A bright future: the best ways to invest in solar energy

This year has seen many dramatic changes, but one milestone in particular stands out. For over two months, from early April to mid-June, coal power made no contribution to the national grid – the longest period since the 1880s. While this was partly due to the slump in energy prices, it shows that non-renewable sources of energy – coal in particular – are on their way out.

The renewable-energy sector is made up of multiple sources, such as wind and tidal power, but the biggest winner in recent years has been solar energy. In 2009 it accounted for 20,000 megawatts (MW) of global capacity; by the end of 2020 the figure is estimated to be 720,000MW – enough energy to power around 522 million homes. And the future for this energy source looks bright.

Costs are falling everywhere

The key reason solar power is taking over as the energy of the future is that its cost has plummeted in recent years as the technology behind it has improved. Liam Thomas, chief investment officer (CIO) of New Energy Solar (a company that buys and runs large solar-generation facilities), and also CIO of the US Solar Fund, notes that there are several ways to measure the price of solar energy.

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The levelised cost of energy (LCOE), the long-term price that a utility needs to charge to cover its costs and satisfy its investors, is generally regarded as the industry benchmark. Using this measure, the cost of energy from large-scale US solar plants has declined by an average of 13% a year for the last five years. This means that in the US, solar power “is already competitive with other forms of newly-built energy generation”, and in many states, especially in the southern part of the US, “solar is now the cheapest form of new-build energy production”.

While it is still generally cheaper to generate energy from a conventional power plant, the cost of solar energy is declining so quickly that solar plants are starting to undercut them on price. This cost-competitiveness means that a majority of new solar build in the US is now motivated by economics rather than the demands of regulators.

America receives a lot more sunlight than most of Europe and the UK, so solar producers in Britain are still at a cost disadvantage compared to other power sources. But even this is changing, says Wayne Cranstone of Gresham House Asset Management. In Britain solar and onshore wind are “already the lowest-cost forms of renewable energy”, and they are also “very close” to grid parity, which means that developments of the right size in the right location “can still be profitable in the UK without subsidy”. There are even a few projects as far north as Scotland.

Solar producers are also finding ways to get around the volatility of electricity prices. One strategy is to agree a power purchase agreement (PPA) with clients. Under these arrangements, companies agree to purchase a certain amount of power generated from a solar plant at a fixed inflation-linked price for between ten and 15 years. These agreements can either involve the company getting the power directly from the plant, or via an electricity company, which in turn buys an equivalent amount of power from the solar plant. This greatly reduces the risk for the producer, and greater certainty lowers overall financing costs.

Batteries are getting better

Until recently one of the problems hampering widescale adoption of solar power has been that, unlike coal or gas plants, which could effectively provide power on demand at any time of day, the output of solar plants is limited by the amount of sunshine. This was a particular problem since demand tended to peak in the evenings when people came home from work – precisely when solar generation is at its lowest. However, while this is still an issue, both solar power companies and utilities are starting to find ways to get around it, says Christian Roessing of Pictet Clean Energy.

One simple solution is to find economical ways to store the electricity generated. Fuelled by the growth of the electric-car industry, the costs of lithium-ion batteries, which can store excess electricity, “have come down by around 90% over the last decade”, says Roessing. While they are still not yet quite low enough to completely eliminate the need for additional power, he predicts that “within the next three to four years, [costs] are likely to have fallen enough to make short-term storage of solar power affordable”.

Meanwhile, as Andrew Buglass of Buglass Energy Advisory says, a “big shift” is taking place in how national energy grids are operated, which should hopefully smooth demand and reduce (though not completely eliminate) the need for storage. For example, the National Grid in the UK has developed the Demand Turn Up service, which encourages conventional producers to reduce output at times of low national demand and high renewable output, so that they only operate when renewables are silent.

In addition to encouraging conventional power companies to fill in the gaps in solar power generation, the National Grid’s initiative also attempts to nudge demand toward the times where solar production is at its strongest, cutting the cost of consuming electricity at these off-peak times.

