Green Energy and Red Ink

It’s important in investing not to let preconceived notions get in the way of real world economics and financial results. A great example of this is what I wrote about last week, the problems suddenly confronting car makers due to worsening EV supply and demand dynamic (Supply and Demand: Inescapable)

This week, I will expand the general theme to include green energy, specifically offshore wind projects. In 2021, the President targeted 30 gigawatts of offshore wind capacity by 2030 and directed funding and tax incentives to promote construction and expansion. At the time, and given the increased focus on climate change, it was deemed an ambitious, but viable, target. As a result, solar and wind manufacturers and developers were one of the hottest, and socially responsible, investments around. But that was then, and this is now: skyrocketing costs, interest rates, oil prices, and physics have introduced a dose of hard reality into the picture.

What happened? I thought wind and solar were the future of power generation and were leaving fossil generation behind? A few issues unexpected issues cropped up along the way:

  1. Most important: the end of cheap money. By some estimates, renewable energy stocks are four times more sensitive to interest rates than fossil fuel companies due to higher and longer duration debt levels. Typically, renewable projects use debt to purchase equipment and develop sites before any revenue is realized. In addition, higher rates are used to discount cash flows in the distant future. The higher the discount rate, the lower the future return, especially for 20 to 30 year investments. Higher rates also affect residential solar panel manufacturers and installation, since buyers often finance the conversion.
  2. Increasing costs, quality and supply chain issues. As wind turbines have become more popular, costs have skyrocketed for the raw materials (concrete, steel, fiberglass, carbon fiber, magnets, high-end lubricants, etc., etc.) that go into their manufacture and construction. Paradoxically, many of them are very sensitive to oil prices. Compounding this is the ever increasing size of the turbines themselves in order to produce increased capacity (some blades are now more than 100 meters in length), causing quality issues. This leads to the last issue,
  3. Wind turbines have relatively low output and capacity factors, i.e., they don’t produce much power individually and only at a fraction of their maximum output. The average windmill produces, on average, about three megawatts and has a capacity factor of 34% (actual output/max output). Compare that to a single gas fueled turbine that generates 250 MW with a capacity factor of about 55%, and you get the idea — you need a lot of windmills, and the land and materials that go into building them, to replace fossil fuel generation.

All of the issues above, but especially higher interest rates, have conspired to cause a reckoning in the green energy sector. Developers and manufacturers that have executed fixed price contracts for wind projects with public utilities (some of which haven’t even been built yet) are in a bind, and are seeking state or federal relief or taking the extreme step of paying breakup fees to cancel existing contracts. Requested contractual price increases for the power supplied are not minor, and range for certain projects from 27% to 66%. That’s real money, and money that the ratepayers will be forced to pick up. Unsurprisingly, state regulators have rejected the proposed increases.

Obviously, none of this is good news for windmill manufacturers or developers. And the carnage extends beyond wind to solar as well. One example is SolarEdge (SEDG), which makes power inverters for solar panels. Citing higher than expected inventories and slower installations, SEDG cut its Q3 revenue forecast by almost 20%. The stock subsequently declined 27% in one day, and dragged down related solar stocks, such as Enphase (ENPH).

Below are some representative results for several wind and solar stocks, as of 10/31/23:

Company Ticker YTD (%) 1-Year (%)
Siemens Energy ADR SMNEY (52.3) (23.3)
Vestas VWDRY (24.5) 9.7
Eversource ES (36.2) (29.5)
SolarEdge SEDG (73.3) (66.9)
Enphase ENPH (68.8) (74.3)
iShares Global Clean Energy ETF ICLN (34.1) (31.2)

Not encouraging, to say the least. For comparison, the SPX is up 9.7% for the year.

Similar to the current demand and supply problems confronting EVs, are these issues surrounding wind generation just part of the long term decarbonization process, to be sorted out once rates and costs decline? Frankly, I don’t know — and no one does. If you accept that the political tailwinds are such that governments will not be hesitant to throw money at the problem to meet their net zero targets, then current stock valuations in the clean energy sector might present a compelling long term opportunity. On the other hand, and nearer term, the market seems to be unwilling to overlook the financial unsustainability of many wind projects, as well as their operational problems, and is increasingly skeptical of clean energy projections. Reality has intruded, as it always does.