With the exception of our holdings related to water solutions, all other holdings linked to the renewable resources theme have experienced serious losses. These are companies in the wind and solar industry like Nordex and Enphase Energy, but also companies generating and distributing renewable energy, such as Voltalia and Acciona Renovables. Irrespective of their strong impact narratives and their strong long-term prospects, the mood around renewable resources and especially renewable energy is negative.
“Renewable energy stocks hit hard by higher interest rates” ran the headline in the Financial Times early October, but there is more at play than only higher interest rates. True, renewable projects are hit by rising interest rates, making borrowing more expensive, and at the same time, higher rates also have a negative impact on the net present value of the long-term cash flow streams of new projects. Developers are therefore hesitant to commit to new projects, as the failure of the latest UK offshore wind power project bid and Orsted’s problems in US offshore wind demonstrate. Delaying or even cancelling new projects will be felt in the total value chain.
In addition to rising interest rates, companies in the renewable energy industry must cope with cost inflation, the increasing complexity of projects, cyclical headwinds and reduced government incentives in several countries. Declining power prices, as of late, did not help either, hurting renewable utilities in particular.
Wind turbine manufacturers have a tough time. The increased complexity of (offshore) wind farms and the race for scale (jump in turbine size) have led to profit warnings from several players, due to increased warranty expenses caused by quality issues. At the same time, they had to work through a backlog signed at unfavorable prices now that costs are escalating. The result of this is that profits evaporated, especially of companies related to offshore wind activities. Although there are only a few large turbine manufacturers, it is a competitive environment. Margins eroded further with the introduction of auction systems for wind projects across Europe. These auctions were designed to make price setting more efficient but have in practice made it harder for turbine manufacturers to pass on input cost increases due to lower flexibility in contracts. Companies have struggled to make healthy profits. As a result, balance sheets have deteriorated. Siemens Energy, not one of our holdings, is one of the most beaten down stocks in this sector. The company ultimately had to turn to the German government to secure state guarantees, which are important to secure financing for new projects.
In solar, other factors drove recent demand and profitability. In the US, for example, the Inflation Reduction Act (IRA) signed in 2022 was an important positive driver for solar stocks. As part of the IRA, the Investment Tax Credit (ICT) has been extended. The ICT allows homeowners and solar project developers to deduct 30% of the cost of installing a solar energy system from federal taxes. This long-term extension greatly improves visibility for the solar market and makes it more attractive to purchase solar systems and build new solar parks. In addition, the IRA includes domestic manufacturing credits, from which especially First Solar benefits. This company, in which we have a position, receives millions of US dollars for every gigawatt of solar panels produced in the US. This cash credit fully feeds through to the company’s bottom line. SolarEdge and Enphase, which we also have in portfolio, benefit from these domestic manufacturing credits as well, but to a lesser extent. Both have lower production capacity in the US and credits for microinverters and power optimizers, their core products, are smaller. Solar stocks were the winners over the last few years, that said, as fast as investors pushed these shares higher and valuation multiples increased, they exited them as quickly in 2023, the recent profit warnings from SolarEdge and Enphase, both active in microinverters, gave them enough ammunition to do so. There is no tolerance for companies missing on numbers in the current climate.
In California, accounting for 35% of US solar installations, new rules have made solar less cost competitive for businesses and homeowners compared with other kinds of electricity. The new regulation aims to stimulate the use of storage, making the combination of solar system and battery storage cheaper, but this transition takes time. In Europe, economic pressures have also weighed on panel sales. This was the background of recent warnings, according to the CEO of Enphase, especially in Europe in countries like Germany, France and the Netherlands there has been substantial demand reduction. The increasing resistance to green policies and ambitions prevalent in some EU member states is not helping either.
Enphase may serve as an example for the solar sector. The company’s CEO is positive about 2024. "We believe the pullback in Europe will be temporary," he said. Although we must admit that visibility is low (also for the CEO of Enphase) and timing a bottom is difficult, we are positive on the long-term trends. According to Bloomberg New Energy Finance, new-built capacity will grow at an average of 14% per annum in the next few years. Sell-side analysts forecast a resumption to growth for Enphase in 2024. In addition, Enphase still has a positive free cash flow in this deteriorating demand environment and has a very healthy balance sheet. We believe the company can manage this downturn. Future growth is also supported by the expansion into batteries, a promising new growth vertical. Shares of Enphase are heavily de-rated, reflecting investors’ disbelief in a recovery. We think this is unwarranted and therefore hold on to Enphase and SolarEdge. If visibility improves, we are even inclined to add to our positions.
Developments are improving, both top-down and at individual company level. The European Commission (EC), for example, recently presented its Power Action Plan, which aims to increase investment in the wind power industry. The action plan addresses the key obstacles of the sector and includes measures to speed up the process of granting permits, to improve the auctions systems, to increase access to funding, to facilitate the build-out of the grid infrastructure and to ensure fair competition.
Onshore and offshore wind accounted for 16% of the EU's electricity production last year, in order to meet its 2030 targets, wind capacity should increase in excess of 10% per year. In the US, the wind industry also benefits from developer tax credits from the IRA, this improves long-term visibility and should lead to continued mid-to-high single digit growth for the wind industry going into the next decade.
Backed by support from these green transition plans in Europe and the US, we expect decent sales growth in the coming years for the wind turbine manufacturers we have in portfolio. Following a period of declining margins and pressure on order volumes, we believe the worst is behind. We expect Vestas to reach positive profit margins again next year, for example. This will be driven by cost control, improvement in supply chains and better contract terms. This outlook gives us comfort to remain exposed to this segment.
There are multiple reasons why the renewable energy sector has heavily underperformed so far this year. The disappointing returns are driven by several general developments and driven by industry- or company-specific factors. Investors have given up on renewables and brought most stocks to multi-year lows. With the necessary energy transition far from completed, we believe the long-term growth prospects remain in place, backed by governments’ ambitious green transition plans. And in addition, companies are taking action to adjust to the new realities. This will surely support future profitability and performance.