Climate change matters

- compiled from information supplied by UBS


Successful negotiations largely depend on the positions of the world’s two largest greenhouse gas emitters, China and the US, which account for more than 40% of the world’s CO2 emissions. Washington’s new administration has raised high hopes that the US might play a more active role in climate negotiations. Until now, there has been a lack of broad domestic political support, and the US Senate has yet to pass the necessary climate legislation. As such, the US will only have limited ability to take decisions in Copenhagen. The Chinese government, however, faced with massive environmental issues has already announced measures to reduce carbon dioxide intensity per unit of gross domestic product. Yet ultimately China will only buy in if the US and other industrialised nations give their commitment first. Although the UN and a number of governments have gone to great pains over the past weeks to ensure a successful conference, experts are less optimistic. As a result, skepticism outweighs the likelihood of a comprehensive successor treaty to the Kyoto Protocol, which expires in 2012. This is also underpinned by the fact that Asia-Pacific political leaders, at the APEC summit in mid-November, didn’t agree on a target to halve greenhouse gas emissions by 2050.
Copenhagen, is likely to produce a political agreement that will provide a framework for subsequent conferences. While the Kyoto Protocol remains in force until 2012, time is running out. Greenhouse gas emissions must be quickly and drastically reduced if global warming is to be kept at an acceptable average of +2 degrees centigrade.

How can we save the climate?

The UN has suggested four strategies to combat climate change: mitigation, adaptation, technological development and transfer, and financial mechanisms. The International Energy Agency (IEA) has also presented an energy policy scenario to tackle climate change. It requires a drastically reduced growth rate of fossil fuel usage, more renewable energies and an efficiency revolution. Apart from global political advances in climate protection, additional factors look set to raise energy efficiency and increase the use of renewable energy sources.

• According to the International Energy Agency (IEA) the global energy requirement will grow another 40% by 2030, compared with 2007 levels using the reference scenario.
• Current energy sources are mostly finite and not sustainable.
• When it comes to energy sources, governments are focused on increasing diversity and reliable supply.
• We expect additional major steps forward in the development of energy efficiency and renewable energy sources.

Wake up call for energy efficiency

As a cost-efficient way to achieve significant reductions in CO2 emissions, energy efficiency is the best “alternative fuel,” and continues to offer substantial hidden potential. Nearly all aspects of daily life can be made more energy-efficient as losses are often not perceptible and occur throughout the product life cycle. Moreover, costs and benefits often end up in different buckets, while operating expenses are too rarely factored into the decision-making process. We see major potential primarily in buildings, transport, electricity production and transmission.

Buildings:
Buildings are a focus of most green stimulus measures, as improvements in buildings (for example, weather-proofing and energy efficiency upgrades) have the potential to create green jobs while tackling climate change goals. Apart from stimulus measures, in Europe we can expect positive impetus on energy efficiency from the Directive on Energy Performance of Buildings, which introduced the Energy Certificate throughout Europe. The EU and other countries plan to phase out incandescent light bulbs. This is surely a positive longer-term development for companies offering energy-saving lighting products.

In the area of home appliances, both the US and the EU have recently introduced new energy efficiency regulation, making the Energy Star label a requirement for many appliances. India has also announced that it will require energy efficiency ratings for a range of electrical appliances from next year on.

Transportation:
The auto industry has been a significant victim of the economic crisis, which has also hurt automotive suppliers who are potential beneficiaries of stricter energy efficiency regulations. At the same time, prospects for legislative measures calling for increased efficiency are clearly strengthening; and the potential for traditional engines and drivetrains continues to exist. One of the most obvious options would be lighter vehicles with smaller engines. At the same time, we note a trend towards electrification, starting with hybrids but moving towards vehicles that are powered by electricity alone. Even though electric cars are unlikely to catch a majority share of the market within the next 10 to 20 years, companies who can demonstrate progress, particularly on more efficient, cheaper batteries, should profit.

