Should we be concerned about renewable energy? (Part 2) (Note)

Should we be concerned about renewable energy?

Part 2: Are renewable energies a « credible » alternative to fossil fuels?

Summary:

· The renewable energy sector is clearly on an upward trajectory, with steadily falling production costs making it increasingly competitive with fossil fuels (coal and natural gas) – even without public subsidies.

· Furthermore, green energies are not subject to the price volatility and uncertainties associated with fossil fuels (oil in particular); on the contrary, they benefit from strong political support in the wake of COP21, as well as growth in developing markets;

· However, the lack of long-term visibility on prices and available oil quantities should encourage us to view the development of renewable energies as a long-term process.

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In the first part of this article, we showed that there is no observed link between oil prices and the development of renewable energies, and that therefore the energy transition is not expected to be « slowed down » by low oil prices. However, we can go further by asking whether the energy transition could simply be slowed down by fossil fuels—regardless of their price. A study of the comparative advantages of each type of energy (cost, efficiency, availability, geopolitical issues, etc.) is therefore necessary to determine whether renewable energies are a credible alternative to fossil fuels, and whether their long-term development can be viewed positively.

Renewables are becoming structurally cheaper

The cost of building renewable energy facilities has always been the biggest obstacle to their development, inevitably weighing on investment in the sector. However, the development of new technologies (smart grids, new biomass conversion or electricity storage techniques), strong demonstrations of support from regulators (renewable portfolio standards, tax credits, feed-in tariffs, etc.) and accelerated competition between players are all factors encouraging rapid growth in renewable energies.

As a result, according to consulting firm McKinsey and the US National Renewable Energy Laboratory (NREL), the cost of wind energy has fallen by 58% since 2009, thanks to cheaper materials and greater efficiency. As for solar energy, the cost of residential and commercial photovoltaic systems fell at a rate of 6-7% per year between 1998 and 2013, and even reached 12-15% per year between 2012 and 2013. If this pace continues, according to the study, renewables will be competitive with fossil fuels by 2020 in most US states.

Another factor boosting confidence in the sector’s development is that further improvements in the cost and efficiency of renewable energies are widely expected in the future, whereas there is little innovation in conventional energy extraction and processing technologies (oil, gas, and coal), in a sector facing increasingly strict regulations that are driving up costs. In the renewable energy sector, economies of scale (particularly on « soft costs » such as permitting systems, licensing agreements, and maintenance) and market deregulation (e.g., lower tariffs on modules manufactured in China) are expected to effectively reduce costs.

In its Levelized Cost of Energy Analysis 9.0[2] report, financial services leader Lazard logically asserts that despite significant declines in the cost of fossil fuels, certain renewable technologies (primarily wind and solar) continue to be competitive in certain scenarios, even without taking into account environmental and social externalities or public subsidies. This competitiveness stems from the fact that the typical long-term cost-benefit analysis of an energy production facility corresponds to energy production over the lifetime of the facility. In this regard, the future costs of renewables will continue to fall, due in part to the physical impossibility of them becoming scarce. Renewable energies such as solar power are already significantly more competitive than fossil fuels in the few markets (mainly in the Middle East and post-Fukushima Japan) where a significant proportion of energy is produced from petroleum derivatives (only 5% globally). The 2014 report by the International Renewable Energy Agency (IRENA) also points in this direction, concluding that the cost of generating renewable energy is now equal to or lower than that of fossil fuels in many parts of the world, and will remain financially competitive even if oil prices remain low.

An optimistic report by Bernstein Research summarizes these observations by stating that, unlike fossil fuels, which rely on an extractive industry where costs are bound to rise, green energy is a technology where costs are bound to fall. While the market shares of the two industries are comparable today, those of renewable energies are set to increase compared to their fossil fuel competitors. Many investors now see renewable energy as a market opportunity—regardless of the (unpredictable) evolution of oil prices—as self-sustaining cost reductions and specific advantages for investors (see below) show that we are on the verge of a « tipping point « [6]for renewable energies, which are only beginning to reveal their full potential.

The current oil price situation may even be particularly favorable for renewable energy, as summarized by Angus McCrone, senior analyst at Bloomberg New Energy Finance, who also asserts that the current situation is particularly favorable for green energy: « There is another consequence of falling oil prices. Cheap oil should be a boost to consumer confidence and economic growth in importing regions such as Europe, India, Japan, and China. This could, in turn, stimulate energy demand, reduce political concerns about energy bills, and increase the potential for new investment in renewable energy. »[7]

Renewable energies also have many attractions for investments and portfolio investments.

