A perfect storm in energy markets

The energy crisis unfolding across the globe is rocking energy markets and impacting households, firms and investors. For now, electricity prices in Europe have been the most seriously affected, but the problem is not exclusively a European one and price hikes could easily spread to other regions.

Some of the crisis’ causes, notably explosive demand due to economic re-openings, are cyclical and will eventually fade. Overall, however, price volatility is here to stay. This, combined with tightening regulation and net zero initiatives, present excellent opportunities for investments across the clean energy value chain.

The last quarter of 2021 saw a convergence of external forces that have unleashed a wave of volatility across the energy sector. Starting in Europe, spiking electricity prices have wreaked havoc on energy systems across the continent. Simultaneously, higher energy prices in the form of gas, oil and coal, have added fuel to the fire. Even more troubling, forward curves are pointing towards persistently elevated power prices in the coming years.

Numerous factors are to blame. While demand has been stronger than expected, the issue is mainly one of supply. Energy reserves are at unprecedented lows after weak wind conditions decreased wind energy output and lower rainfall reduced capacity at critical hydropower stations. Moreover, replenishment via imports from the US and Russia, Europe’s traditional trading partners, have also failed to materialize amidst international competition and geopolitical gaming.

The EU Emissions Trading System (ETS) which entered into force in 2020, has had the intended consequence of raising carbon prices, thus making it more expensive for heavy-carbon producers like coal and gas. The price of carbon certificates has already reached unprecedented levels (EUR 90 as at 8 December 2021) and have nowhere to go but up given shrinking carbon certificates, COP26 pledges and supportive energy prices. Although supply shortages have remained the main force at play, we believe carbon has accounted for about 10-20% of the recent spike in electricity prices.

Analyzing publicly available electricity consumption data from companies’ sustainability reports¹ we calculate that electricity costs (assuming EUR50/MWh) represent on average 0.4% of revenue. From a purely theoretical perspective, assuming electricity costs double, ceteris paribus, the impact on profitability would be roughly 2.8% (0.4% higher costs on average EBITDA margin of 15%), with most energy intensive sectors such as Materials² being hit the most (impact >10%). Industrials, Consumer Discretionary (which includes car makers) and Information Technology (which includes semiconductor companies) being relatively less energy intensive³, would suffer a smaller impact on profitability (1%-2.5%).

In order to counteract the negative effects of higher energy prices, companies can establish hedging policies, structure long-term supply contracts or set commercial relationships where prices are adjusted to reference raw material prices. However, the key action to defend profitability is to pass on higher energy costs to customers. This normally happens with time lags depending on operating frameworks and competitive environment.

Companies with higher pricing power, will be able to raise selling prices to pass through higher energy prices. Conversely, lower pricing power in highly competitive landscapes not only means inability to translate higher costs into higher selling prices, but also a greater negative relative impact of energy prices on profit margins.

Wind and solar equipment suppliers and component manufacturers are a case in point for highly competitive markets. Commodity shortages and increased demand for steel, aluminum and polysilicon have created inflationary pressure on the raw materials required for renewable energy installations, pushing prices up. Ballooning shipping costs and deliver delays have exacerbated the problem by reducing production inventories and pressuring supplier margins.

While public sector mechanisms still need to smooth the impact on vulnerable sectors of society, we believe the impact of higher power prices will be absorbed by the energy system. This should serve as a wakeup call for companies to avoid energy volatility and accelerate the shift to renewable energy sources. Around a third of the MSCI World’s constituents provide renewable consumption data; on average 18% of energy used in 2020 was from renewable sources. Financial service companies performed best with more than 60% renewable energy while Industrial companies ranked well below average with only 11% of renewables in their energy mix.

Further fears over power cuts or break-ups of contracts from utility suppliers, will boost investments in energy storage solutions such as battery and green hydrogen. These will also help to overcome renewables’ intermittency issues and ensure reliable energy supply always matches demand. This creates an even stronger incentive for corporates to reduce future risks by investing in cleaner energy sources and more energy-efficient devices. We are already seeing corporates backward integrating into renewable generation rather than just securing renewable energy through long-term power purchase agreements. As renewable capacity ramps up, costs will continue to fall, making it cost competitive with traditional energy sources whose prices will continue to rise.

Higher energy prices provide strong tailwinds for our sustainable thematic strategies which aim to decarbonize energy and manufacturing activities. The businesses in which we invest offer a unique value proposition that is driven by addressing the need for energy efficiency. As a result, they should enjoy higher demand and growth rates in the future.

Footnote

¹ Out of 1,555 of the MSCI World’s constituents, more than half provide energy-use data for fiscal year 2020.
² Given an average energy intensity of ca 500MWh per million of Euro revenue.
³ Given an average energy intensity of ca 50-60MWh per million of Euro revenue.
⁴ The graphic depicts the historical mean levelized cost of energy (LCOE) values of energy sources over more than a decade. Solar power costs have fallen dramatically over the past decade and are now lower than, natural gas, the cheapest fossil fuel. The LCOE of a given technology is the ratio of lifetime costs to lifetime electricity generation, both of which are discounted back to a common year using a discount rate that reflects the average cost of capital.