Europe has led the drive to generate electricity from renewable sources, a trend that is gathering pace around the world and will create a wide array of opportunities for investors.

After a few false dawns, renewable energy is moving into the mainstream. Europe led the race to generate a significant proportion of energy supplies from renewable sources, but other regions are catching up fast. The drive towards renewables began in countries such as Germany in the early 1990s, but Europe’s charge gained fresh impetus in January 2008, when the European Commission published its legally-binding `20 20 by 2020` package. It included proposals for reducing the EU’s greenhouse gas emissions by 20 per cent and increasing its proportion of final energy consumption from renewable sources to 20 per cent by 2020[1].

Despite being the world’s biggest source of carbon dioxide emissions, China is also likely to emerge as a major player in the renewables sector in the coming years[2]. The government set out robust environmental targets in its 13th Five-year Plan covering the period 2016-20, including energy intensity, carbon intensity and a new cap on total energy consumption.

“China's energy sector is set for a major transformation as the dominance of coal gives way to natural gas, nuclear power and renewables,” says Stephanie Maier, Director of Strategy and Research, Global Responsible Investment, Aviva Investors.

Meanwhile, progress in the US has been hindered by advances in shale drilling technology, and this has proven a disincentive to invest heavily in green energy.  The election of Donald Trump as president could further hinder the development of renewable energy sources in the US, at least in the short-term.

During the election campaign, the president-elect pledged to implement an “America First Energy Plan” by exploiting “$50 trillion in untapped shale, oil and natural gas reserves, plus hundreds of years in clean coal reserves”[3]. Trump has promised to reverse the Obama administration’s commitment to fighting climate change, and many of the people chosen for senior positions in his administration have expressed doubt that human activity has caused climate change. However, Trump appears to have softened his stance on quitting the Paris agreement to combat climate change[4].

Elsewhere, Japan and other countries with large coal reserves tend to be laggards in the adoption of renewable energy. “Japan is less keen on the nuclear energy option following the Fukushima Daiichi accident, which resulted in the closure of almost all its nuclear plants and a massive planned increase in coal capacity,” explains Maier. Four coal plants are currently under construction with a combined capacity of 1.9 Gigawatt (GW), while 49 plants, comprising a capacity of 28 GW, are at various stages of planning[5].

However, the amount of planned and under construction coal-fired generating capacity in Japan greatly exceeds the capacity required to replace the retiring fleet, according to a report by the Smith School of Enterprise and the Environment at the University of Oxford, published in May 2016. It warns that this “may result in overcapacity and combined with competition from other forms of generation capacity with lower marginal costs (e.g. nuclear and renewables), lead to significant asset stranding of coal generation assets[6].”

Powering up Europe

Europe’s progress in renewables is underpinned by favourable legislation. Many European countries adopted a Feed-in-Tariffs (FITs) regime to encourage the uptake of renewable and low-carbon electricity generation technologies. These schemes offered long-term contacts to renewable energy producers and were priced above the market price of energy. The aim was to encourage investment in renewable schemes that produced economies of scale and propelled the development of new technologies to eventually reduce the cost of production – and hence the level of subsidy for the next generation of assets.

European governments are in effect subsidising renewable energy producers. However, both developing and emerging markets are also heavily subsidising fossil fuels. The Organisation for Economic Cooperation and Development estimates around US$200 billion per annum is spent on fossil fuel subsidies[7]. The International Energy Agency (IEA) places an even higher figure on fossil fuel subsidies, which it estimates amounted to US$493 billion in 2014[8]. By contrast, the IEA estimates subsidies to aid the deployment of renewable energy technologies amounted to US$112 billion in 2014, with another US$23 billion spent on supporting biofuels[9].

Renewable energy can be broken down into a few main categories: biomass; wind; solar; and hydroelectricity, with geographic-focused reliance on geothermal power. The latter is regarded as a legacy source since it has been generating relatively large amounts of energy for more than a hundred years. The latest figures from Eurostat show the considerable variance in the use of renewable energy sources across the European Union.

 

Figure 1: Share of renewables in gross final energy consumption, 2014 and 2020

Source: Eurostat Renewable energy statics explained, July 2016 http://ec.europa.eu/eurostat/statistics-explained/index.php/File:Share_of_renewables_in_gross_final_energy_consumption,_2014_and_2020_(%25)_YB16.png

Countries such as Norway and Sweden have exploited natural advantages of topography to generate a large proportion of their needs from hydro electricity. By contrast, the likes of Denmark and the UK have focused on wind power, while Spain and Italy have targeted solar. The UK and France are laggards and may not reach the EC’s 2020 target; partly because they started investing in renewables later than other European countries, but also because they do not have as much solar or hydro potential as, for example, Italy or Spain, according to Alessandro Rovelli, Senior Credit Analyst, Aviva Investors.  The French can make a strong argument that their focus on nuclear generation has reduced CO2 emissions significantly.

