Markets can over-react

Recent years have not been kind to those of us investing in the global renewable energy sector. Following a stellar performance in 2020, the S&P Global Clean Energy Index, which the Trust uses as a comparator index, has recorded losses in each of 2021, 2022, 2023, and is also currently showing a negative performance so far in 2024. So, what has been driving this loss of value, and can we expect a turnaround in the sector’s fortunes?

It is fair to say that markets can sometimes over-react and that sectors come in and out of favour. While clean energy companies could once reasonably be said to have been “expensive”, the opposite may now be true.

Taking the trust’s own portfolio into consideration, holdings of renewable energy investment companies, which once traded at a premium to net asset value (NAV), now trade at sizable discounts. Dividend yields are high, even considering the higher interest rate environment.

Likewise, other renewable energy companies, which markets might once have been prepared to give credit for potential future value creation, often now trade at valuations which appear only to take into account existing assets, and sometimes not even those. Companies may not be given any credit for investment spent on the development of assets which are not yet operational, but which will contribute to earnings in future years. It can often take several years to bring a renewable energy facility from the drawing board through to actual electricity production, and I view this as a hidden source of value for many companies.

Interest rates – from a headwind to a tailwind

Perhaps one of the more significant performance impediments in recent years has been increased interest rates.

Given the largely fixed nature of their costs, renewable energy companies often reduce risk by selling electricity on fixed long-term contracts or are in receipt of pre-defined fixed government tariffs. This can produce a steady stream of profits, with relatively modest variability mainly based on variations in weather. Stock markets tend to view such cash flow profiles as bond-like, turning the companies, in market parlance, into “bond-proxies”.

In an increasing interest rate environment, investors require higher returns from bonds, forcing the price of bonds down. For the same reason, share prices of companies viewed as “bond-proxies” can also be expected to fall in such an environment.

I believe this over-simplifies the dynamics of renewable energy companies, as they benefit from growth in the clean energy sector while also being subject to other variables such as power prices. However, taking market assumptions as they are, it is reasonable to assume that the headwind of a rising interest rate environment will now give way to a tailwind of a falling interest rate environment, which should be of benefit to valuations within the sector.

Heading into calmer waters

Russia’s invasion of Ukraine in early 2022 set off a chain reaction of rising gas and other commodity prices. This was felt particularly strongly within Europe, which has had to replace Russian gas with imports from elsewhere, mainly in the form of more expensive liquified natural gas (LNG). Gas prices are a key determinant of electricity prices, as gas-fired power stations are often the highest cost, or “marginal” producer on the electricity grid.

More recently, markets have adjusted, and both gas and electricity prices have fallen, although remain substantially above “pre-Ukraine” levels. As might have been predicted, those renewable energy companies with market-based electricity volumes (i.e. not subject to long-term fixed contracts or government backed tariffs) recorded very high levels of profitability in 2022 and 2023, with earnings now falling in 2024 as power markets adjust.

Therefore, volatility has been high, and the fall in earnings in 2024, although widely expected, seems to have led to a negative stock market reaction. German global renewable company RWE is a good example of this.

However, over recent months, European gas and power prices have been relatively stable as markets adjust to the new reality, and this in turn should lead to lower volatility in company earnings. I expect that, assuming this trend continues, this will be taken well by markets with earnings growth becoming more reflective of underlying business growth rather than commodity price movements. I also expect that Europe will remain an LNG importer and will not return to reliance on Russia for its energy needs irrespective of future outcomes in Ukraine, keeping both gas and power prices at attractive levels for renewable energy investment.

Fluctuating costs

For many years the direction of travel for costs in the renewable industry has been steadily downwards as turbines have increased in size and China came to dominate solar panel production, driving down costs through scale.

However, in recent years, costs of building a wind farm have increased, particularly so for offshore wind. This was caused by a combination of higher prices for inputs such as steel, and manufacturers seeking to improve their thin profit margins. Higher financing costs also contributed. As a result, several projects have been cancelled, leading to large losses for their promoters, or sold to players with better access to supply chains or a lower cost of capital. Likewise, an auction for new offshore capacity in the UK failed to attract bidders due to an insufficient price being offered.

This came as a shock to many investors, conditioned to renewable energy becoming ever cheaper and more competitive, and led to some arguing that the sector presented an unreasonably high risk.

However, the negative reaction of stock markets is overstated in my view. Power prices and tariffs awarded for offshore wind have increased to take the new environment into account, with the UK Government running a subsequent successful auction for new offshore wind with a higher maximum bid price. I expect that ever-larger turbines will continue to increase efficiency keeping offshore wind competitive against other technologies. In addition, the cost of installing other technologies, primarily solar and battery storage, continues to fall.

All eyes on the US election

Aside from the above trends, perhaps a shorter-term opportunity lies in the US. Markets currently assume that a Democrat win would be good for US renewables, and a Republican win would be negative.

I believe this to be overly simplistic. While a Democrat win would be more likely to lead to a continuation of the current policy environment in the US, an environment which the market likes I would add, it doesn’t necessarily follow that a Republican win would be quite as negative as is perhaps assumed.

The US Inflation Reduction Act, being the legislation driving financial incentives such as tax credits for new renewable power, is primarily of benefit to those states where fossil fuel production is a major part of the economy. Indeed, it is designed specifically to operate this way, offering financial incentives to build renewable energy assets in fossil fuel producing states. At the risk of over-simplifying, it is probably fair to say that these states tend to lean Republican, and it would therefore be an act of self-harm for a Republican president to change the existing system substantially.

Finally, renewable energy demand is, to an extent, being driven by investment in new datacentres. This is particularly the case for datacentres with artificial intelligence capability, where power demand is even greater. I would expect that these trends will continue unabated, irrespective of the outcome of the US presidential election.

Is the time now right?

In summary, I believe that many of the negative trends seen in recent years are now giving way to a more benign outlook for renewable energy investment, and I hope that this might trigger a turnaround in the performance of the sector. The Premier Miton Global Renewables Trust will continue to provide a broad spread of renewable energy companies and will seek to benefit from any improvement in the investment environment.