By Michael Liebreich
Chairman and CEO
New Energy Finance
As investors around the world in all sectors – not just clean energy and carbon – try to work out how to play the recovery, they are facing their deepest quandary for decades. Will “quantitative easing”, near-zero interest rates and spiralling government deficits result in a nasty bout of inflation, or will record consumer debt burdens, rapid corporate and bank deleveraging, enforced fiscal responsibility and over-capacity in exporting economies sink the world into a deflationary spiral?
It seems almost foolish to believe that the economy can bounce back from its near-death experience and pull off a “Goldilocks” recovery – neither too hot nor too cold. Yet in the clean energy sector, that appears to be exactly what people are hoping for: a return to the pre-2008 “norm”, with low inflation, fast economic growth and buoyant consumer spending and bank credit.
Our data for investment in the third quarter of 2009 certainly shows investment in clean energy continuing to recover from its lows during the financial crisis. The past quarter was not a boom by any means, but with total worldwide investment at $25.9bn, only 9% shy of an upwardly revised figure for Q2 and nearly double Q1’s miserable $13.3bn, the sector is clearly on some sort of recovery trail. Venture capital, private equity and public markets investment picked up in Q3.
As long as private sector activity continues to rebound, the arrival of government “green stimulus” money over the quarters to come may help get total investment in clean energy back up from the forecast $105bn to $115bn outcome for 2009, to – and maybe above – last year’s peak figure of $155bn in 2010 or 2011.
However, although clean energy should continue to outperform the wider economy because of its underlying growth drivers of climate change and energy security, it is not insulated from it. A sustained period of either higher inflation or of deflation would have profound and painful implications for the sector.
Of those two extreme macroeconomic scenarios, the mainstream media seems to think inflation is the more likely – a recent analysis by London’s Absolute Strategy Research showed that many more articles are being written about inflation than deflation. However the hard numbers point the other way, at least temporarily: the US annual inflation rate in September, for instance, was -1.3%, euro area inflation in September was -0.3%, and Japanese inflation in August -2.2%. Admittedly, “core” figures excluding energy remain above zero in most countries.
At first sight, inflation might appear to offer some cheer for clean energy. A dose of inflation ought to keep oil and electricity prices on the rise, while eating away quickly at the debt burden of renewable energy project developers.
Higher inflation is being advocated as a way of easing the pressure on government finances feeling the strain of financial rescues, stimulus packages and lower revenues. With inflation, tax revenues would rise, and deficits could be trimmed by means of the relatively easy device of under-indexing tax allowances and thresholds. Public debt would be eroded by inflation. In those circumstances, would governments not have more money available to help finance low-carbon technologies?
In addition, generators might shift investment differentially into wind and solar power, which have no feedstock costs, at the expense of gas or coal-fired generation, where the feedstock would most likely escalate in price over the lifetime of the plant. This would not help biofuels or biomass, because agricultural feedstocks too would be expected to rise in price over the lifetime of a project.
Much also depends on the relationship between the average rate of inflation over the 25 years of a power plant, and the discount rate used by utilities and other potential clean energy investors over the same period. For utilities, the “normal” discount rate for net present value estimates is some six percentage points above the expected inflation rate. If investors are so keen to get out of cash and into assets that the spread shrinks to three or four points, say with inflation at 5% and the discount rate at 8%, then there could be a flood of investment into new capacity.
However, as inflation accelerates, past experience shows the opposite occurs – investors require a greater spread over the rate of inflation in order to ensure they are not wrong-footed by accelerating inflation. Even assuming the spread between the cost of capital and inflation simply remains unchanged, then the higher the inflation rate, the worse the investment looks. Assuming that feedstock and electricity prices, and therefore project cash flows, all march in step with overall inflation in the economy, the NPV of a project is higher with a combination of 4% discount rate and 2% deflation than it is with an 8% discount rate and 2% inflation; it would fall still further with a 15% discount rate and 9% inflation.
The big problem with inflation is uncertainty. In particular, if inflation threatens to move into the 5% to 10% range, there would be increasing worry about what the authorities might do to curb it, about how high interest rates might go and whether the policy response would cause recession. There would also likely be destabilising moves in foreign exchange rates as interest rate differentials shifted.
This volatile environment would deter investors from taking decisions on new capacity throughout the economy, creating the double whammy of lower demand for electricity at the same time as risk aversion among the asset owners who ultimately fund investment.
So if higher inflation would be uncomfortable for the clean energy sector, should we be perhaps be hoping instead for a few years of deflation?
In a period of 1%, 2%, or even sharper, deflation, an NPV analysis would seem to justify healthy investment in renewable energy capacity. However the reality of deflation would be likely to be different. With falling prices, as the experience of the Japanese economy has shown, consumers and businesses tend to hold off from making purchase decisions because they believe those items will get cheaper still. As investment is delayed throughout the economy, so power prices slide.
In addition, the value of holding cash in a deflationary world might tempt generators to build plant that costs less upfront – such as gas-fired capacity – and to hope that gas prices continue to be weak over the lifetime of the project. And even though a deflationary environment might offer project developers some mouth-watering deals on wind turbines and PV panels, they may well end up delaying decisions in the hope of getting a better deal later.
Finally, deflation would most likely be accompanied by other economic characteristics that would also be deeply troubling for the clean energy sector. It would be likely to coexist with highly indebted public finances (as in Japan now, where national debt is some 170% of GDP), with low world GDP growth and protectionist tendencies.
The parlous state of public finances could affect the ability of governments to offer the sector tax breaks and research funding. Low GDP growth would be likely to mean low carbon prices, and therefore less incentive for efficiency improvements and investment in low-carbon generating capacity. Although environmentalists might be relieved at the lower trajectory for emissions in the short term, our modelling shows that the reduction in investment results ultimately in higher levels of emissions.
Protectionist tendencies, already surfacing in relations between the US and China, could see countries trying to block imports of renewable energy equipment from lower-cost producers and could also engender distrust in international climate change talks.
Overall, inflation and deflation both look highly unappetising for the clean energy sector. So what should we hope for on the macroeconomic front? If anything, we believe that a modestly inflationary environment looks better than a period of deflation.
In the worst case, the combination of stimulus spending and quantitative easing results in accelerating inflation, followed by a deflationary shock as national finances hit the buffers and countries have to turn the taps off in a hurry.
The best result for the clean energy sector might be a few years of inflation in the 3% to 5% range, followed by a slow reduction to around 2%. To complete the wish-list, we might opt for moderate economic growth as well – fast enough to require additional investments in energy capacity, but restrained enough to prevent the re-emergence of supply-side bottlenecks or a leap in carbon emissions and an unexpected spike in carbon prices.
But whatever the outcome, what are the chances that recovery continues smoothly and serenely without any more stomach-churning twists and surprises?
I’ll let you be the judge of that.
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