Most long-term investments in infrastructure, be they toll roads, railways, hospitals or conventional power generation rely on stable government policy. Investors in infrastructure understand those policy risks, and balance them against the long-term, relatively stable returns offered by the asset class. Renewable energy investments are no different.
Professional investors generally base their investment decisions on rigorous analysis rather than gut feelings and unchallenged preconceptions. However, when it comes to renewable energy, many investors are unwittingly deterred by three myths – around subsidies and oil prices – that could lead them to miss out on the opportunities presented by a revolution in energy generation.
Renewable energy is uncompetitive and depends upon government subsidies to compete with traditional fossil fuel generation.
In challenging fiscal times, the argument goes that these subsidies are vulnerable, making these investments high-risk.
It is true that many renewable energy projects benefit from government support, whether in the form of tax breaks or guaranteed prices for the power they generate. But this observation obscures a wider truth: almost all energy is subsidized in one way or another.
The International Energy Agency has calculated that global oil, gas and coal generation was subsidized to the tune of $550 billion in 2013, compared with just $120 billion for renewables1. According to the International Monetary Fund, these subsidies cost much more: if you include the failure of governments to price and tax fossil fuels to take into account the environmental and climate damage they cause, that subsidy increases to $1.9 trillion a year2.
Rather than propping up expensive technologies, subsidies for renewable energy merely serve to level an uneven playing field. The eventual removal of ALL energy subsidies would actually serve ALL participants in the energy sector well.
Renewable energy detractors also choose to ignore the fact that a large number of significant technological advances have benefitted from government investment; aerospace, computing, nuclear energy – even coal-fired power generation – were all initially supported by generous public funding.
Renewable energy projects are more vulnerable than other infrastructure projects to changes in government policy
The days of government subsidy are gradually drawing to a close in most countries. For many years and in many parts of the world, subsidies for renewable power projects have underpinned a significant expansion of capacity and often internalised some of the (external) costs of fossil fuel combustion, for example air pollution.
Most subsidies are typically paid for (indirectly) by ratepayers rather than from the government’s accounts, and thus less attractive as a means to reduce a budget deficit.
Renewable power generation projects in the US and Europe sell their power under long-term contracts, either under pre-specified pricing or at prevailing “merchant” prices. In the US, wind and solar projects have benefited from long-term investment tax credits (or their equivalent) but these are scheduled to be phased out in 2016. Many European countries are also phasing out support for feed in tariffs over the next few years.
Where longer term subsidies persist, governments can, of course, find ways to renege on these deals and expropriate from investors. However, as we have seen in Spain, it would do so at the risk of permanently discouraging further investment. But there are many instances in other infrastructure sectors where governments have reneged on their commitments. For example major rail projects in the UK, conventional power generation in India, and long-term funding of transportation infrastructure projects in the US.
It’s also worth noting that government support for renewable energy has done exactly what it was intended to do: helping to bring down its cost. Due to rapid growth in demand and Chinese state support for manufacturing, solar panel costs have fallen by up to 90% between 2010 and 2014, and many onshore wind sites are now able to compete directly, without subsidy, with conventional fossil fuel power.
As technology costs fall, we are approaching a series of tipping points as unsubsidized renewable power systems become directly cost competitive in major markets. As that happens, the valuations of listed renewable energy companies – whether equipment makers, project developers or the projects themselves – look set to soar. Investors in public equities might be well advised to buy into the sector earlier, rather than attempting to finesse the timing of those moves.
Falling oil prices have a significant adverse impact on renewables
This myth has deep roots. A rout in the oil market in the 1980’s did enormous damage to a nascent alternative energy sector that had grown rapidly in response to the two oil shocks of the 1970’s. At this time there was a much closer relationship between the oil price and the price of electrical power. Now, oil accounts for just 5% of power generated worldwide, compared with 22% for renewables3.
Many investors are still stuck with this memory or retain the misperception, and as the oil price tumbled in the second half of 2014 we saw a rush for the exit. In March 2015, some benchmark solar companies were trading 30% below their mid-2014 peaks4. Actually, this misperception about the relationship between oil prices and renewables provides a compelling investment opportunity – to buy into a sector destined for massive growth, irrespective of where the oil price heads over the years to come.
So, it’s time to lay the myths to rest. Forward thinking investors should recognize the long-term opportunity as the world slowly but steadily transitions from fossil energy to renewable energy.