The Energy Report: John, how has the renewable space changed in the last five years?
John McIlveen: Cost. The cost of standardized technologies for wind and solar have fallen by at least a half in five years, to just below $2 million per rated megawatt ($2M/rated MW), versus the same cost for a coal plant. That coal plant may deliver two to three times the power at that all-in cost, but the costs are about the same because wind and solar do not have fuel and heavy maintenance costs. Fossil fuel plants deliver much more power, but because they pay for their fuel, the overall cost is about the same as for renewables.
JM: I think Vox. Bloomberg measured the growth of the power grid only. If you include all sources, especially transportation, fossil fuel is still the leader. Vox is also right in that fossil fuels deliver two to three times the power per rated megawatt as renewables such as wind and solar. However, I believe renewable growth will surpass fossil fuel growth within 20 years.
TER: Besides wind and solar, do any other renewable technologies approach competitiveness?
JM: Geothermal and also small hydro. Small hydro is totally dependent upon its distance from the road. It can cost $2M/MW if it's right beside a road, but if you have to go deep into the woods and create a base camp, roads and a lot of infrastructure, then the cost could rise as high as $4M/MW.
"I believe renewable growth will surpass fossil fuel growth within 20 years."
Geothermal can be competitive too—if all goes right, and that's difficult for geothermal. After all, there's drilling risk, and a dry hole will cost you about $5M. If you get too many of those, you'll end up with a price for power that's higher. But if it's done right, geothermal can also be cost-competitive with fossil fuels.
TER: Can renewable energy compete without production tax credits, investment tax credits and the renewables portfolio standard (RPS)?
JM: I think so. In the areas where renewables now have grid parity, they are already cost-competitive. I don't think you're going to need monetary incentives. It's always good to have targeted mandates in terms of how many megawatts you want by a given date. But I don't think the monetary incentives would be necessary for those renewables that have already achieved grid parity.
TER: Some states in the U.S. have discarded the RPS because they've shot past the goal and don't need it anymore. In other states, the RPS is under attack. Is this a sign that the standard is no longer required?
JM: No, I think you still need it. For all those renewables that are not cost-competitive, we still need some monetary incentives. I think it's always good to have a mandate, a measuring stick.
Really, the evidence is that the RPS worked. Twelve years ago, solar cost 10 times what it does today. There are still a variety of technologies that could solve a lot of big problems, like municipal solid waste through to power. But this is not yet a standardized technology. When the technology becomes standardized, and you can get the General Electrics (GE:NYSE) and the Siemens AGs (SI:NYSE) of the world involved, that's when the costs come down. For those technologies, the focus should be on becoming standardized.
TER: How do low oil and gas prices affect the investment attractiveness of renewable energy?
JM: Low gas and oil prices only affect the renewable power prices for new projects. They don't change an existing project because these companies have 20-year take-or-pay contracts. So their price is set, and the grid must take all the power that they can produce. However, it does lower prices for new projects. It can put pressure on a new renewable energy project.
In North America, the gas price sets the marginal price of power. In the rest of the Western Hemisphere, it's largely oil prices that set the marginal price of power. The fuel of necessity or choice in those two areas sets the price.
TER: What trends in the power industry are boosting the prospects for renewable energy now?
JM: I think the trends are all favorable here. If we want to talk about distributed power, utilities actually like renewables. They don't have to build transmission. They don't have to build transformers. What's needed, from a regulatory point of view, is for states to allow for individual residences to sell power back into the grid if they're producing more, say with rooftop solar, than they actually consume in a particular afternoon. Quite a few jurisdictions already allow this, but not all of them do.
"The cost of standardized technologies for wind and solar have fallen by at least a half in five years."
What's really holding back a lot of these systems is battery, or storage, technology. For solar to make a residence independent of the grid, we would need to be able to store power for a few days and release it as needed. This battery would have to fit into an existing home. You shouldn't need to renovate your basement to put in a battery that's as large as an automobile to hold power for a few days. It needs to get down to the size of a water heater or something similar. Right now, you have to consume the power as it's produced. It can't be feasibly stored, and that holds back a lot of different renewable power technologies.
TER: Are conditions for renewable energy more favorable in Canada or in the U.S.?
