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Don’t be distracted by short-term noise

25 May 2023

Renewable energy shares have experienced a difficult period for returns but are investors missing the bigger picture?

By James Smith,

Premier Miton Global Renewables Trust

Renewable energy shares have experienced a difficult period for returns, but I wonder if investors are missing the bigger picture. So, what has been driving share prices over the past 12 months?

Perhaps the key negative remains the increased interest rate environment and the effect this has on share prices through “discounting” future cash flows at higher rates into present-day values.

I am encouraged that, while central banks may not quite have reached the end of their tightening cycles, market interest rates as reflected in the yields on traded government debt, appear to have reached a plateau. This should be positive for the sector as the dampening effect that increasing yields have on valuation multiples begins to abate and possibly goes into reverse toward the end of 2023 or early 2024.

However, politics remains difficult. On the one hand, Europe’s politicians talk a good game about wishing to see more renewable energy but, on the other, have imposed “windfall” taxes that have increased investment risk and will take money out of the sector, which could have been used to fund new development.

Given the recent falls in electricity prices, the amounts collected through these taxes are likely to be well below initial expectations; their benefits being more than outweighed by the additional risks borne by companies who will naturally demand higher investment returns, via higher power prices, to compensate them for increased political risks.

The US has taken a more incentive-based approach to renewable energy development, offering tax credits rather than windfall taxes. A migration of capital across the Atlantic, and a realisation that windfall taxes are doing more harm than good, may hopefully lead to a change of heart among Europe’s politicians (nice if it happens, but I’m not holding my breath). 

On the positive side

While investors have been quick to reflect higher interest rates into share prices, the positives of higher inflation have been largely ignored, in my view. Many renewable companies have government price guarantees, or historic subsidies for older assets, which are repriced annually for inflation. In addition, inflation adjustments may be written into electricity sales contracts between generators and energy users. In any event, with renewable generators having mainly fixed cost bases, inflation linkages on revenues can have a more than proportionate benefit on the bottom line.

Finally, power prices. European power prices have fallen back as gas prices have moderated.  What was a positive factor in 2022, is now seen by some as a headwind. However, despite exceptionally mild weather in Europe, and historically high levels of gas storage as a result, power prices remain relatively high by historical standards. 

The underlying economics of power generation, taking into account higher carbon prices, a fleet of ageing nuclear reactors with limited remaining lives, the prohibitive cost of new nuclear, the need to close substantial coal capacity in Germany and throughout Central and Eastern Europe, and a reconfiguration of Europe’s gas system from piped imports to more expensive liquefied natural gas (LNG) – with associated costs of new importation infrastructure – have moved electricity prices to a structurally higher level in my opinion. This is positive for renewables.

Short-term pain, long-term gain

Considering all of the above, it is easy to get sucked into a debate about what are mainly short-term trends and influences. This would be a mistake, and it is worth restating that an investment in renewables should be made primarily with the intent of gaining exposure to what I expect will prove to be an almost unique growth story over the next 30 years.

As is widely accepted the world needs to reduce its carbon emissions. To do this it will increasingly switch from fossil fuels to renewable energy, mainly consumed in the form of electricity, but also hydrogen and other synthetic fuels. I also believe that renewables, which already have a cost advantage in the electricity market (hence the windfall taxes), could eventually establish a cost advantage over fossil fuels in other sectors, but this is a matter for debate and another article.

For those not yet convinced, Bloomberg New Energy Finance’s data (excluding hydrogen) shows that global renewable energy production has grown at an average 15% per year since 2009. It is worth remembering that the growth to date has been almost entirely within the electricity generation sector as renewables increase their market share.

The potential impact of hydrogen produced from renewable electricity, or the increased electricity demand through the “electrification” of the global economy, will add to growth in future. Further, looking at global renewable energy capacity additions, it can be expected that renewable energy production will, if anything, accelerate its growth to levels above that seen in recent years.

While economic challenges will pass in time, the growth in renewable energy production should continue. The world’s leading renewable energy companies are well placed to satisfy these fundamental changes in the way we both produce and consume energy.

James Smith manages the Premier Miton Global Renewables trust. The views expressed above should not be taken as investment advice.

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