The EU has taken a particularly aggressive approach with respect to the use of renewables in power generation, adopting a new framework back in October 2014, the details of which are still being worked on. It is called the 2030 climate and energy framework and has three key elements:

• Greenhouse gasses must be cut by at least 40% from 1990 levels.
• Renewable energy sources must deliver at least 27% of total energy needs.
• Energy efficiency/consumption must improve/be reduced by at least 27%.

The somewhat confusing third objective requires some explanation. On the two official EU websites that cover the topic, different wordings are being used. Whereas the first refers to a 27% improvement in energy efficiency, the latter talks about energy savings of at least 27%, and it makes a massive difference whether it is one or the other.

Energy savings of at least 27% means that total energy consumption must fall by 27%. A 27% improvement in energy efficiency could theoretically happen without any fall in actual consumption although, in practice, it is likely to result at least in some decline.

Industry insiders I have spoken to are of the opinion that the EU is referring to energy efficiency when talking about the 27% target. Consequently, in the following, I will assume that to be the more likely outcome.

I should also point out that the EU plan has been driven partly by climatic concerns and partly by a desire to make the EU less dependent on rogue regimes in Russia and the Middle East for its energy needs, which is perfectly understandable.

All 28 member countries must meet all the three targets by 2030 (with some lower interim targets to be met by 2020). You can read more about the EU plan here or here.

It is indeed a very ambitious plan, and you can understand why the institutional investor community is paying more and more attention to renewables, but the story is not so straightforward. That is what this research paper is about.

Before I start, a couple of mentions. Michael Wilson and Andrew Lees of the Macro Strategy Partnership, and Søren Kjær Petersen of Neas Energy, have all made valuable contributions to this research paper, and I owe them all a great deal of gratitude. Thank you.

What would happen if the EU were to cut energy consumption by 27%?

As you can see from chart 2 below, provided by the European Commission, the EU - or at least parts of the EU - certainly expect a fall in total energy consumption of significant proportions between now and 2020 (the interim target in the 2030 plan). The concerns I have about the possible impact on GDP growth, should energy consumption be cut that dramatically, haven’t just been picked out of thin air. Chart 2 is testament to that.

According to the Macro Strategy Partnership, in Europe, energy elasticity (a measure of how much energy it takes to achieve a 1% change in GDP) is 0.94. In other words, should the EU really force its member states to cut total energy consumption 27% by 2030, the only realistic outcome is a massive recession.

The more likely EU strategy

On the other hand, assuming that the European Commission have ‘just’ worded itself incorrectly, one shouldn’t expect the recession to be that dramatic, but a 27% increase in energy efficiency could still cause one or two problems, and here is why.

Every 1% increase in electricity from renewables has – at least so far - increased the electricity bill by 6-7% around Europe (Source: The Macro Strategy Partnership). How much of that is down to an increase in actual costs (capex as well as operating expenses) and how much is down to rising electricity taxes (presumably to finance the subsidising of the renewables industry), varies from country to country and over time, but it is probably no coincidence that the countries with the highest allocation to renewables - Denmark and Germany - also have the highest electricity prices (see chart 3).

It is therefore not unreasonable to expect electricity prices to rise across the EU, as other countries follow in the footsteps of Denmark and Germany. That wouldn’t be quite so important if the European economy were firing on all cylinders but, as we all know, it isn’t, and the EU strategy pushing for more renewables could be quite a stunning own goal.

Very poor demographics across the EU will hold back GDP growth for many years to come, and the European economy will need all the help it can find in order to deliver any economic growth at all between now and 2050. Higher electricity prices will have exactly the opposite effect.

The facts are being misrepresented, the bears say

In this context, I should also note that there is a very clear link between productivity and energy consumption, but that the link is quite different from the official story delivered by the EU. Productivity across the EU has fallen 4.4% since 2007, which has led to a fall in energy consumption. The EU has chosen to interpret that as a gain in energy efficiency, but the true story is not exactly what the EU want us all to believe.

I have made the point before that, in a world of no growth in the workforce, falling productivity always leads to lower GDP growth and shall not tire you with too many details. Suffice to say that:

∆GDP = ∆Workforce + ∆Productivity

Over the next 30-40 years, the EU workforce will shrink by approx. 0.4% per annum, meaning that GDP in the EU will only grow if productivity improves by at least 0.4% per annum, but it isn’t at the moment. Hence, what the EU is portraying as a gain in energy efficiency is in fact no more than poor economic growth as a consequence of little or no growth in the workforce combined with falling productivity.

Even worse, a switch to renewables could hold back productivity gains (because of the higher cost) and virtually guarantee little or no economic growth for years to come.

The argument in favour of renewables

The bulls on renewables argue that the costs continue to come down, and that we are not that far away from being able to produce electricity from renewables at a lower cost than we are capable of from conventional sources today.

The bears argue that electricity prices will continue to rise as renewables make inroads, but the bulls say that this is a backward looking argument. Going forward, there is absolutely no reason for electricity prices to rise 6-7% for every 1% increase in renewables. Over the last 5 years, we have seen an increase in efficiency, as technology has increased output for the same amount of capex. That trend is expected to continue, the bulls tell me.

