Forecasters at the International Energy Agency anticipate that over the next 20 years $10trn will be invested in renewable assets. In the shorter term, by 2024, they expect new capacity installations to bring renewable power to 200 million homes around the world. By Will Argent
The rapid evolution in renewable energy has been prompted by legislators and the dawning realisation that we can and must do less damage to our precious planet.
There is still a very long way to go and we are still at the beginning, so for investors there are plenty of opportunities to participate in and support this emerging, but enduring, transformation.
Energy efficiency has recently come into focus, and the opportunities to make improvements are vast and span all areas of the economy."
The early entrant renewable energy companies are already very substantial. They have relatively simple business models and throughout this troubled year they have remained largely unaffected by the market turmoil brought on by the ravages of Covid-19.
But to invest globally takes great skill and knowledge of the underlying issues that drive prices and valuations.
There are four aspects underpinning the renewable energy sector and broader decarbonisation theme.
Power purchase agreements
As government subsidies for renewable energy assets wanes, private investment will be crucial to ensuring the continued development and build out of renewable energy assets. To encourage investors with the vast sums needed at their disposal, long-term and detailed financial planning is required.
The sector has developed a simple pricing model which provides renewable energy companies with an element of predictability for the value of the electricity they generate.
In North America in particular, renewable energy companies negotiate long-term contracts with utility companies (and increasingly, large corporates) through which a pre-determined price is agreed.
Both parties are able to determine with some accuracy their long-term revenues and costs.
These contracts are known as power purchase agreements (PPAs), which, as the name suggests, are agreements between two parties for the sale of electricity at a pre-determined price for an agreed and often lengthy period of time.
For other parts of the world, considerable time and effort has been expended predicting power pricing and the trends to which the sector is exposed.
Electricity prices are usually linked to the prevailing and forecast price of gas, which fluctuates depending upon economic activity. Over the past year or so, electricity price forecasts have been under pressure, owing to a range of dynamics.
On the supply side, a general oversupply of oil and natural gas has weakened pricing (electricity prices are still somewhat linked to the trajectory of gas prices) while on the demand side, the coronavirus pandemic and resultant cessation of economic activity meant that demand fell sharply during March and through the second quarter of 2020, compounding the price weakness.
Nevertheless, we have observed a sharp improvement in pricing in Europe and the UK since the lows of April and May, with spot prices moving beyond pre-pandemic levels in many areas.
Moreover, futures prices have firmed significantly and while futures markets may only 'go out' a few years in key markets, this improvement is of importance.
If renewable energy companies value future cash flows based on energy consultancies' price forecasts and those forecasts are at odds with the reality of what may be presently achieved, as we see now, then the challenges and inaccuracies resulting from using long-term price forecasts to drive asset valuations becomes apparent.
While we know that there will always be a market for clean electricity, it is not always possible to forecast how much is likely to be generated and when, dependent as it is on the weather. A sunny, but breezy day in midsummer can lead to a huge oversupply when we least need it.
In order to harness the increase in intermittent renewable energy production, a new and logical market in industrial batteries has developed in recent years.
These batteries enable generators to store excess electricity, before releasing it back into the grid when generation is below requirements.
Sadly, and like the rest of the world, the UK wastes more than 50% of the electricity it generates. The wastage occurs as a result of inefficient transmission, from generator to consumer, as well as during consumption.
In the case of fossil fuels, a significant amount of the energy generated is used to aid the burning of yet more fuel.
Energy efficiency has recently come into focus, and the opportunities to make improvements are vast and span all areas of the economy, whether it is increasing the performance of buildings, improving efficiencies within energy generation and distribution, or efficiencies linked to transportation and industrial/agricultural production.
Sustainable Development Capital (an established specialist in energy efficiency project development) estimates that up to 75% of the original energy resource is lost through the process of generation, transmission & distribution, and end usage.
Meanwhile, the International Renewable Energy Agency forecasts that of the $120trn of global energy sector investment required to achieve the ambitions laid out in the Paris Climate Accord, 44% will need to be directed towards energy efficiency.
With numerous areas of the economy required to improve credentials in this regard - as well as the commercial incentive to reduce costs and wastage - we expect to see an increase in capital flowing to the energy efficiency sub-sector.
All of the issues explored here mark out many opportunities for investors to participate in the rapidly growing renewable energy sector.
The foundations are in place for the wall of money being pumped into the sector to increase significantly, and investors are now able to access this theme in its early stages while there are still attractive returns to be had.
Will Argent is adviser to the VT Gravis Clean Energy Income fund
(First published by our sister title Investment Week)