the last 10 years. If we are right, renewables may become a more attractive way to exploit a turn in rates than other classic “bond proxy” sectors, as the growth rate of the segment should drive long term equity gains even as fierce competition keeps EBITDA margins constrained.
“Alignment” Ahead of the Fed
The Federal Open Market Committee (FOMC) meets this coming week (March 20) and while markets are not pricing in cuts until July, we are likely to glean more about its thinking from an update to the Fed’s quarterly “dot plot”. Chair Powell may also provide additional color around progress towards the Fed’s goals following slightly higher inflation and mixed employment indicators so far this year. We believe the Fed will cut rates once disinflation resumes, though easing could be more modest than in previous cutting cycles. Despite a shallower path for the Fed Funds rate, and while always susceptible to short-term volatility, the stock market should continue to grind higher over the next 12-18 months on the back of nearly 15% EPS growth in 2024 and 2025.