And, yes, renewables need upfront investments (capex) that are higher than conventional power generation but, once up and running, operating expenses are small, and fuel costs are non-existing. Therefore, in year 1, total expenditures on renewables are higher, but that is not the case in the long term, even at today’s prices (or so I am told).

The undisputable facts

One argument put forward by the bear camp, which is hard for the bulls to argue against, is related to the energy available in the atmospheric airflow. Every wind turbine already installed reduces the energy available, so that nearby turbines are less efficient. This effectively means that only 12.5% of the actual resource can be utilised in a 100 km2 wind farm, and it means that the more wind turbines that are installed, the less they produce on average, and hence the less cost effective they are.

Consequently, the cost of producing energy from wind turbines may not fall as much as the bulls believe. With wind accounting for 40% of renewables, it is an argument that cannot be ignored.

In their defence, the bulls say that, in practice, it only becomes an issue when an area is saturated, and there is a long way yet to go. I am told that offshore wind farms have a load factor of up to 60%, whereas onshore farms are running around 35% in the UK, and at 25-28% in most other European countries, supporting the argument for offshore.

In this context, I should also mention that some of the numbers reported are not reliable at all. Take rooftop solar in the UK, where the electricity provided is calculated as negative consumption rather than production in the official statistics. The consequence of this abnormality is that energy consumption in the UK is in fact 2-3% higher than what you can read out of the official numbers. I suppose that is another way to ‘prove’ to the EU that you are turning more energy efficient!

One final point. As Europe ages, and the cost of servicing the old rises dramatically, political leaders are likely to become more and more creative when looking at ways to raise the money required. Maybe the bulls are right – maybe Denmark and Germany have already seen the worst in terms of rising electricity prices, but what would you do if you were in charge of public finances in, say, the UK? Wouldn’t you look at electricity prices in other countries, and in particular at prices in relative successful countries such as Denmark and Germany? And wouldn’t you assume that, if they can get away with such prices, so can the UK?

I think most would do so, but they would (conveniently) ignore the fact that there could be other reasons behind the success of those countries, and that they would almost certainly have been even more successful, had electricity prices been lower.

Investment implications

As I hope to have demonstrated by now, there are powerful arguments in favour of renewables, but there are equally strong arguments against. As a consequence, I have looked some of the corporates over the shoulder. They would know better than anyone (you would have thought) what is going on in the political corridors, so their action may tell you one or two things.

E-On (the German utility company) announced only a few days ago that, as a consequence of changing regulations, they have decided to halve the renewable energy pipeline from 10GW to 5GW, and that most of the cut-backs will come out of Europe. E-On is the latest of a number of European utility companies changing tact as circumstances change, and it is a manifestation of the high risk nature of renewable energy investments.

You can argue (as the bulls do) that E-On’s decision is balance sheet management, and is reflecting a desire to set money aside for nuclear clean-up costs, but that doesn’t explain why a substantial number of other European utility companies have done precisely the same. I think we are fast approaching the end of the road, as far as governments subsidising the industry is concerned, and I believe the utility companies in question have reached the conclusion that, without subsidies, the story is not quite so compelling.

I also note that China has recently committed to a 20% increase in coal power capacity by 2020 despite a pledge to reduce overall pollution levels, so the industry approach at present seems to be a rather cautious one – betting on both horses so to speak.

Furthermore, with Trump in power in the US, it is not unthinkable that the renewables industry over there faces a rather bleak future. Trump has already promised the coal workers of the rust belt that their mines will be re-opened, and how that will go hand-in-hand with a commitment to renewables is difficult to see.

In Europe, given the rising budget constraints, it is not entirely impossible that the EU does a complete U-turn on its energy strategy and puts the 2030 plan to rest. As pointed out by the Macro Strategy Partnership, Jevons paradox is at play here. The only way to become more energy efficient is in fact to use more energy.

As a consequence of all of this, the only conclusion I can reach is that investing in renewables is a high risk strategy – at least if the investment return on the strategy in question relies on more and more money going into renewables. And should the EU renege on its long-standing commitment to renewables, it wouldn’t take long before governments in other parts of the world would do the same.

In the best of all worlds – the bull story - older, non-profitable, renewable projects will continue to be grandfathered; support schemes may disappear, but that will be largely meaningless, as new projects will be able to stand on their own legs. I would certainly prefer for the bulls to get this right, but I don’t like the fact that utility companies all over Europe (the insiders) are pulling back left right and centre.

If you are inclined to conclude that the EU pulling back on its 2030 plan is never going to happen, don’t forget that the overall GDP growth outlook in the EU will get progressively worse as people age, and desperate people are known for doing desperate things.

Now, I am not at all suggesting that renewable energy is a bad concept. From an environmental point of view, it certainly isn’t. However, I am saying that in a time of low economic growth, pursuing such an aggressive strategy could be near suicidal for the EU.

Finally, if you remain convinced that the EU will definitely pursue the aspirations outlined in the 2030 plan, you should still go ahead with an investment in renewables, but you should reduce your exposure to European equities at the same time. As far as I can judge, the two don’t go hand-in-hand, as the emphasis on renewables will almost certainly lead to a further slowdown in economic growth in the years to come.

Niels Jensen

22 November 2016