If you take a half-hour boat ride off the Kent coast at Thanet, you will come across the word’s biggest offshore wind farm. The 100 giant Blackpool Tower-sized turbines cost £780m to build and the project has a total capacity of 300MW. That’s enough energy to power 240,000 homes per year – but only if the wind is blowing.
As critics have pointed out, the average UK wind farm produces only a quarter of its potential output. As well as being unreliable, wind is also expensive. A recent study by the Royal Academy of Engineering estimates that power from an offshore wind farm costs more than twice as much as that from a coal or gas plant. Projects such as Thanet are only feasible because of massive government subsidies.
Yet, despite their cost, renewable energy projects continue to spring up. On the one hand, governments around the world are committed to reducing greenhouse gas emissions. The EU, for example, wants to reduce such emissions by 20% of 1990 levels by 2020. Needless to say, it’s some way off those targets, with energy consumption levels and emissions still rising. But environmental politics aren’t the only reason governments are backing renewables. Take Britain. Our production of North Sea oil and gas has fallen by 50% since 1999 – the country is now a net energy importer. Indigenous renewable energy would protect us from volatile energy prices and the geopolitical worries that go with being dependent on fuel from sometimes unpredictable foreign powers.
This issue has gained fresh urgency as energy prices have soared. Geologists disagree over whether we’ve hit ‘peak oil’ – the point at which we can’t raise production rates any further – but there is no doubt that with a lot of the easy oil and gas already gone, more of our energy will come from unconventional, and usually more expensive, sources.
Competition from emerging economies is also putting pressure on existing resources. So whether we look to conventional fuels or renewables, the fact is that we are moving into an era of expensive energy. As US energy analyst Gregor MacDonald puts it: “The US, and the West, have permanently lost access to cheap energy inputs.”
But humans are a resourceful bunch when pushed. And the good news is that there is “huge scope for [energy] commodities to be used more efficiently”, says Capital Economics’ Julian Jessop. “For example, China’s economy could increase in size by another 150% in the next 15 years, but its energy demand would remain the same as it is now if it used energy as efficiently as [South] Korea does today.” Energy inefficiency is on the Chinese government’s hit-list. Between 2005 and 2010, energy consumption per unit of GDP was cut by 20% from 2005 levels. The government is thought to be aiming for another 17% cut from current levels over the next five years.
These sorts of cuts are achievable because most of the energy infrastructure we use today was built when prices were lower, and efficiency was less of a priority. As a result, there are huge amounts of waste that can be cut. Using energy more efficiently is one easy way for governments to cut emissions and reduce energy imports. That is creating opportunities for companies offering ways to boost energy efficiency. There are two main themes.
1. Smart grids
The ‘smart grid’ is the glamour model of energy efficiency, attracting the most headlines and investor attention. Our existing system is effectively a ‘dumb grid’ the power plants, transmission lines and end-users have limited communication with each other. On the demand side, factories and household appliances are ‘unintelligent’ and ask for power for non-urgent tasks at more expensive peak times – when utilities have to use inefficient older power plants to meet demand – instead of waiting for demand to drop.
The aim of a smart grid is to attach sensors and controls that let producers and consumers talk to each other and thus save energy – almost like an energy internet, as some of its more enthusiastic advocates have described it.
Sounds exciting. Yet 2010 was a bad year for smart-grid investors, with the JP Morgan Smart Grid Basket underperforming the S&P 500 by 10%. This was partly due to investors avoiding small, riskier technology stocks, and also because the financial crisis briefly brought down the price of fossil fuels – making ‘cleantech’ (as the sector is known) less competitive. But the weak performance also reflected the patchy take-up of smart grid technologies. In Britain, utilities have been slow to implement the technology and little government funding has been forthcoming. In the US, “weak federal policy power… and the huge number of utilities… combine to make developing a coherent smart-grid strategy daunting”, says Gail Reitenbach in Power Magazine. Yet these concerns “are overdone”, says JP Morgan analyst Paul Coster. Companies in the sector are very cheap: “any hint of an energy crisis and multiples should expand across the space, so we think investors should be building a portfolio right now”. The Chinese government recently unveiled plans to spend at least $50bn on smart-grid technologies by 2015, while the US smart-grid industry is expected almost to double in size to reach $10bn by the same year.
