Before covid-19 became a global crisis, renewable power growth was accelerating. Renewables accounted for nearly two-thirds of the total power capacity additions last year and renewable power capacity had been increasing at over 8 per cent annually over the past 10 years. The various technological advancements over the past decade have made renewables highly cost competitive. However, investments in clean energy are still falling short of the level needed to put the world’s energy system on a sustainable path. In addition, investment gaps differ starkly by sector and scenario, reflecting variations in differing pathways for energy security and sustainability. Moreover, financial markets have changed dramatically this year with unprecedented economic conditions leading to deteriorating fundamentals in the energy sector. To align with long-term energy transition goals for the power sector, a more dramatic reallocation of capital towards renewables would be needed. Renewable power spending will need to increase steeply by the end of this decade, with additional investments in electricity networks and electricity storage to facilitate system integration.
An ideal renewable power investment offers improved diversification, better liability matching, and less volatility. Yet this idealised hypothesis about renewables has not received universal support from quantitative assessments. The problem is not just a lack of data, but a series of challenges associated with making a reliable comparison. Private sector relies upon expectations while making capital allocation decisions, which is often guided by history. The joint report on “Energy Investing: Exploring Risk and Return in the Capital Markets” by the International Energy Agency and the Centre for Climate Finance & Investment, Imperial College Business School investigates the historical risk and return proposition to investors in the energy sector. This study examines the financial performance of listed companies engaged in fossil fuel supply as compared to those active in renewable power over the past five and 10 years. For analysis purposes, hypothetical investment portfolios were constructed in three countries or regions: The United States, the United Kingdom, and Germany and France. Thereafter, the total return and annualised volatility (a measure of investment risk) of these portfolios over five and 10-year periods were calculated. Here are select findings of this study:
It was found that over a period of 10 years, renewable power portfolio generated higher returns and higher volatility than the fossil fuel portfolio in the United States. However, this changed over the last five years, with renewable power portfolio delivering higher returns with less risk than the fossil fuel portfolio. This coincides with a fall in oil prices and stronger investment in renewable power. From 2014 onwards, a downturn in oil prices resulted in lower returns on invested capital and dramatic cost cutting by oil and gas companies. The US shale gas sector was hit particularly hard, resulting in bankruptcies and persistent negative free cash flows. A run up in capital expenditures by oil and gas companies in the first half of the decade was followed by a 75 per cent decline in the years 2014-16.
Renewable power started outperforming other segments from 2015 onwards due to improving fundamentals. Steep consistent reductions in technology costs, federal tax credits, and improved availability of power purchase agreements (PPAs) from utilities and corporate buyers improved cost-competitiveness. Thus, price appreciation further accelerated from the end of 2018, with growth steepening again from mid-2019 onwards. More ambitious renewable portfolio standards and clean energy standards adopted by several states also provided better long-term visibility for the sector.
In the United Kingdom, the renewable power portfolio had a higher average annual return and half the volatility, when compared to the fossil fuel portfolio. After a short period of decline between 2015 and 2016, the UK renewable power portfolio started to appreciate from 2016 onwards. This may stem in part from the introduction of the renewables auction scheme towards the middle of the decade, which provides long-term pricing for renewables projects under contracts. This also helped spur the development of the world’s largest offshore wind market. Moreover, the renewable power portfolio outperformed the fossil fuel portfolio throughout 2019.
Germany and France
The renewable power portfolio in Germany and France exhibits higher returns and lower volatility over both the ten- year and the five-year periods. The renewable power portfolio is driven by German projects set up under the Energiewende plan, and long-term policy support has led to a steady appreciation of shares since 2012. However, uncertainties regarding auction schemes and the presence of persistent project-level risks like delay in approvals and grid integration issues for solar PV and wind have impacted performance at times. A surge started by the end of 2018 with the publishing of the long-term European Union target of 32 per cent renewable energy in final energy consumption by 2030. It also coincides with the initial public offering of renewable energy developer Neoen. Interestingly, the renewable power portfolio exhibits a return of 171 per cent compared to the 10-year total return of -25 per cent for the fossil fuel portfolio.
