The era of electrification

by Danie Pretorius | 5,Nov,2023 | Coronation Fund Managers, Investments, Q4 2023

Financial advisers are heroes

Danie Pretorius, Equity Analyst, Coronation Fund Managers

In multiple industries and use cases, the energy mix is undergoing structural change.

Energy that was historically provided by burning fossil fuels, such as gasoline in transportation and natural gas in residential heating, is slowly being replaced by electricity generated from renewable sources. The primary reasons for this push to diversify the energy mix are environmental considerations and concerns about energy security, which are largely driven by geopolitical risks, such as war and related supply restrictions.

These long term forces are leading to significant growth in renewable generation capacity, with the overall share of renewable energy demand projected to grow more than fivefold over the next two decades. Bloomberg New Energy Finance estimates it will cost more than US$190 trillion over the next 30 years to reach Net Zero. Even if the world were to fall short in fully decarbonising, growing electricity demand is likely to absorb almost US$120 trillion in investment by 2050.

The standalone economics of renewable generation has improved significantly over the past decade and, in many cases, are now cheaper than fossil fuels. For instance, the levelised cost of electricity production for solar in the US is estimated to have fallen from US$0.24/kilowatt hour (kWh) in 2010 to US$0.06/kWh in 2022, and is now cheaper than coal and gas. Likewise, offshore wind in Denmark is producing electricity at US$0.04/kWh.

However, across the world, government support has still been necessary to spur the development and ensure the viability of the green energy sector. This has taken the form of support for shifting demand as well as subsidising generation.

Who will ultimately bear the cost of the energy transition is, to some extent, still an open question (with answers that are vulnerable to change depending on the election cycle). In the UK, for instance, disagreement on the timeline and funding for certain Net Zero initiatives has emerged as a potential wedge between the Conservative and Labour Parties ahead of a potential election in 2024.

Renewable generation, which is at the core of the energy transition, is still somewhat boom-bust and remains reliant on government support. For instance, the euphoria that surrounded offshore wind developers has fizzled out, as raw material inflation and rising interest rates have increased the cost of some projects by up to 40% over the past 18 months. Recently, Swedish power giant Vattenfall abandoned a project in the North Sea; Danish player Ørsted announced a major impairment of its US projects (contributing to a 70% share price decline over the past two years); and, the most recent round of auctions in the UK failed to attract a single bid, since the level of price support offered by the government was too low for projects to be viable. While developers have the option to proceed without government support, and assume the risk of volatile wholesale electricity prices, the ability to fund projects with long term debt is predicated on very stable revenues.

The implication for investors is that while powerful secular forces and large budgets are creating investment opportunities across the value chain, there is still a lot of uncertainty to navigate. Some areas of disruption are very visible, such as the rapid emergence of the electric vehicle industry in China, where more than 100 new original equipment manufacturers (OEMs) are competing for domestic market share, and increasingly becoming contenders in the export market.

Providers of the capital equipment required to build out the infrastructure are likely beneficiaries, such as the manufacturers of wind turbines or solar panels for renewable generation, or transformers and switchgear for additional grid connections. Lastly, utilities will be deploying significant amounts of capital in building out generation, transmission and distribution grid capacity.

We see an attractive opportunity for investment in the transmission and distribution infrastructure in a number of markets. Expanded transmission networks are critical for connecting new renewable generation to end users and, in many cases, are a key bottleneck today. Renewable generation is often built in locations without any existing transmission capacity, such as solar plants in the Mojave Desert or offshore wind farms in the North Sea. Renewable energy also tends to be far more intermittent and unpredictable – the sun doesn’t always shine, and the wind doesn’t always blow. This requires a greater degree of resilience and network intelligence to be built into the grid.

Local distribution networks, in turn, are likely to see significantly higher demand from applications like electric vehicle charging, and replacing gas boilers with electric heat pumps. For instance, charging an electric vehicle could increase the average household’s electricity usage by more than a third, and in some cases even more. In many cases, the higher load will necessitate investment in incremental capacity.

At the same time, much of the existing infrastructure in many developed markets is reaching the end of their useful life and requires replacing. For instance, grid investment in Europe peaked in the 1960s, resulting in close to a third of the grid being older than 40 years, which is the typical lifespan for important network components such as transformers.

As a result, the level of capital investment in electricity transmission networks is likely to meaningfully increase in coming years relative to the past. The owners and operators of transmission networks are typically regulated entities. They are compensated for maintaining sufficient network capacity, independent of the total amount of power consumed. Generally speaking, investment in expanding the network is recovered through an allowed return on capital, which is set by the regulator in each jurisdiction. Therefore, transmission operators in favourable markets should be able to grow their asset base at a faster rate than they have historically, all while earning a highly secure rate of return in excess of their cost of capital.

Regulators have a difficult trade-off to make in limiting the impact to consumers’ bill, while also providing sufficient incentive for the asset owners to make the necessary investments. The impact of this tension is proportionately less acute for transmission than other portions of the value chain. In the UK for instance, transmission only accounts for around 5% of a customer’s overall electricity bill. Any incremental recovery of expenditure on the transmission network will therefore have a relatively small impact on the overall cost to the consumer and may thus be more easily absorbed than other portions of the energy transition.

Danie Pretorius
Equity Analyst at Coronation Fund Managers | + posts