But before you pile in, it is important to make a distinction within the sector, says Etienne Pollard of cleantech venture-capital group Good Energies. Most of today’s smart-grid opportunities are on the consumer side – mainly in metering. Smart meters – known in the trade as advanced metering infrastructure (AMI) – are the fastest-growing area of smart-grid technology. In the US, 60 million homes are already contracted to upgrade to smart meters, while a further 35 million have agreed to trials. That means 65% of the US housing market has gone, or is likely to go, smart. Over the next ten years, “EU contracts will dwarf those already announced in North America”, says Coster. That’s because part of the EU’s drive to cut emissions states that 80% of meters must be upgraded by 2020.
“Much longer term, we think there is big potential for innovation in the distribution and transmission parts of the grid,” says Pollard. But investors in technologies that improve the overall grid efficiency may find themselves waiting a while for slow-moving utilities to act. As the CEO of one cleantech firm put it: “The utilities are nothing more than billing machines. They like to think they are innovative energy companies, but they are not.”
2. Energy from waste
Another target for governments looking to cut wasted energy is waste itself. Japan, a country that imports all of its energy needs and has little room for landfill sites, has long pioneered waste-to-energy techniques. But northern Europe and America have begun to catch up. Analysts now expect waste-to-energy to catch on in the rest of Europe – including Britain – and Asia. Waste-to-energy technologies vary. The traditional method was to power steam generators by incinerating rubbish. Burning rubbish may not sound very environmentally friendly, but a combination of filters and ‘scrubbers’ means that new rubbish incinerators produce fewer toxins than a barbecue or a home fire. As a result, hundreds of incinerators have sprung up in Europe in the last ten years.
Cleaner but more expensive processes involve extracting gas, biomass or biofuel from the waste, which can then be used to produce electricity. Those materials not used for fuel are then recycled or placed in landfill. Investors should be aware that this is a long-term investment with plenty of pitfalls, says Cedriane de Boucaud of Curzon Park Capital. The processes are “still difficult and not sufficiently efficient”.
A lot of the impetus for these plants comes from government legislation. For example, the landfill tax has gradually risen from £12 a tonne in 2003 to £40 today, and is set to hit £72 in 2013. Such taxes help the industry, but investing on the back of government policy is always risky. Another risk, as with smart grids, is betting on the wrong technology. At this early stage it is hard to tell which will prevail.
With so many risks it might be hard to see why anyone would invest. But de Boucaud feels that “in the medium to long term… it is where the money is”. Waste-to-energy ties into important themes, says Nigel Taunt of Impax Asset Management. Government taxes, restrictions and a lack of space are making landfill less viable, while energy demand is going up. “Waste-to-energy will increasingly be the story – every non-incineration waste treatment will need an energy solution as part of the package.” We look at ways to invest in both smart grids and waste-to-energy below.
The five best investments to buy now
JP Morgan reckons Europe’s plan to upgrade 80% of meters to smart systems by 2020 will mean installing up to 350 million meters. US market leader Itron (Nasdaq: ITRI) looks best-placed to benefit. It makes AMI products (see above) for the energy and water industries. The stock trades at $57 a share – up 40% from when we tipped it in March 2009. Yet on a forward multiple of 13, well below its four-year trailing p/e, Itron still has plenty of upside. A deal with a US or European mega utility, or a takeover bid, are possible catalysts to send the price higher. JP Morgan has a target price of $95 for December 2011.
