Renewable Energy – There's Blood in the Streets

An article highlighting the opportunities to invest in renewable developers.

The last months have been awful for the renewable energy universe. Since the 10-year US Treasury started its recent ascent from 3.8% in mid-July to above 4.6% at the end of September, the two clean tech indices have declined by about 21% while the S&P 500 Utilities index fell by 12%.

The main culprit for the weak performance is clearly higher interest rates. When the risk-free rate increase and is perceived to shift to a higher level, the net present value of all future cash flows declines. Valuation multiples must be reduced. It is not complicated.

Yet, even within this backdrop, renewables notably underperformed compared to other growth sectors. The clean tech bubble of 2020-2021 is still in the process of deflating likely causing many investors to throw in the towel on the sector. While the market was willing to put extreme values on growth pipelines three years ago, it is currently in complete disbelief that future growth has any value. Some companies are trading at less than 50% of currently locked in, contracted cash flows, implying sharply negative value of future growth. This is what happens when a bubble deflates, we have gone from extreme greed to extreme fear in three years.

Compounding the challenge of rising interest rates, the sector has been beleaguered by a series of unfavourable announcements. In September, Nextera Energy Partners (NEP), the YieldCo of Nextera Energy (NEE), the world’s largest renewable developer, warned that that it would have to reduce equity distribution growth targets due to higher financing costs.

If a company financing projects for the largest developer in the US have issues raising capital, the market is assuming that this problem is probably widespread and even worse for smaller developers. We believe this is only partly true as NEP is a financing company with a lot more leverage than the average renewable energy developer.  Yet, we agree that everything else equal, it is logical that higher rates will result in some project cancellations and at least some delays. However, higher interest rates will not stop the growth in this industry.

While the cost of capital has increased, there are mitigating factors that we believe the market might be overlooking or undervaluing. First, LevelTen Energy, a renewable energy consultancy, estimates that the average power purchase agreement price (PPA) for onshore wind surged by approximately 85% since cost inflation took off in early 2021. During the same period, utility-scale solar PPAs have risen nearly 60%, reflecting both increased input costs for solar installations and the rise in electricity prices due to the energy crisis. Moreover, the Lawrence Berkeley National Laboratory estimates that in 2022, the construction cost (Levelized Cost of Energy – LCOE) of an average utility-scale solar project in the US was USD 39/MWh, whereas it calculates the wholesale value of the electricity to be worth USD 71/MWh. This offers a considerable margin of safety to account for any cost inflation.

How much would LCOE increase with higher interest costs? According to Morgan Stanley, a 1%-point higher financing costs would raise the LCOE by around 5% or roughly USD 2/MWh from a base of USD 39/MWh. We believe the increase could be higher, maybe closer to 10% in certain circumstances, but still well below the rise we have seen in the PPAs the last two years.

Additionally, the tax credit adders in the Inflation Reduction Act (IRA) will soon come into full effect when the final details are published. These two adders, a domestic content bonus and an energy community bonus, provide supplemental tax credits—10% for each—added to the already generous Production Tax Credit (PTC) of USD 27.5/MWh. For projects obtaining both adders, an additional USD 5.5/MWh could be available. These two adders alone would, using Morgan Stanley’s calculation, cover a 2.75%-points increase in the financing cost.

Finally, solar panel prices have dropped sharply as Chinese manufacturers have oversupplied the market. Prices for delivered panels in Europe have declined by about USD 10c/W, which for an average solar project could lower LCOE by as much as USD 3/MWh. There are indications that the US has witnessed a similar price reduction, albeit from a higher starting point.

Despite all these offsets, we can understand the market’s reaction that when rates rise steeply, companies with cash flows far into the future get indiscriminately sold. However, at one point interest rates will stop going up and investors will again appreciate the intrinsic value of these companies. It is a matter of time. We think a good time might be, as Baron Rothschild said, when there is “blood in the streets”.