Buglass also notes that the coronavirus crisis, which has seen more people working from home, has already led to some dramatic changes in power consumption, which should further favour solar producers as well as show electricity companies that the “pattern of consumption is not set in stone”.

Regulatory and political tailwinds

The fall in the cost of solar generation means that it is “increasingly competitive on an unsubsidised basis”, says Thomas. However, subsidies and mandates have clearly been “helpful” in encouraging investment and speeding up the process. In the US the main turning point was the federal Solar Investment Tax Credit in 2006. This allowed owners to claim a tax credit equal to 30% of a project’s capital cost. This scheme largely explains why the US solar power industry has grown more than 100-fold in the last 15 years.

There has been plenty of action at the state level too, with “37 out of 50 states implementing some form of subsidy”. A majority of states have also set targets for renewable energy. As these targets are met, they are usually increased, “further driving the demand for installations”. Indeed, seven US states (California, Hawaii, Maine, Minnesota, Nevada, New York and Virginia), as well as Washington DC and the territory of Puerto Rico, have passed laws that commit them to meeting all their energy needs from renewable sources by a set date.

The US is not alone in promoting renewable energy. There are also several schemes “helping to promote the adoption of solar energy across the world”, says Claudia Quiroz, lead fund manager of Quilter Cheviot’s Climate Assets Fund. However, the situation is a little more complicated in the UK. The government scrapped interest-free loans for domestic solar panels in 2015, which reduced the number of panels installed. It also subsequently phased out a Renewables Obligation scheme that encouraged the construction of solar and wind farms.

This means that at present the solar industry in the UK receives no direct subsidies. On the other hand, since 2014 the government has been running a Contract for Difference scheme whereby developers are “paid a flat (indexed) rate for the electricity they produce over a 15-year period”. Although more generally suited to wind rather than solar, this “de-risks investment in renewables”.

It hardly seems crucial, however. The technology has now advanced to the point where both the domestic solar panel industry and the solar power generation market are “quite healthy without the need for any direct government subsidies”, even though annual new installed solar capacity is still less than it was six years ago.

Cheaper oil and gas is no longer a threat

This year has seen unprecedented volatility in the energy market, with the price of a barrel of West Texas Intermediate (WTI) oil plunging from around $60/barrel at the start of the year; it briefly turned negative, but even after a subsequent rally, WTI currently trades below $40/barrel.

While natural gas prices move more smoothly, the trend is also sharply negative, with the spot price of the main Henry Hub benchmark less than half the price at the end of 2018, and a third of its level six years ago. Oil and gas price-slumps fuel concern that cheap fossil-fuel prices will discourage new investment in solar power, and could even result in a move back to oil and gas.

Quiroz accepts that the dip in gas prices may lead to “lower marginal costs for existing gas-fired electricity generators”. Similarly, it will also make gas plants “more attractive” when it comes to installing new electricity generating capacity. Still, any effect is likely to be extremely mild, since companies understand that energy prices can be “extremely volatile”.

As a result, when deciding whether to build energy plants, they tend to look at forward energy prices over the lifetime of the project, reducing the impact of short-run fluctuations in prices. Quiroz notes that the International Energy Agency (IEA) also thinks that the low oil and gas price will have a minimal impact on solar power (and other types of renewable energy such as wind). In its latest update on the prospects for renewable energy, published in May, the IEA predicted that, “planned renewable electricity projects with long-term contracts will be mostly shielded from low natural gas prices”.

This is because the medium and long-term economic case for wind and solar “remains strong thanks to expected continuing cost reductions and to the long-term price predictability over project lifetimes”. In essence, solar is now established enough not to sustain significant damage from slumping fossil-fuel prices.

Buglass agrees, noting that the current price falls in natural gas haven’t prevented an increasing number of solar projects being economically competitive, even without government support. Moreover, the low maintenance costs of domestic solar panels also mean that they provide a cheap form of insurance against a sudden spike in energy prices.

What’s more, no matter how cheap oil and gas get, they are still extremely polluting, a cost that governments around the world will have to price in, either via taxes or carbon trading schemes, “if they are at all serious about meeting their stated emissions targets”.