Of course, if you want to play the complete smart-grid story, including the gradual upgrades to the transmission and distribution networks, then a larger engineer is an option. Siemens (Xetra: SIE) is a global leader in automation and communication systems for industrial, energy and healthcare businesses. The group is a natural fit for the smart-grid industry – its wide range of expertise means it is involved in every part of the sector.
What’s more, if larger utilities ever do begin handing out ‘super contracts’ for grid upgrades, the German firm is one of the few with the scale and size to pull it off. Wolfgang Dehen, CEO of Siemens Energy Sector, recently hailed the dawn of the smart grid as “a new age for power” and pledged to capture 20% of the global market by 2014. It is already a leader in ‘grid intelligence’ and aims to beef up in metering and data handling. The stock looks good value on a forward p/e of 12.
Waste-to-energy is an interesting sector, but it’s more established in the US than in Britain. Analysts also expect the industry to grow further as a large chunk of America’s current crop of ageing incinerators is due for replacement. One way in is through US firm Waste Management Incorporated (NYSE: WM), which generates power from landfills it owns in America.
However, the most exciting growth may come from new technologies and relatively undeveloped waste-to-energy markets, such as China or Britain. The market is competitive and fragmented, with many small firms each using different technologies, so rather than betting it all on one stock, the safest way in is to invest in a cleantech fund with exposure to waste-to-energy. Impax Asset Management’s Environmental Markets (LSE: IEM), an investment trust, buys stocks that provide efficient ways to deliver energy, water or waste management. Overall, the waste sector accounts for 35% of the trust’s holdings. Most of the holdings are listed companies, such as US water treatment giant Nalco. However, it also invests in small start-ups, such as British waste-to-energy company Sterecycle. The management team of Bruce Jenkyn-Jones and Jon Forster has a good track record – the fund is up 29% over the last five years. With the share price at a 9% discount to net asset value (NAV), compared to the lifetime average of 5% or so, now looks a good time to buy.
Impax has also launched the Asian Environmental Markets (LSE: IAEM) trust to capitalise on Asia’s energy efficiency drive. The fund is more than 40% invested in China. It’s up 16% since launching in 2009, and trades on a wider-than-average discount of around 5% to NAV. Both trusts charge a 1% management fee.
The drive to replace fossil-fuelled cars
Energy efficiency isn’t all about fancy technology. For example, simply insulating our offices and homes can make big improvements to their efficiency and environmental impact. Altogether, commercial, residential and industrial buildings account for 40% of the world’s greenhouse gas emissions.
The metal and glass shells of modern skyscrapers offer little heat insulation, while their interiors often require huge amounts of artificial light to illuminate. As a result, thanks to poor design, we spend a fortune heating, cooling and lighting our buildings.
Obviously, we can’t knock down our cities and start again, but we can upgrade older buildings. New York’s Empire State building recently received a green makeover to improve its energy use. The refit, which included new windows, insulation and boilers, wasn’t cheap at $20m, but the owners reckon it will pay for itself pretty quickly – saving more than $4m a year in reduced energy bills.
Transport is another source of energy waste. While hybrid and electric cars attract the headlines, diesel has been one of the overlooked winners as car drivers look to cut fuel costs. Following the spike in oil prices in 2008, US sales of diesel cars jumped 20-fold – admittedly from a low base. Diesel used to be seen as slow, noisy and dirty, but improved engine design and cleaner fuels have helped it close the gap with petrol. Diesel car-makers, such as Mercedes and Audi, are set to benefit as customers fight to keep their energy costs down.
Gas-powered cars have also done well from the drive for efficiency. The global number of natural gas vehicles has risen ten-fold in the last decade while liquid petroleum cars – another gas-based technology – are also on the up. The biggest growth has been in emerging markets in Asia and Latin America. So while fossil-fuelled engines aren’t going away in the near future, demand for more efficient versions will continue to rise – which should be good news for leading manufacturers in the sector.
• This article was originally published in MoneyWeek magazine issue number 520 on 14 January 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.