Review of recent events
The renewable power portfolio has held up better than the fossil fuel portfolio in an analysis of the US portfolio over January – April 2020, showing higher returns with less volatility. This is most likely on account of the revenue benefit from long-term solar and wind power PPAs. However, the sector has also displayed higher volatility than the market benchmark. This is mostly due to the influence of companies involved in equipment manufacturing, where near-term supply chain uncertainties have grown.
The Covid-19 pandemic has suppressed the global demand for oil with unprecedented losses for the industry. Based on the International Energy Agency forecast, global oil demand is expected to fall by a record in 2020 and the recovery will be gradual. Since increased consumption on account of lower prices is unlikely due to the ongoing pandemic, oil and gas companies have slashed capital expenditure for the year, with potentially larger cuts on the horizon. Thus, the fossil fuel portfolio has posted the worst daily returns and highest volatility, second to only the oil price itself. With the excessive drop in returns for fossil fuel companies over the period, financial challenges emerging for the US shale sector and record low oil prices, the outlook for many of these highly leveraged companies looks bleak. Despite improving finances and efforts to reduce debt over the past four years, credit spreads have widened. This has effectively closed the financing channel of high-yield debt issuance in early 2020. Even as companies are trying to extend bond maturities and keep revolving credit facilities open, banks are cutting their exposures. Credit downgrades and debt restructurings are happening as investors reassess their lending practices and cash flow expectations. The entire covid-19 experience highlights the importance of risk management and portfolio diversification for investors, and the role of renewable power in such volatile market conditions.
The future of renewable energy may be embedded in larger energy companies. Wind and solar power are at an earlier stage of growth compared to the oil industry which has built up a large global supply chain over many decades. However, the competitiveness of renewable power is rapidly improving and creating new opportunities into other sectors as well including the electrification of transport and heat. Another example is the increased interest by industry players in the production of low-carbon gas like clean hydrogen from renewable-powered electrolysis. There are already considerable synergies between the oil and gas industry and some renewable power technologies, such as offshore wind and geothermal, with several integrated oil companies already investing in these sectors.
“The dramatic fall in the oil price over the first four months of 2020 has changed many assumptions about the financial returns on new exploration and production projects. This may signal a new opportunity for the clean energy sector to grow and build scale within the oil and gas industry.”
The dramatic fall in the oil price over the first four months of 2020 has changed many assumptions about the financial returns on new exploration and production projects. This may signal a new opportunity for the clean energy sector to grow and build scale within the oil and gas industry. Some oil and gas majors have already announced plans to step up their spending in renewables areas in the coming years. However, shareholder risk exposures will continue to be dominated by oil and gas irrespective of how fast their renewable power businesses grow.
Conclusion and the way forward
The main finding of the report is that listed renewable power portfolios have outperformed listed fossil fuel portfolios in all geographies. Moreover, during periods of high market and oil price volatility, fossil fuel portfolios experienced larger drawdowns than renewable power portfolios. In addition, the annualised volatility for the renewable power portfolios was similar, or lower than, the fossil fuel portfolios. The analysis shows that the financial performance of renewable power portfolios has significantly improved over the last five years and their volatility has decreased. This is crucial for investors, who need to manage portfolio risks, and an improvement in risk and return profile makes renewable assets more attractive. This is expected to help in strategic asset allocation to the renewable power sector.
The renewable portfolio listed today is low liquidity, while large asset managers, asset owners, and other institutional investors, such as pension funds need ample liquidity to enter a market. Although, it is easier to allocate a larger share of assets to renewables if the market is deep and liquid, that is not the case currently. There is a lack of depth in the listed renewables portfolio and the vast majority of renewable energy securities in the market today would not be deemed eligible investments due to their size and daily traded volume. Moreover, many investors still treat renewables as a developing area, with limited choices in listed equity markets as listed companies account for a small fraction of all investment possibilities in renewable energy. Thus, there is an urgent need for greater transparency for unlisted investments.
To sum up, the results of this study indicate that renewable power shares offered investors higher total returns relative to fossil fuels, with lower annualised volatility for the renewable power portfolio. The analysis shows a superior risk or return profile for renewable power in both ordinary market conditions and a recent tail risk event. Even with the apparent financial attractiveness of renewable power, financing via public markets has not really taken off. While risk and return are the cornerstones of investment beliefs, strong performance may not be sufficient to mobilise listed equity investors towards decarbonisation. Going forward, a host of additional measures will be required to prepare the industry for full-fledged support from global capital markets.