Efforts to support the introduction of electric cars can also be observed in emerging markets, particularly China, which seeks to become a leader in this field. China is gearing up its electric car production capacity, by granting generous subsidies and installing a charging infrastructure for electric cars in several cities.
Increased efficiency in transportation can also be achieved by shifting from carbon-intensive air and road transportation to rail and marine.

Improving the rail infrastructure is an important element of several stimulus packages, particularly in China, but also in the US, South Korea and some European countries. Plans include the extension of long-distance, high-speed train lines to compete with air travel and an improvement in urban mass transportation. Rail, especially electrically powered, is likely to grow in popularity.

Electricity production and transmission:
Electricity production and transmission are feeling the capex cuts from the economic downturn; and power generation, in particular, has been hit by reduced investments. However, surveys indicate that utilities expect capital spending to revive over the next 12 months. Transmission and distribution (T&D) appear to profit from the stimulus packages. Over the long term, there is little indication that demand for electricity will decrease, even if climate change policies drive electricity prices higher.

There is a clear trend towards electrification in many areas, for example, in electrical cars and trains, and the replacement of oil heating by heat pumps. In this context, energy efficiency can offer ways to satisfy growing electrification without the need for additional power capacity.

Inefficiency in the electric supply chain continues to be considerable. Companies which can offer energy efficient solutions in generation, smart grids, and transmission, including more efficient transformers or metering services to reduce final electricity demand will have a positive future.

Renewable energy sources will change the energy landscape

Renewables should reshape the energy landscape in the coming years. Further falling prices will make renewable electricity production more competitive and grid parity in some areas a near term reality. Yet, renewable energy sources are still dependent on government support. A good example is Germany’s solar energy industry, which has grown dramatically in recent years thanks to a generous feed-in tariff.

The credit and economic crisis has not left the renewable energy sector unscathed. While capacities swell in the solar and wind sectors, prices and margins are tumbling, resulting in a market that looks set to consolidate. This will encourage renewable energies to quickly hone their competitive edge on conventional energy suppliers. The general outlook remains promising with longer-term growth rates of 10-20% for wind and solar. The share of renewable energy in additionally installed capacity worldwide has already risen from 5% to nearly 25% since 2003. This trend should continue, thereby fundamentally transforming the energy market. The current economic situation and subsequent overcapacities increase cost pressure on renewable energies, leading to greater efficiency, innovation and competitive pricing. We feel certain that numerous companies will emerge from the crisis even stronger and that the big winners will be companies with cost advantages.

Wind:
In the US, cash payments have been received for projects approved under the American Recovery and Reinvestment Act. In Europe focus has been placed on the offshore-market, and turbine manufacturers are gearing up for the challenge. The Chinese wind industry has grown rapidly over the last three years and the official wind installation target of 30GW for 2020 is expected to be achieved by the end of 2010. Yet rapid global production increases and the financial crisis have led to an oversupply in turbines in all major markets.

Solar photovoltaic (PV):
As a result of oversupply, prices of solar modules are on the decline, putting pressure on margins along the whole value chain. In Germany, substantial feed-in-tariff adjustments have been announced to start as early as mid 2010. In the mid-term, solar industry sentiment remains subdued given the oversupply situation. Asian low cost producers continuously enlarge their market share while European companies – driving the PV boom in the last years - have struggled and missed the opportunity to lower prices in the heydays. Prior to the credit crisis, the slogan for most high tech players in the industry was, “our product offers the best technology;” whereas nowadays, most companies present products focused on “the cheapest prices.” The PV market now behaves like a commodity market, where scale and mass production determine success and failure. We prefer Asian PV producers, but believe there is value in European equipment suppliers. As yet, only a few Asian companies exist while European companies develop state-of-the-art PV equipment.