Figure 2: Share of renewables in gross inland energy consumption, 2014 by percentage

Source: Eurostat Renewable energy statics explained, July 2016 http://ec.europa.eu/eurostat/statistics-explained/index.php/File:Share_of_renewables_in_gross_inland_energy_consumption,_2014_(%25)_YB16.png

The UK has made significant progress over the past 10 years. Renewables met 8.3 per cent of final energy consumption in 2015,[10] compared to 1.3 per cent in 2005,[11] according to the government. The most rapid expansion has taken place in electricity generation, with renewable electricity accounting for almost a fifth of total generation in 2014[12]. Investment in renewables amounted to £8 billion in 2015, according to the government, adding that the UK is set to meet its “ambitious” target of generating 30 per cent of electricity from renewables in 2020[13].

Wind is the most viable renewable source of energy in the UK, according to Rovelli. A Bloomberg New Energy Finance (BNEF) report published in October 2015 supports this view. It found that onshore wind energy is now the cheapest way to generate electricity. The cost of onshore wind power, which produces about 60 per cent of the UK’s wind power output, had fallen from US$108 per tonne in October 2014 to $85, according to BNEF. By comparison, the cost of producing electricity from coal amounted to $115 per tonne, while the figure for gas was $114 per tonne[14].  

Meanwhile, the cost of generating electricity from offshore wind farms is also falling fast. In October 2016, BNEF estimated the benchmark (weighted average) costs of generating electricity from offshore wind globally at US$126 per megawatt-hour in the second half of 2016, down 22 per cent from the first half of 2016 and 28 per cent from the second half of 2015[15].

BNEF’s long-term forecast points to further falls in the costs of generating electricity from renewables. It anticipates wind and solar costs will fall sharply over the next 25 years and onshore wind and solar will be “the cheapest ways of producing electricity in many countries during the 2020s and in most of the world in the 2030s”[16] .

Living off the grid

However, there is a problem associated with renewables, namely the need to store and transmit the intermittent energy they generate. National grids can only function effectively when renewable energy accounts for a relatively small proportion of output.

Traditional grids radiate energy from relatively few large power sources to the end users. In future, as dependency upon renewable energy increases, `smart` grids will be required. They will have the capability to harness power generated from tens of millions of sources, such as private homes, whose occupiers sell solar and wind power back to the grid.

Smart meters, which can monitor energy flows and improve consumption, are the building blocks upon which smart grids are built. A national rollout is taking place in the UK, which will see 53 million meters installed in around 26 million homes between 2015 and 2020[17]. Meanwhile, the EU aims to replace at least 80 per cent of electricity meters with smart meters by 2020[18].

Energy utilities are also investing heavily in smart meters. By August 2016, the Spanish utility Iberdrola, for example, had installed eight million smart meters in Spain as part of its STAR (Remote Grid Management and Automation System) project. It aims to complete the installation of 10.5 million smart meters by 2018.

Smart meters bring advantages to consumers by providing detailed information about their power consumption. By displaying real-time energy use and costs, smart meters should encourage consumers to alter their consumption habits, resulting in savings on their energy bill.

But smart meters, and the smart grids they enable, also bring significant benefits to power suppliers such as Iberdrola. Smart meters establish a new two-way communication channel with customers, and provide a wealth of information about consumption patterns, which utilities can use to manage their power output more efficiently. Meanwhile, smart grids are more efficient and less capital intense than traditional grids.

As a result, utilities can use smart grids “to optimize staffing levels at power plants and manage the intricate energy terrain of renewable and conventional sources, trading options, and patterns in demand”, according to a report by McKinsey, published in May 2016[19]. This can result in very large cost savings.

Moreover, smart grids enable utilities to respond intelligently to variations in supply and demand, allowing energy to firms to operate tariffs under which householders pay more for watching television or running other goods, such as washing machines, during the morning and evening “rush hours”.  This flexibility could reduce peaks in energy use and even eradicate the need for new power stations.

In addition, smart meters can identify early which customers are at risk of default and bringing costs saving in eliminating the need to employ staff to read meters in customer homes. They can also increase customer retention.

Smart grids are now beginning to be used on electricity networks. In the UK, for example, Centrica launched a trial to develop ‘a virtual energy market’ in Cornwall in December 2016 that allows local businesses to sell energy back to the grid. In October 2016, data was transmitted across the national electricity grid for the first time, in what “could be a significant step towards the creation of virtual power stations, where many thousands of homes and businesses combine to manage electricity use more smartly”, according to The Guardian[20].

