A little over a month ago the future of nuclear seemed radiant. The BRIC economies’ pick up in growth momentum was setting the stage for escalating demand, while, simultaneously, instability in the Middle East and North Africa was making global markets anxious about the supply of oil. Meanwhile, coal had begun to look increasingly unattractive due to raised awareness of its carbon footprint.
And then Japan was struck by an earthquake. The impact of the subsequent Fukushima Daiichi nuclear crisis on the nuclear energy industry remains continues to be debated. One thing is certain--it has put the question of optimal energy mix on the global table and along with it the future of alternative energy.
Sources of renewable energy, i.e. wind power, hydropower, solar energy, biofuel and geothermal energy, have always held the appeal of being environmentally friendly, safe and relatively evenly redistributed across the globe. Their economics, however, have been less persuasive, particularly in the short term. The current heightened fears over nuclear energy could alter this reality by turning electorates against nuclear, and thus incentivising governments to further subsidise alternative energy projects. In addition, should recent events result in increased regulation of the nuclear energy industry, piling expensive safety requirements on to fission could also make the economics of wind and solar more lucrative.
I recently spoke to Luciano Diana, co-manager of the Pictet Clean Energy fund, and Edward Guinness, co-manager of the Guinness Alternative Energy fund, about the validity of this argument and how it might impact on investment portfolios.
The Clean Energy Universe
An introductory caveat is in order. Within the alternative energy space, not all funds are created equal: there is a fairly broad divergence across different funds’ definitions of clean energy and, therefore, their investment mandates. For example, the Pictet fund includes natural gas in its concept of green energy and invests a third of its assets in companies that provide energy-efficient solutions such as efficient lighting or smart grids. In comparison, the Guinness fund allocates just over 10% to efficiency stocks and has no exposure to natural gas. Keeping such portfolio differences in mind is important in assessing the risk-and-reward profiles of clean energy OEICs.
What’s Hot and What’s Hotter
For Pictet, allocating 17% of assets to natural gas reflects both the fund’s broader investment mandate and the manager’s expectations of what are the most attractive opportunities in the clean energy space. Both Diana and Guinness see liquefied natural gas (LNG) as a main beneficiary in the wake of Japan’s disaster.
Increased demand for natural gas would be positive for renewable energy, pointed out Guinness, given that LNG is one of the major price setters for alternatives. At present, natural gas prices are trading at the greatest ever discount to the oil price (on a per unit of energy basis). As such, with new ‘green’ technology driving down the cost of producing alternatives, any increase in the price of traditional sources of energy could improve the economics of the more green offerings.
Among the traditional alternative energy sectors, Diana expects wind to be the next beneficiary of Japan’s disaster after natural gas, followed by solar. Specifically, he said, onshore wind producers will benefit. Diana also pointed to China’s 2020 wind energy target as an indication that opportunities here are set to grow. In the developed markets, Diana expects to see Europe push for more offshore wind energy, specifically off the coasts of Germany and the UK.
Tim Guinness, CEO of Guinness Asset Management, holds a slightly different view. He believes that it is solar energy that stands to gain from global interest in alternatives as it is “much less objectionable” in terms of visual impact, noise and vibrations compared to wind energy. Cost is the main hindrance to solar, Guinness explained, yet the industry is seeing a dramatic reduction in production costs and this, in combination with the heightened nuclear concerns, could persuade the world’s largest economy, the US, to put in place some “decent solar incentives.”
Regional Drivers
Both Pictet and Guinness AM’s funds are looking to East Asia to drive demand and investment in alternative energy. China’s exposure to the sector has been very much self-driven, rather than a response to Western carbon emission concerns, and it is likely to remain that way, said Diana. He highlighted an increasing focus on environmental issues within the country’s economic planning decisions and pointed to an emphasis on energy efficiency in the Central Party’s latest five-year plan. This prompted Diana to conclude that Beijing will find it “difficult” to ignore nuclear energy concerns and could therefore further expand its investment in alternative energy.
Edward Guinness agrees that emerging markets will be “essential.” Though he is of the camp that China’s ramping up of nuclear capacity will not cease, he believes Japan’s nuclear crisis “adds urgency” to the need to develop alternative energy sources. He also pointed to the low production cost opportunities available in emerging markets, noting that while public policy is very important for the alternative energy sector, cost is key. “I hope that in five years’ time policy will be really unimportant and economics will be driving growth in the industry,” Edward Guinness said.
Bottom-up View
It is difficult to precisely outline a single approach for stock-picking within alternatives, given the heterogeneity of its subsectors. Yet Diana shares a few key investment considerations that he believes apply across the green energy space. In cases of oversupply, he said, an investor would want to analyse the barriers to entry in various parts of the value chain and bet on companies that look relatively unthreatened by new players entering the market. This logic is very much in line with Morningstar’s own approach to equity investing—looking for companies that enjoy an ‘economic moat’. In addition, companies that hold substantial market share are often production cost leaders and, if their stocks are attractively valued, can present an investment opportunity, Diana believes.
Edward Guinness invests about 70% of his portfolio in the manufacturing side of green energy rather than utility providers, which highlights the disconnect between a company’s location and the local demand for alternative energy. However, he pointed out that if, in 10 years’ time, the overall alternatives sector has experienced an upswing in demand, this could create attractive investment opportunities in utility providers particularly if the manufacturing sector goes ex-growth.
Top-down View
The specifics of the alternative energy sector also require an understanding of market dynamics beyond company boardrooms and business strategies, in order to identify areas of growth in the industry. This is due to the significant role played by government regulation and subsidies. Diana identifies subsidy dependence as a key industry risk and explains that the profit made on selling clean power is limited by state-imposed price ceilings and is reliant on state-determined subsidies in the short term. Thus, Diana points out that “diversification is important” for investors in the clean energy space as some segments of the industry are not tied to subsidisation--energy efficiency being one of them.
The close tie between public policy and corporate growth is the reason why last month’s proposal of a 70% cut in the UK’s feed-in tariff (a state subsidy for green energy producers) for large solar enterprises created havoc in the industry. Edward Guinness actually spoke in favour of this proposal shortly after it was introduced. He explained that it is not a step back in terms of support for renewables, but is rather a move away from large-scale solar production and the redirection of funds to other sectors in a country that is not known for its sunshine.
Elsewhere in Europe, Edward Guinness believes Germany will remain just as supportive of solar energy, “if not more so.” In Italy, a recent round of tariff cuts is in Guinness’ opinion only supportive of a better industry structure. Meanwhile, France, as the largest generator of nuclear power in Europe, enjoys an attractive solar tariff that has recently been scaled back, but Guinness believes that the French government will need to readdress its pro-nuclear strategy.
The Green Vote
The high sensitivity of alternative energy to public policy could raise concerns for some investors, but both Pictet and Guinness AM believe that the fallout of Japan’s disaster will create tailwinds for green energy. The combination of recent energy disasters, including BP’s Macondo well explosion, the threat of radiation leaks in Fukushima, and earthquakes in other seismic regions has put the pressure on policymakers to address energy safety. This is a key stimulus for alternatives given the sector’s reliance on a favourable subsidy regime. Though governments’ nuclear stance is not always driven by economic rationale alone, in the current environment, political support of alternatives could have a positive impact on the economic arguments for further direct investment in the sector.