Concentrated Solar Power (CSP):
After a long period of stagnation, the market is becoming more dynamic. Interestingly, for regions in the sun belt, CSP offers opportunities similar to Europe’s large offshore wind farms. However, this is a tiny market with only about 0.5 GW capacity installed globally at the end of 2008, compared with the more successful low- and medium-temperature solar water heating that has reached a capacity of 145 GW thermal. The investable universe for CSP is small; however, with the potential for initial public offerings (IPOs) of specialised companies and the strong involvement of utilities, the universe could expand.

Biofuels/Biomass:
In Europe, the heated debate on food vs. fuel ended for many biodiesel and bioethanol companies in insolvency. Many survivors face production with break-even costs and low capacity utilisation.
Besides the negative sentiment for biofuels, the reasons for the collapse of the industry are fairly simple:

1. unpredictable developments in raw material (input) prices hurt many companies in autumn 2007, when wheat prices went up to EUR 300 per ton from only EUR 150 per ton in April the same year;
2. lower input prices for the Brazilian bioethanol industry due to the availability and abundance of sugarcane, providing an unbeatable advantage. We see a similar situation in the US with maize.

At first (2005/06), high import tariffs protected the European industry from cheap Brazilian and US imports. In the end, however, the development of wheat prices destroyed the business case. We believe that the so-called 2nd generation biofuels can provide new growth potential in Europe, using biomass consisting of the residual non-food parts of crops, such as stems, leaves and husks that are left behind once the food crop has been extracted. The marketability of this technology, however, still needs some time. The biogas sector already uses some non-food parts of crops. The sector is, however, in its infancy and investment possibilities are limited at this point.

Geothermal:
Currently, about 10 GW of capacity is installed globally, producing electricity at a competitive cost of 4-10 US Cents per kWh.
More geothermal plants are planned, but the installation process is expensive and can be risky. Geothermal power plants produce baseload electricity with high load factors of about 90% which is comparable to nuclear. Thus, they have the advantage of constant production, unlike wind and PV. Additionally, most governments with significant geothermal resources offer some type of support, like subsidies or tax credits.

Large caps to spark consolidation in the renewables space

In UBS’ view, large industrial conglomerates will initiate the consolidation of the renewables sector. From 1995-2008 M&A transactions tended to focus on wind turbine manufacturers, but now other renewable energy sources are taking precedence. The last transactions to make headlines were primarily in the solar sector. Bosch acquired ersol and aleo solar (both PV companies) and Siemens bought the solar thermal company Solel.

What drove the consolidation phase in the wind sector and what is the the future of the solar sector? Fifteen years ago turbine manufacturers experienced their first major consolidation phase. Players such as Gamesa and Vestas enlarged their operations through targeted acquisitions, while General Electric and Siemens entered the market by means of takeovers.

The slowdown in market growth from 2002-2004 resulted in a significant earnings slump for many turbine manufacturers. Given the dire financial situation, M&A activities soon came to a halt. In 2005, the picture changed when the demand for wind energy began to pick up. This strengthened the incentive for out-of-industry companies to enter the lucrative wind energy sector (e.g. Alstom) and for existing industry players to enlarge their footprint (e.g. Suzlon). The current financial crisis again brought M&A transactions to a halt.

However, a lesson we have learned from the wind sector is that as soon as financing becomes available, we can expect a consolidation of the solar market. Yet this time, unlike in the wind sector, the process will be driven not only by M&A but also by closures due to the financial shakeout. In PV, we expect Asian companies (wafer, cell, module producers) to emerge as the champions of the consolidation.

Investor risks and opportunities

The credit and economic crisis has not left the renewable energy sector unscathed and renewable energy funds have suffered as well. Companies in this sector are undergoing a massive transformation, in which not only a competitive advantage but also new technologies are key. Most of the companies exposed to energy efficiency operate in industries that are significantly affected by the economic cycle. Some of these companies are diversified conglomerates; and thus positive developments in energy efficiency can be overpowered by other industry concerns.

Given the dynamic and challenging environment of renewables, careful stock selection is essential. We therefore prefer broadly diversified and actively managed investment products such as funds to reduce the risks of clean energy investments.