Investment implications

Rovelli believes there are a number of companies that should benefit from the growth of renewables. They include Centrica and SSE, “who are collecting renewable subsidies from the UK government and have developed a large number of wind farms in partnership with other companies”, says Rovelli. Their partners include DONG Energy of Denmark, reportedly the global leader in offshore wind power, and also well placed according to Rovelli.

To give an idea of the size of the subsidies these firms are reaping, Dong owns or part-owns eight operational UK offshore wind farms, comprising two-fifths of the UK’s existing 5.1-gigawatt (GW) offshore wind capacity. According to figures from Ofgem, the independent energy regulator for Great Britain, these wind farms received subsidies worth at least £650 million in 2016. Based on Dong’s stakes, it could have been entitled to receive more than £250 million of that money[21].

Rovelli says that although the three companies face some construction risk in building offshore wind farms, they are guaranteed future payouts if they keep the wind farms running. They are also well placed should other parts of the world, such as the US, Latin America or Africa, decide to develop offshore wind farms.

Wind turbine suppliers such as Siemens of Germany, Vestas Wind Systems A/S  of Denmark and General Electric of the US, among others, should also benefit from heavy investment in wind-generating capacity in the coming decades.

Infrastructure investment

The 2016 BNEF’s New Energy Outlook forecasts that around $11.4 trillion will be invested in global power generation over the 25 years to 2040. Around two-thirds of this sum, or $7.8 trillion, will be invested globally in renewables. Of this, $3.1 trillion will be invested into onshore and offshore wind power, while $3.4 trillion will go into utility-scale, rooftop and other small-scale solar projects, and $911 billion will be invested in hydro-electric power[22].

Ian Berry, Head of Infrastructure Equity at Aviva Investors, says that while many investors focus on larger investment opportunities, typically requiring a commitment of between £200-500 million, there are – particularly in renewables infrastructure – many smaller opportunities (perhaps below £10 million per asset). He believes there are opportunities to build platforms to acquire such assets.

“Large scale projects tend to be the focus for traditional infrastructure investors, however, by designing a standardized approach to both acquisitions and the ongoing management of assets it is possible to drive process and cost efficiencies sufficient to justify the time and effort of dealing with many, many individual assets,” he explains.

Renewable and other infrastructure projects tend to have long-term, low-risk characteristics, including the promise of stable cashflows, which are often inflation-linked. They also provide diversification and, given their relatively illiquid nature, offer a premium over other investments. Berry believes these factors should clearly appeal to pension funds and other institutional investors. Carbon savings and the positive impact of renewable projects on the environment are an added bonus.

One obstacle to increased investment in renewables is that pension funds and international investors currently tend to have a rigid approach to asset allocation. “A particular pension fund, for example, may allocate 55 per cent to fixed income, and 35 per to equities and just 10 per cent to alternatives. Perhaps a small sliver of the alternatives bucket will be allocated to infrastructure and an even smaller sliver of that to renewables,” explains Berry.

“We believe investors will increasingly seek opportunities to deliver the outcomes they are targeting – for example to deliver stable cashflows to pay pensioners every month, rather than retaining the traditional high level allocation approach. This should mean more than the historic `trickle` of capital being allocated to the infrastructure, including renewables,” adds Berry.  “We also believe it is best to do this on an unlevered basis. Why contaminate the attractive, low-risk yields from investments in infrastructure, including renewables with financial leverage that increases the risk?”

The yields on offer in the renewables sector vary considerably. “Biomass is intrinsically more risky that solar or wind, which means that – managed well – it also generates higher returns in the low to mid-double digit levels on an unlevered basis,” says Berry.

Investors nevertheless need to consider the political risk associated with renewables, notes Berry, who points out that regulatory regimes vary significantly across borders. “Often a government will say if you invest in a wind farm and it's built before a particular date, the investor will qualify for a particular support regime that will guarantee a price, possibly plus inflation over a period of 20 or 25 years. A key question, that was often overlooked some years ago, is what is the risk around a retroactive change in these regimes. All countries/regimes are not equal – even across western Europe” explains Berry.

Germany pursued that course in the early 1990s, an approach followed by France, Italy and Spain in the mid-2000s, and the UK in 2010. However, governments have reneged on their promises. In recent years, Spain has slashed subsidies written into renewable power contracts, particularly affecting solar producers, who have filed law suits against the state.

Other examples include Italy, which has introduced retroactive changes to the FIT scheme for solar power[23]; and the Czech Republic, which has ended subsidies for renewable energy and implemented a tax on solar power plants[24].

