June 30, 2022
Renewable Energy
A recession can alleviate some renewable development headwinds
Our view: Looking at a recessionary scenario has been very topical with clients, and we believe a recession will actually benefit the capital-intensive renewable energy sector. Similar to many other sectors, the renewable energy sector faced a number of cost inflation and supply-chain headwinds in the past year, and we expect some pressures would be alleviated in a recession. The Canadian renewable energy sector is also defensiveness under a recessionary environment due to long-term contracted power prices and limited exposure to demand.
A recession could benefit renewable developers. As the market debates whether a recession is on the horizon, we believe a recession could actually help renewable energy developers. Over the past year, the renewable energy sector has been hit with higher project and logistics costs, labour availability issues, supply-chain disruptions, and higher interest rates. Under a recession scenario, we believe the pressures will ease. In addition to lower project costs, we believe the cost of capital for developers will improve, assuming the 10-year benchmark interest rates stabilize or head lower as inflation moderates. The majority of project costs in contracted developments can generally be funded with project-level non-recourse debt (including tax equity).
Pace of renewable energy deployment could accelerate in a recession. Due to the various pressures faced by developers over the past year, as highlighted above, a number of developers have been delaying the construction start dates. Developers with fixed-price power purchase agreements (PPAs) that have not locked in project costs have seen developments become uneconomic to pursue. As a result, some developers are trying to negotiate higher contracted power prices before commencing construction. If project costs and interest rates moderate under a recession scenario, we expect developers to accelerate the construction of renewable energy facilities.
Demand for renewable energy remains robust. The demand for renewable energy was already on the rise as various organizations looked to green their energy consumption. Power (and fossil fuel) prices were already on the rise, particularly in Europe, and the Ukraine war worsened the situation. Europe is weaning itself off Russian imports, and increasing renewable energy production is part of the solution. There is significant demand for renewable energy, even at higher prices, but due to the various headwinds highlighted above, many developers cannot deliver. Based on recent discussions with renewable energy developers, they have indicated that demand for renewable energy remains robust despite their estimate that long-term contracted power prices in PPAs have increased by 20-25% since the beginning of the year and increased by 25-30% year-over-year.
Relative valuation could improve in a downturn. The renewable energy sector has been sensitive to interest rates, and is generally viewed as a defensive investment due to the contracted power price profile of the Canadian renewable energy sector. When we assess renewable energy developers that target contracted projects, we view the value of the contracted operating portfolio (generates stable cash flows) as interest rate sensitive, as it drives the discount rate. However, the value of the development and growth platform is driven by a number of factors including the development pipeline, and management's ability to deploy capital at attractive returns.
Ideas for different investment strategies. When taking inflationary pressures and higher interest rates into consideration, we favour AQN due to its large weight in regulated utilities, while also advancing a sizeable contracted renewable energy business. Some other ideas include BEP (long-term buy and hold), BLX (low risk highly contract profile), INE (value play), and NPI (offshore wind exposure).