When your job is picking stocks for a managed fund focused on renewables and energy efficiency, you want an outcome where investors profit as much as everyone else on the planet. EcoGeneration asks Tom King of Nanuk Asset Management how it’s done.
To what extent are clean energy investments prone to falling electricity prices?
The economics of renewable generation and energy storage continue to improve at very rapid rates and the implications are significant for the future economics of all energy infrastructure, not just clean energy investments.
In some parts of the world the development of renewable generation has been supported by regulatory mechanisms and subsidies that increase the prices paid by electricity users, but this is not universally the case. As the price of clean energy technologies has fallen the necessity for subsidies and regulatory support, like mandated targets in Australia, is reducing and in many parts of the world solar and wind are the cheapest sources of new generation and it is economically viable to develop them without subsidies.
In competitive “merchant” electricity markets, like Australia’s, the introduction of even relatively small amounts of renewable generation is likely to significantly reduce wholesale power prices. In fact, in many markets it is now common to see zero or negative wholesale power prices during times of strong wind or solar generation. Not surprisingly this can have a materially negative effect on the revenues and value of traditional generating capacity. Longer term, the value of renewable generation will decline if market prices fall – at least until the point that there is a large reserve of very cheap energy storage.
So to answer the question, the implications for clean energy investments depend on the nature of the investment. Some generating assets like wind and solar farms will be negatively impacted in the longer term by falling wholesale power prices, but there will be many business models and technologies that will benefit from falling electricity prices and a more complex electricity network with large amounts of intermittent renewable generation supported by large amounts of storage and sophisticated demand management solutions.
Economics will dictate that inevitably we end up with such a system. The real challenge is that much of the value of existing generation and transmission infrastructure will be lost during this transition. Not surprisingly the owners of these assets seek political and regulatory support to protect their value and slow the transition. Unfortunately, the public and political debate is neither well informed nor honestly presented, and we are at significant risk in this country of continuing to invest in traditional infrastructure that will be redundant well short of its intended lifecycle, leaving significant costs to be borne by someone.
What percentage of your portfolio could be considered R&D?
The companies held by the Nanuk’s New World Fund have, on average, higher than average levels of investment in R&D. It is a key source of competitive advantage and in many cases a driver of future revenue growth. We do not, however, invest in “early stage” companies seeking to commercialise new or unproven technologies.
What have been some great investments for you?
Within the clean energy space we have generated excellent returns from investments in SolarEdge, a global leader in solar inverters and module level power electronics, and SunRun, the leading US residential solar leasing company. In both cases they are beneficiaries of the continuing decline in solar panel prices and improving economics of solar systems and stand to benefit from the increasing “attachment rate” of battery storage to solar systems. The Fund has also benefitted significantly from investments in leading wind turbine manufacturers Vestas and Siemens Gamesa Renewable Energy over the past year, during which time the falling cost of wind energy resulting from competitive tendering processes replacing fixed subsidies and feed in tariffs has driven a significant uplift in project development and order flow for these businesses.
What have been some not-so-great investments?
The fund’s investments in the automotive industry have not performed as well as expected, and we now hold less exposure in this area. Our focus has been on suppliers that will benefit from increasing vehicle electrification and the adoption of active safety and autonomous driving technology. The development of these technologies has been more expensive and slower to deliver revenue growth than expected, and the businesses have suffered from slowing global automotive sales and increasing costs and the uncertainty created by the ongoing US-China trade dispute. It remains an area of interest and the significant fall in share prices of companies in this area is now presenting some interesting longer-term opportunities.
What have you learned along the way?
Ten years ago we recognized, correctly, that there was likely to be very significant change in large parts of the global economy in coming decades as technologies like solar and wind became competitive and displaced existing infrastructure. Over time we have learned that the scope of similar changes across the economy is far larger than we initially understood it to be, and the implications much more significant for investors. Areas like electric vehicles, energy storage, the industrial internet of things, big data, machine learning and artificial intelligence are not only delivering a much broader range of sustainable solutions, but they are accelerating the rate of change.
We continue to be astounded by the rate of improvement and reduction in cost of new technologies, which year after year continue to exceed the most aggressive forecasts. It provides us with optimism that capitalism and innovation can deliver solutions to the world’s environmental challenges and resource constraints – not to mention an ongoing stream of interesting investment opportunities.
With borrowing rates this low, do developers favour debt over equity?
Yes. Developers typically use project finance debt to support the development of renewable energy projects. Leverage ratios are typically quite high for projects with good quality offtake agreements or feed in tariffs. The cost of debt is a significant factor in the overall project costs and has a material impact on the electricity price at which projects are economic. Higher interest rates have been one of the reasons Australian renewable projects have not achieved the same low costs as in other parts of the world.
What are some simple investment criteria to apply in the fast-changing world of energy efficiency and clean energy?
Nanuk approaches its investment with a belief that over the longer term share prices tend to reflect the economic value of businesses, and we seek to invest in businesses that are able to grow economic value or are priced at significantly less than their economic value, and preferably both.
The approach often leads us to invest in profitable, mature (and boring!) businesses that are going to grow faster because of growth in clean energy or energy efficient technologies. The analogy is investing in businesses selling “picks and shovels to the gold rush”. We avoid investing in uncommercialised technologies, businesses that compete in commoditised markets and paying excessive prices to buy “leaders” like Tesla which still face enormous challenges to reach consistent profitability and meet the ambitious expectations implied by the share price.
The solar industry is a good example of the challenges of investing in some fast-growing technologies. The industry has grown in volume terms by around 25 times over the past decade, but at an industry level shareholder returns have been substantially negative. Even the industry leaders today have performed poorly as investments. It is an illustration of the impact of falling costs in commoditised markets, where companies need to invest large amounts of capital to produce more product just to keep revenues and profits flat. The outcome is typically very low returns on capital and poor long-term outcomes for equity holders.
The same dynamic is likely in many industries with similar characteristics and as an example it won’t be surprising if many companies involved in manufacturing lithium ion batteries suffer a similar fate.
Tom King is chief investment officer of Nanuk Asset Management, a funds management firm which invests in listed companies associated with clean energy, energy efficiency, industrial efficiency, waste management, pollution control and sustainable materials. Tom has a background in equity funds management, investment banking and private equity.