2023 will undoubtedly go down as an annus horribilis for investors in renewable energy companies. A perfect storm of high interest rates, supply chain disruption, increased material and labour costs made for a tough slog in getting projects up and running and shovels in the ground. Add to that mix a US government that has dragged its heels in deploying the funds of the Inflation Reduction Act (IRA). All told, the sun wasn’t shining and the wind wasn’t blowing in the manner we needed it to in order to address the major challenges the global economy faces when it comes to electrical grid demands and sourcing energy from non-fossil fuel burning sources.
The Global Climate Summit (COP28) recently concluded in Dubai, with little in the way of concrete pronouncements: The much-anticipated final language of the summit’s declaration to phase out fossil fuels did not come to fruition, mainly because of a few major oil and gas economies ruling against any fossil-fuel related commitments.
That said, it was not all doom and gloom. There was a pledge by as many as 118 nations, including Canada and the United States to triple renewable energy capacity by 2030, and double energy efficiency. While China and India did not sign along to the pledge, this does bod well for the industry. Tripling the investments in the next 6 years is a massive commitment and is part of a win-win strategy because with increased investment comes lower climate mitigation costs, less chronic damage to the climate and a global net GDP increase that will pay dividends well into the future. The other interesting development from COP28 was the acceptance of nuclear energy as a carbon-free energy source, with over 20 countries agreeing to triple nuclear capacity by 2050.
What’s not to like about that scenario, and more importantly, how can a long-term investor participate in the future growth and innovation that this trend portends? These are both important questions, and they tap into what looks like a favorable entry-point into some of the world’s leading renewable energy companies.
Up until now, while many (but not all) companies in this space have grown their topline by between 14-21% annually over the past 7-9 years, the cash available for distribution to shareholders has only averaged 5-7% according to a recently published RBC Capital Markets Report entitled ‘North American Renewable Energy: Big demand, small appetite for capital: A look ahead at the winding road ahead’. Eroded in large part by development costs, dilution of equity, contract expirations and low projected project returns, it’s been difficult to remain invested.
Key to all this has been the higher cost of capital for many of the renewable energy companies. Should rates roll over and decline, we can expect companies to tap a more favorable credit environment. If we have seen a peak in near-term inflation, we may see a market more supportive of higher project returns. Of course, this also depends on how conservative companies are in calculating the investment returns of the projects they propose. In the past several years, with low interest rates, there was a low hurdle to clear for many projects to get approved, but with the rapid rise in costs, companies have either abandoned projects or sought to renegotiate power prices to continues, neither of which has proven to be a consistently winning strategy post factum.
It is a capital-intensive endeavor to build a renewable energy project, but companies that are successful in deploying capital at a return that exceeds its cost of capital will emerge the winners along with their shareholders. So long as companies do not paint themselves into a corner and are forced to issue dilutive equity or are at the mercy of suppliers have supply and quality control issues of their own. It also helps to negotiate power prices that are fully indexed to inflation and/or have built-in escalators to take advantage of the increase over the past 2-3 years. Companies with access to pools of capital, those that have joint-ventures with government, and those whose energy portfolio is devoid of aged assets and are savvy capital allocators will come out on top.
Needless to say, with investor sentiment so weak given the past couple of years in renewables, there is a possibility of surprises to the upside. It can best be summarized as a question of ‘when’ not ‘if’. Let’s remember, that 2023 did represent a record in terms of renewables deployed, with solar reaching approximately 413 GW and wind approximately 103 GW and the Chinese market growing by leaps and bounds according to JP Morgan in their December “Alternative Energy and Services” report. And let’s not forget the long-term electricity demand/generation forecast according to the EIA will be compounding annually at a rate of 1.5% through 2050. Granted, for existing investors the road has been a bumpy one, but for those looking for long-term growth opportunities in what promises to be a secular trend for the next 30 years, the future is bright with sunshine and the wind is blowing at your back.