However, political risk is clearly associated with investments elsewhere in the energy industry and the trend towards renewables is clear. The IEA predicts that renewables will make large strides in the coming decades but these will largely be related to electricity generation. The IEA says “the next frontier for the renewable story is to expand their use in the industrial, building and transport sectors where enormous potential for growth exists.”

Finally, Maier points out that it is now compulsory for UK-quoted companies to disclose their greenhouse gas emissions, and asset managers around the world are trying to understand climate change transition risks. These institutions, including pension schemes, see climate change as a financial risk with increasing prominence in their asset allocation process. “The main transition risks relate to the Paris Agreement, which aims to limit greenhouse gas emissions and keep global temperature increases `well below` two degrees centigrade. That commitment implies a significant change in the way we currently generate electricity and is likely to have a key impact on sectors such as energy utilities, agriculture, industry and transport,” says Maier.

 

 

[1] The EU’s Target for Renewable Energy: 20% by 2020, House of Lords October 2008 http://www.publications.parliament.uk/pa/ld200708/ldselect/ldeucom/175/175.pdf

[2] United States Environmental Protection Agency

https://www.epa.gov/ghgemissions/global-greenhouse-gas-emissions-data

[3] https://www.donaldjtrump.com/policies/energy

[4] New York Times, November 22nd 2016

http://www.nytimes.com/2016/11/22/us/politics/donald-trump-visit.html

[5] Stranded Assets and Thermal Coal in Japan: An analysis of environment-related risk exposure, Working Paper, May 2016

http://www.smithschool.ox.ac.uk/research-programmes/stranded-assets/satc-japan.pdf

[6] Stranded Assets and Thermal Coal in Japan: An analysis of environment-related risk exposure, Working Paper, May 2016

http://www.smithschool.ox.ac.uk/research-programmes/stranded-assets/satc-japan.pdf

[7] The OECD Inventory of Support Measures for Fossil Fuels, 2015

http://www.oecd.org/environment/support-to-fossil-fuels-remains-high-and-the-time-is-ripe-for-change.htm

[8] IEA World Energy Outlook 2016, November 2016

http://www.worldenergyoutlook.org/resources/energysubsidies/fossilfuelsubsidydatabase/

[9] Financial Times, 26 July 2016

https://www.ft.com/content/fb264f96-5088-11e6-8172-e39ecd3b86fc

[10] UK Energy Statistics, Q1 2016 https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/532938/Press_Notice_June_16.pdf

[11] http://www.publications.parliament.uk/pa/ld200708/ldselect/ldeucom/175/17506.htm

[12]  Third Progress Report on the Promotion and Use of Energy from Renewable Sources for the United Kingdom, January 2016

https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/493857/3RD_UK_PROGRESS_REPORT_ON_RENEWABLE_ENERGY.pdf

[13] Third Progress Report on the Promotion and Use of Energy from Renewable Sources for the United Kingdom, January 2016

https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/493857/3RD_UK_PROGRESS_REPORT_ON_RENEWABLE_ENERGY.pdf

[14] http://www.independent.co.uk/environment/wind-power-now-the-cheapest-source-of-electricity-but-the-government-continues-to-resist-onshore-a6685326.html

[15] Bloomberg New Energy Finance, November 2016

https://about.bnef.com/press-releases/giant-fall-generating-costs-offshore-wind/

[16] Bloomberg New Energy Finance, June 2016  https://about.bnef.com/press-releases/coal-and-gas-to-stay-cheap-but-renewables-still-win-race-on-costs/

[17] https://www.smartenergygb.org/en/the-bigger-picture/about-the-rollout

[18] https://ec.europa.eu/energy/en/topics/markets-and-consumers/smart-grids-and-meters

[19] The digital utility: New opportunities and challenges by Adrian Booth, Niko Mohr, and Peter Peters, published by McKinsey, May 2016.

http://www.mckinsey.com/industries/electric-power-and-natural-gas/our-insights/the-digital-utility-new-opportunities-and-challenges

[20] The Guardian, 11th October 2016

https://www.theguardian.com/environment/2016/oct/11/energy-first-as-uk-successfully-transmits-data-via-national-electricity-grid

[21] http://www.telegraph.co.uk/business/2016/09/10/the-new-viking-invasion-how-denmarks-offshore-wind-giant-conquer/

[22] https://about.bnef.com/press-releases/coal-and-gas-to-stay-cheap-but-renewables-still-win-race-on-costs/

[23] http://www.renewablesinternational.net/italy-imposes-retroactive-changes-to-the-feed-in-tariff-for-pv/150/452/80973/

[24] http://reneweconomy.com.au/czech-follows-spain-in-deciding-to-tax-output-from-solar-power-49694/

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 17 January 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

RA17/0102/30042017