Green Energy Transitions Part 2

We spent last week framing the ambitions, progress, practicalities and challenges of the green energy transition. This week, we are discussing how this framing translates to investing.

The green energy transition market is small in the context of global investing. Small markets have more price volatility because consistent index flows do not support prices. Recall that over 50% of new investment dollars today go directly into indexes.

We spoke with our friend Shawn Kravetz at Esplanade Capital to help frame the opportunity, and I’ve incorporated our discussion into the comments below. Shawn has been operating his renewables and solar-focused investment strategy since 2004. When Shawn started, solar energy was nearly non-existent globally with 1GW world wide. Now there are 1GW in new installs per day. Today, solar provides roughly 4% of the US’s electricity. It now accounts for over half of the new electricity generation (that jumps to 80% when you account for added battery capacity that supports solar).

We live in a highly competitive world, and for renewables to be widely adopted in the way that many people hope, they have to be cheaper than fossil fuels. Subsidies help close that gap. Even better than subsidies are the economies of scale and efficiency gains. More solar production leads to lower costs, which leads to more interest as it becomes more price competitive, which leads to more production and so on. We may be entering an era where solar subsidies are no longer needed.

Michael Cembalest pointed out in his paper (from last week) that the methodology used to calculate the per unit solar energy cost is dubious. This is referred to as the LCOE, the levelized cost of energy. The variables in the LCOE model are open to bias based on life cycles (20 vs 30 vs 40 years), storage costs, changes in the discount rates and so on. While the lifecycle cost comparison of solar power could be clearer, solar energy is relatively simple compared to energy produced from a natural gas power plant, which requires many moving parts and an active gas supply chain. Once a solar farm is operational, the only feedstock is the sun, which is abundant and freely available.

Like other trendy investment themes, the solar sector has suffered from repeated hype cycles. Inflated expectations lead to inflated valuations. Investments in this space have to be made based on realistic near-term projections, not hope and excitement about the potential for the future.

The goal of any investment is to own productive assets that generate earnings that can be reinvested into the business or distributed to shareholders. The green energy industry has to show markets that it can generate positive, sustainable earnings. Markets have been tolerant of loss leaders for a while now thanks to the success of big tech, and Amazon’s multi-decade no-earnings policy in particular. That “unprofitable tech” label often gets abused by leadership trying to justify broken business models. Today’s markets are becoming less forgiving, which is a good thing. We don’t want unjustifiably high valuations based on flimsy results. Fortunately, much of the solar industry is mature enough at this stage that many leading companies do show positive earnings results. Subsidies from sources like the Inflation Reduction Act help as well.

Rising rates were a black swan event for solar and solar-adjacent businesses, as well as commercial real estate and community banks. To illustrate the impact of the rate hikes, TLT, the long-duration treasury ETF, is still down -35% from its peak in December 2021. The value of all long-term cash-flowing contracts, including those in solar, had to fall by an equivalent amount due to the increase in the discount rate.

Much of the hype in the solar sector is now gone, and much of the asset class is currently in a deep bear market. In fact, there are no assets listed in the central green energy ETFs trading at their 52-week highs. As long as there are tailwinds, like record installations, subsidies and fundamentally profitable business models for solar, grid, and solar-adjacent products, then the bear market presents an opportunity.

Emergent opportunities exist as well but in much smaller numbers. The IPO market is showing green shoots and could present new opportunities for public market investors soon. Nextracker is one recent IPO success example. They provide systems that optimize panel alignment to boost yields. Shawn has identified roughly 500 green energy-related public companies, half of which are utility businesses. Only 40 or so of that list can be considered emergent disruptors. Hydrogen, green hydrogen, geothermal, nuclear fission and eventually fusion are exciting opportunities, but they are not necessarily well represented in public markets.

Emerging assets are fun to discuss because they can have tremendous impact and the cost inflection points can lead to big changes. One interesting example is there could be an inflection point in the cost of solar where it becomes cheaper to synthetically produce oil and gas from atmospheric CO2 and water vs drilling it from the ground. Each emerging energy technology deserves its own article and I don’t have the space here to do them justice. I picked solar and solar adjacent businesses to discuss because that appears to be the asset class with the largest tailwinds and the best representation in public markets for the green energy transition.

In general, the green energy transition is not well represented by passive funds or indexing. The better way to approach this market from the public side is to invest with the support of a knowledgeable, dedicated strategist. Of course the other opportunity is to invest via private markets. For larger balances, we can invest directly in emerging private green energy businesses. These are not consistently available, but they do come up from time to time. Please reach out to us if this is an area of interest for you.

This is not investment advice and the statements made above are not an endorsement. Please contact us if you have any questions, thoughts or comments.