Clean tech, an investment in the future

Alternative energy, clean tech, and new energy tend to conjure up different definitions — for good reason. The industries and technologies that comprise clean tech are extremely diverse, ranging from jatropha plantations for bio-diesel to advanced battery technologies. In essence, clean tech is composed of industries using newer or cleaner technologies to generate or use energy better — a noble pursuit, given the evidence that our world’s reliance on dirtier fossil fuels is leading to a gradual warming of our planet.

While the clean tech industry has expanded considerably during the past decade, it has been around for centuries, growing in spurts and stutters. In the 1860s, during the heart of the industrial revolution, peak coal fears in Europe encouraged early research into solar and other forms of renewable energy generation. During the roaring 1920s, Henry Ford believed vehicles would increasingly be run on biofuels. The 1970s spike in oil prices caused by the Arab OPEC members’ embargo led to a significant push by the U.S. government to subsidize and foster alternative energy sources. Between 2006 and 2008, high oil and energy prices, coupled with the scientific community’s acknowledgment of the impact of global warming and popular awareness, helped usher in the most recent spike in clean tech advances.

One recurring theme with clean tech is its relativity. Periods of rapid advancement in these industries tend to coincide with supply disruptions of fossil fuels and/or rapid increases in traditional energy prices. This is simple economics. If a gallon of gas costs $2, the economics of a $5 gallon of ethanol just don’t add up. But there are non-financial factors that provide support for clean tech and help bridge the cost gap.

With much of the Western world reliant on fossil fuels sourced from relatively volatile parts of the world, clean tech offers a vehicle to increase energy security and diversity. This can help mitigate supply shocks and is at the root of the U.S. corn-based ethanol or the Brazilian sugarcane-derived ethanol industries. Clean tech also creates high-paying jobs. Germany, not known for its sunny climate, is a leader in a solar industry that employs over 300,000. On top of this, there is the difference in financial and economic cost. It is cheaper to produce electricity from coal, but this financial cost does not capture the total cost to the environment due to emissions. It is these additional factors and declining costs of clean tech that have encouraged many governments to subsidize clean tech projects and industries.

Clean tech will continue to evolve, finding cleaner ways to generate energy or use existing sources, and garner a larger piece of the global energy market. Some of the technologies being developed are truly game-changing. However, when it comes to investing in the public clean tech market, overall investor risk appetite, oil prices and government policy have big impacts on price performance.

A rocky decade

Clean tech investing is not for the faint of heart. The NEX Index enjoyed fabulous returns from 2003 through 2007 to the tune of 35% compound annual return. But during the financial crisis, the knife cut the other way, and the Index lost over 60% of its value during 2008.

Risk appetite

Despite strong growth during the last 10 years in the amount of energy generated from renewable sources, the publicly traded portion of clean tech remains relatively small. Some larger-cap companies do exist, including Spain’s Iberdrola Renovables and Tesla Motors, but the majority of the NEX Index is comprised of smaller-cap companies. The market capitalization of the entire index is about $250 billion, which, put into perspective, is a little more than half the market cap of Exxon Mobil Corp.

An investor in the clean tech space requires a high appetite for risk, not just because the publicly traded companies tend to be smaller in size, but also because a large portion of these companies are not yet profitable. Many clean tech companies are still developing or deploying new technologies and are still in the unprofitable stage, though some companies have great potential. In 2010, only 73% of NEX constituents generated a profit, compared to 95% for the broader S&P 500. Given the smaller size and portion of companies still not profitable, when the general investor becomes more risk averse, clean tech does not do well. But when risk appetite rises, clean tech outperforms.

Unfortunately, risk aversion is still stubbornly high following the recession. This has been one of the limiting factors for clean tech investments of late.

Energy prices

Higher energy prices are perhaps the biggest catalyst for fostering increased renewable energy capacity. Before the financial crisis, strong global economic growth meant energy prices were at elevated levels. The world witnessed the price of a barrel of oil climb to $140 ($87 in late January), natural gas was over $12/MMBtu ($4.50 in late January), electricity spot prices in California rose to $1.20/MWh ($0.36 in late January) and gasoline was over $3.50/gal ($2.36 in late January). The higher the energy prices, the lower the hurdle for providers to switch over to clean tech solutions.

The NEX Index has followed the price of oil much more closely than the broader equity market, through both ups and downs (see chart, “Tracking the NEX Index 2006-2010”). We would not expect the oil-clean tech relationship to change anytime soon, since the higher the price of oil, the more investors turn to alternatives.

Government policy

Despite the headway made in many clean tech industries, government support in the form of purchase agreements, subsidies or other methods remains paramount for most companies to turn a profit. The good news is as the technologies advance, the cost of installing renewable energy sources continues to decline. For example, the cost of installing onshore wind power is now lower than oil facilities, although still more expensive than coal. Unfortunately, with any government involvement, there are risks. An example was the recent negative pressure on many solar companies due to uncertainty on the renewal of Germany’s incentive program. Once the details were announced, the solar shares rebounded higher.

Investment thoughts

We have a positive long-term view on clean tech. Given the sheer size of the global energy business, clean tech’s current small market share, and the demanding energy needs of our planet, clean tech is well positioned to be a winner. Plus, as the technology advances, the hurdle for adoption should continue to decline.

Unfortunately, in the short term we remain in a relatively risk-averse investing environment. This is gradually improving, but given the size and speed of the past bear market, it will be a longer road back than usual. This is one of the reasons the NEX has not kept pace with the price of oil during the past year and a half.

Valuation metrics are not overly enticing at this point. While the price-to-earnings ratio for the NEX Index is much more reasonable at a little over 17x, growth metrics are just starting to improve. Return on equity, which tracks profitability, has declined to below 7%, which is low. Comparing earnings estimates for 2012 to 2011, earnings growth in the clean tech sector is beginning to look a bit more attractive at 21%. This compares to 15% for the broader S&P 500.

Natural gas & austerity

Two additional factors hurting clean tech share prices at the moment are natural gas prices and the ongoing austerity measures being implemented in Europe and other regions. North American natural gas prices have remained at depressed levels for much of the past two years thanks to slower-than-expected demand recovery and the impact of new drilling technologies. This has effectively flooded the market with natural gas. As the price of gas remains low, adding new wind capacity becomes less attractive.

Meanwhile, Chinese turbine manufacturers are beginning to export more actively, raising margin compression fears.

As government policies are a key driver of clean tech activity and profitability, there is increasing concern that the financial troubles of many European governments may impact the favourable subsidy programs currently in place. With governments under pressure to maintain programs and rebuild balance sheets, these renewable energy subsidies may be at risk. Not helping matters is the lack of a global solution to build upon the Kyoto Protocol expiring at the end of 2012. Until there can be a broader solution, the specific subsidy programs of individual countries will continue to cause fluctuations in specific companies’ share prices.

Clean tech is an exciting piece of the investment universe given the enormous potential of the individual industries or companies and the fact it is operating in perhaps the largest industry on earth, energy. Even small changes can have a dramatic impact on share prices. However, there are some headwinds that may limit returns in the near term.

Craig D. Basinger, CFA, is a Private Wealth Strategist with Macquarie Private Wealth Inc.

Craig Basinger