For investors seeking to build a robust energy portfolio, renewable energy has the advantage of less uncertainty because its price is set to decline in the medium to long term. Linked mainly to sustained consumer demand (which is not set to decline, with emerging markets in particular showing increasing interest) and ambitious political initiatives (with a boost following COP21), the price of green energy is much more « predictable » and less « risky » than that of oil.

In contrast, fossil fuels—oil in particular—are extremely variable and unpredictable (in the short term, a significant portion of the price of oil depends on the political decisions of oil producers, and in the long term, no one can predict when « peak oil » will occur). The main problem with crude oil prices is that they depend not only on the law of supply and demand, but also on political and social changes within producing countries (over the last 20 years, the price per barrel has risen from a low of $16 in December 1998 to a high of $143 in August 2008). This uncertainty leads to a lack of precision in projections of future oil prices. Similarly, the economic consequences of this volatility and the resulting uncertainties can be significant: in the short term, there are few options for reducing oil consumption, which can cause significant economic distortions in the event of sharp fluctuations in the price of crude oil: investment delays, reallocation of resources, and a drop in consumer spending and employment. These uncertainties, combined with the widespread desire for energy independence (see below), are encouraging many countries to accelerate their transition to clean energy, and investors to move towards clean energy (this can be seen in particular in the recent development of attractive new financial vehicles, notably « YieldCos, » which channel dividends to investors in renewable energy projects and now total several hundred billion USD[9]).

The current situation makes things even more difficult for oil players, as low oil prices (and therefore the reduced profitability of drilling and exploration projects) are forcing them to find ways to reduce production costs and are putting the brakes on costly projects in the sector (shale oil, tar sands, offshore, etc.). According to energy consulting firm Wood Mackenzie, approximately $200 billion in investments in oil and gas projects have been postponed since oil prices began to fall. Technological innovations (virtual warehouses to track inventory, digital technologies such as radio frequency identification or the use of drones, etc.) are being developed to improve efficiency within these industries. The advantage of all these developments for the renewable energy sector is that it can benefit from these technological advances in its own production processes. Cheap oil and gas can even help the development of renewable energies through cuts in fossil fuel consumption subsidies, which many governments have taken the opportunity to implement when oil prices have fallen. When oil prices rise again, these cuts will therefore give clean energies a comparative advantage.

However, the main risk for investing in clean energy remains that of a slowdown in government support for the sector, as governments remain the largest investors in green energy. In the UK, following the May 2015 parliamentary elections, a decision to remove subsidies for solar and biomass led to a major slowdown in private investment in these sectors. The British example clearly shows that the development of renewable energies can be threatened by political risks. However, these risks of the ecological issue being removed from political agendas are becoming less and less prevalent, as climate change is increasingly seen by the public as a global priority, with global commitments such as the recent COP21 being characteristic of this trend.

Numerous laws are being introduced to encourage the development of new forms of energy, and in return, fossil fuels are increasingly being penalized by regulators (particularly through carbon pricing mechanisms). The example of the US-China agreement on climate change (the United States is committing to reducing its carbon emissions by 26-28% in 2025 compared to 2005, and China commits to clean energy sources accounting for 20% of the energy mix in 2030 compared to less than 5% currently) clearly shows that many countries are irrevocably committing to « greener » policies, regardless of future oil price developments. The current period of low oil prices is even seen as an opportunity by many politicians and regulators to introduce carbon tax mechanisms, as these would be offset by low oil prices.

Conclusion

Renewable energies have not suffered from the fall in oil prices, mainly because these two products do not operate in the same markets, so there is no reason for their prices to be linked (see first part). Green energies are even on an upward trend, with their development in emerging markets (Asia and the Middle East in particular), strong political support with prospects for energy independence, falling costs, and price predictability that allows them to protect themselves against potential market uncertainties, making them increasingly profitable and competitive compared to fossil fuels.

However, we should be cautious about these seemingly rosy prospects for renewable energies when oil runs out. Even without taking new extraction techniques into account, there are enough known oil reserves to last for the next 50 years, and gas and coal are even more abundant. The much-feared « peak oil » (oil shortage) may therefore not be imminent. In summary, the transition to renewable energies must be seen as a long-term process, but their resistance to falling oil prices is a more than encouraging sign for their future development. Given that the signatory countries to COP21 have agreed to limit global warming to a maximum of 1.5°C by the end of the century, this development appears to be more than a necessity.