How to invest in the solar energy sector

The recent disruption caused by Covid-19 means that many solar projects that were due to go ahead this year have been postponed. However, in the longer term the growth in output is “certainly not going away”, says Louise Dudley, a portfolio manager at Federated Hermes, an investment manager.

The proportion of global new energy capacity accounted for by renewable power is likely to expand “from around 20%-25% now to 42% by 2030, and then to 57% by 2050”, with solar the largest contributor. The sector should also get a boost as total electricity demand continues to grow in line with the global economy. One way to play the solar boom is to invest in companies that manufacture equipment related to solar power, most notably photoelectric cells (PV). However, Dudley thinks that investors have to be careful if they want to go down this path, because many of the companies in this sector “are still quite small”, which means that both their revenue and share price can be extremely volatile. However, a few of them have tried to get around this by using their expertise to diversify into other areas. She also thinks that “green real estate”, projects that incorporate solar power into their design, is another area worth looking into.

Roessing is even more sceptical of PV manufacturers as an investment, emphasising that it is a sector that potential rivals can easily enter, reducing established operators’ profitability. He thinks that the real winners from what he calls the “inflection point around solar energy” will be those companies that run and operate the solar plants. Operators of gas and coal power plants with plans to switch to solar in the near future should also do well given the mounting concern about climate change. I highlight some potential investments in solar energy below.

What to buy now

One easy way to buy into the solar power boom is through iShares Global Clean Energy UCITS ETF (LSE: INRG). This exchange-traded fund (ETF) tracks the S&P Global Clean Energy Index, which contains 30 stocks. While it is not limited to solar power firms and utilities, four out of its five largest holdings are involved in solar power.

The firms in the fund have an average price/earnings (p/e) ratio of 18.5. It has a total expense ratio of 0.65%, which is reasonable for such a specialised ETF, and cheaper than most actively managed funds.

One actively managed fund worth researching is Pictet Clean Energy, run by Xavier Chollet and Christian Roessing. This fund focuses on companies that contribute to the reduction of carbon emissions though clean energy, including utilities specialising in solar power, utilities moving towards solar energy and semiconductor firms involved in the production of more efficient solar panels. Top holdings include NextEra Energy, the world’s largest producer of solar and wind power. While its management charge is 1.6%, the fund has a strong record, significantly outperforming similar funds over the past decade.

Despite advances in demand management, the rise of solar (and wind) power will create a need for utility-scale energy storage systems. Gresham House Energy Store Fund (LSE: GRID) is an investment trust that invests in utility-scale energy storage projects. It currently owns nine, with another five in the pipeline this year. It has a relatively high management charge of 1.64% a year, but it trades at a discount to net asset value of 8% and offers a dividend yield of 4.9%.

The Renewables Infrastructure Group (LSE: TRIG) invests in a diversified portfolio of 78 operational renewable energy projects in the UK and Europe, and an additional project related to battery storage. Solar energy accounts for nearly two-fifths of its portfolio. Claudia Quiroz of Quilter Cheviot’s Climate Assets Fund likes the fact that 75% of its overall portfolio is underpinned by government subsidies lasting until 2024, thus giving investors an added degree of security. It has a solid dividend yield of 5.34%.

The mass shutdown and gradual restart of nuclear power plants in Japan following the 2011 Fukushima disaster has created an opportunity for solar power. Enter Kyocera Corporation (Tokyo: 6971). Not only does it manufacture photovoltaic cells and solar modules, but it also operates solar power plants, including a “floating plant” built on reclaimed land off the coast. Louise Dudley of Federated Hermes says that the firm’s operational diversification allows it to benefit from the solar boom without completely depending of the volatile PV market. It is on a trailing p/e of 20.

Consider also SolarEdge (Nasdaq: SEDG), which supplies storage, battery and monitoring systems for home and business solar projects. Thanks to the boom in home and business solar panels, SolarEdge’s revenue has climbed fourfold from $325m in 2014 to $1.42bn in 2019, while its earnings have risen fivefold in the same period. Its dominant position in its home solar market allows it make a return on capital expenditure of 20%. This more than justifies a 2021 p/e of 27.