Here comes the sun

Over the past couple of years, an increasing amount of attention has been paid to sustainability and alternative energy funds by media and investors alike. And typically, one of the components of alternative energy funds is solar power technology, also known as photovoltaics (PV).

Many in the investment industry hold the solar sector’s recent strong performance largely responsible for the returns achieved by various sustainability funds.

Matthias Fawer, sustainability analyst at Swiss private bank Sarasin, says the value of photovoltaic company index PPVX - which currently contains 30 global solar stocks - has grown 30-fold since its inception in 2001, while its market cap value rose to €30bn from €2bn over the same period. And the PPVX index increased by 124% in the first 11 months of 2007, according to Fawer, well ahead of the 25% growth seen in the Amex oil index.

“The share price performance of solar companies over the last couple of years has been tremendous, with market capitalisation doubling or even trebling for some of the names,” says Bjørn Tore Urdal, an analyst at Swiss-based Sustainable Asset Management (SAM).

The drivers behind the growth in the solar market, according to Fawer, are worries about energy supply and climate change as well as attractive support schemes for PV in various countries, which Urdal also sees as the underlying earnings driver.

Fawer says that although pure solar companies started out in Europe, it has now become a global market, with Chinese and US companies entering over the last two years. “In Europe, the focus is very much on German solar companies due to the favourable investment conditions there,” Fawer says. “The attractive German feed-in tariff for PV systems has heavily supported the industry.”

However, these political subsidies also present a major risk to the industry, Fawer notes. “As of now, solar energy is too expensive and not competitive with conventional energy. That is why it is still dependent on political support schemes like in Germany, Spain, Italy, Greece and California. So a political change that could lead to the abolition of these support schemes is a risk to the industry.”

But Urdal says that this risk is diminishing as more subsidies are expected to be implemented worldwide in order to increase the renewable share of the overall energy mix. “The subsidies have helped jump-start the industry so much that the costs are rapidly being reduced through economies of scale as well as technology developments,” he says. “And once you have an industry with a critical number of employees, it is also politically difficult to terminate the subsidies.”

Investors can choose between investing in listed solar companies or in unlisted small cap firms through a private equity financing company.

According to Fawer, the industry is open to small-scale investments from private investors as well as larger-scale amounts from institutional investors. Currently, most solar investors come from German-speaking countries, the UK and France but numbers are also growing in the US and Asia, he says.

Urdal adds that he has seen particularly strong interest from Asian investors recently.

“The coverage of renewable energy titles and thematic fund products has grown steadily and so has the demand from institutional investors,” says Fawer. “In particular investors with a long-term approach, such as pension funds, really cannot avoid renewable energy and its returns.”

“The industry also catches the attention of mainstream investors because some of these stocks now come up to a market capitalisation that makes them attractive for generalist investors to invest in,” says Urdal.

Terry Coles, co-manager of F&C asset management’s Stewardship International Fund, attributes his fund’s recent returns in particular to solar stocks in the wake of record high oil prices.

“A rising oil price supports renewables in general, and with the oil price expected to remain high, the long-term approach is to move away from fossil fuels to invest in renewable energies,” says Fawer. “Although solar energy does not replace fossil fuels directly, it does also profit from high oil prices and the correlation is in my eyes mainly psychological. And the threat of a sharp drop in the oil price affecting the industry has diminished with the industry’s growing maturity.”

However, Coles admits: “If oil or material prices go down, alternative energy stocks will typically underperform. So oil prices of above $95 are clearly positive for the sector because they bring the cost of solar closer to grid parity.”

“If you look at the stock performance you certainly see a correlation with the oil and gas commodity market but from a fundamentals point of view that risk element is of lesser importance, in particular as climate change will remain one of the big industry drivers,” counters Urdal.

“Exposure to non-traditional energy has often boosted our fund’s performance but it can also hurt, as it did at the end of the second quarter of 2006 when the strong run in the solar industry was ended by a severe bottleneck in silicone supplies, the material used for conventional PV technologies,” Coles notes.

“The producers of solar silicone have invested heavily in new capacity to keep up with the tremendous growth of this industry sector,” says Fawer. “New capacity has been contracted directly to companies to secure their long-term needs for silicone, which is an important criteria for us to judge the companies.”

He adds: “There will still be a spot market shortage in 2008, although this is expected to ease in mid-2009 when there will be a better balance between supply and demand.”

According to Urdal, the problem is that the ramp-up of global silicone production capacity is taking longer than expected. He says that there is a risk the announced capacities may not be reached due to the market’s many new, opportunistic Chinese players without chemical know-how and experience, while new thin-film technologies that are not dependent on silicone are still in the early stages.

“However, the bottleneck has not put off investors who can choose where in the sector to allocate the capital,” says Urdal. “In fact, it is a chance for them to invest in the companies that benefit from the current situation. So far the producers of the raw material of silicone have been the ones reaping the profits because the prices have been so high. The supply situation is only a problem for the market in the sense that it pushes up the prices of the overall PV production and risks choking some of the demand that would otherwise be there.”

According to Urdal, the solar sector is currently seeing cost-reductions of 7-8% per year. He adds that in a few years time, the cost of conventional electricity production will have also increased significantly due to the inclusion of the cost of carbon, creating an additional upside to the solar industry.

“In our recent annual solar energy report we forecast that the photovoltaic market will improve an average 30% every year until 2020,” says Fawer. “It will even increase by 50% until 2010, before coming down slightly, so the long-term prospects are good. On top of this, we expect the industry to be cost-competitive by 2012 or 2013. And this means that solar will become a very attractive energy in southern Europe, developing countries and remote areas. In general, we are forecasting big growth rates for all three solar technologies: electricity-producing PV cells, heat-producing solar collectors and solar thermal power plants.”