JM: Federally, the U.S. has more favorable conditions than Canada. However, in both countries, renewable policies are being initiated more at the state level and the provincial level. The larger Canadian provinces are on a level playing field with a lot of the states. But, of course, typically, the fossil fuel energy-producing states are resistant in Canada, just as they are in the U.S.
TER: The prevalent renewable energy in Canada seems to be hydropower. Is that an accurate assessment?
JM: It is likely the most popular. There are great hydro resources everywhere. Even the prairies in the northern parts have good hydropower resources. It's abundant. Wind is being built in large quantities now, so that would be second, I guess. Solar is being built in large quantities now, too.
TER: Which companies are you talking about with investors now?
JM: My top picks are Algonquin Power and Utilities Corp. (AQN:TSX), Brookfield Renewable Energy Partners L.P. (BEP.UN:TSX) and EnerCare Inc. (ECI:TSX). Innergex Renewable Energy Inc. (INE:TSX) is ascending into that group in terms of its recent results.
TER: What do you like about those companies?
JM: It's all about the dividend. All of these companies pay a good dividend. They have demonstrated consistent dividend growth that's well above the inflation rate, some as high as 10% annually, all while maintaining a constant payout ratio, which is the key dividend sustainability risk measurement.
TER: What earned EnerCare a Strong Buy rating?
JM: It's not for any fundamental changes. That was simply because, for me at least, a dividend-paying independent power producer (IPP) rated a Buy should show more than a 10% potential return. A Strong Buy is more than 20%. EnerCare got into that zone; the return to our target plus its dividend was more than 20%. That doesn't happen very often with the IPPs because they're not rocket ships. They're Steady Eddie companies that pay you a good dividend, and a dividend that usually increases every year as well. I rarely have more than one Strong Buy at any given time.
TER: How long has EnerCare been in that category?
JM: Just a few months. It's probably below 20% return to my target now. It's behaved as I thought it should, and risen a bit more quickly than other IPPs because it seemed out of line with where its valuation should have been.
TER: As a company that provides water heaters and other household equipment, it's different from the others in your portfolio. What makes EnerCare an especially interesting company?
JM: EnerCare does not produce renewable energy, but it has the same contract structure as IPPs, in that contracts are very long term and highly predictable in nature. From a risk point of view, I think the company's profile is very similar to the IPPs.
"In the areas where renewables now have grid parity, they are already cost-competitive."
Another reason EnerCare is interesting is that in H2/14, it bought the home service business of Direct Energy. Direct Energy was its partner in the water heater business. The companies did complementary activities, but there was always the possibility that Direct Energy could compete with EnerCare and withdraw from the partnership. Buying Direct Energy removes that possibility, which was always a little bit of an overhang on the story. The acquisition added about $60M in EBITDA (earnings before interest, taxes, depreciation and amortization), which was a 40% increase, and brought control of the entire operation in house.
TER: How did EnerCare finance that purchase?
JM: It was a combination of debt and equity; almost 50/50. EnerCare is one of the most conservative companies in my group in terms of how it runs its balance sheet. It has the highest bond rating in the group. It does everything on a very conservative basis.
TER: So the financing is not likely to hurt its balance sheet.
JM: Right. I think it issued something in the neighborhood of $300M in equity, and the balance was debt.
TER: What was the catalyst for Brookfield Renewable Energy beginning operations in Europe last year?
JM: There were two reasons. Here in North America, opportunities were becoming too pricey. The cost of assets, whether preconstruction assets or online assets, have gotten quite pricey. So Brookfield is looking beyond North America to find more opportunities. Before the Ireland acquisition, it was a big operator in Brazil. Now, it is ready to look elsewhere. Europe is a mature market. The resale of individual projects is going on there, so there is much more opportunity in Europe versus North America right now.
Second, the assets were large enough to be meaningful. You can't have very good feet on the ground with new opportunities if you're buying something small. This was 463 MW, and that's about a 7% increase in the company's total megawatts, so it's not insignificant. Now Brookfield has feet on the ground in Europe.
TER: Is Europe more hospitable to renewable energy development than North America?
JM: Each country has its own regulations, of course. For the longest time, Germany was perhaps the most favorable market in the world. However, we've seen other countries, like Italy and Spain, try to roll back their contracts, meaning the prices they pay for the power once it has already been built. There's a real hodgepodge of both the attractiveness of renewable incentives as well as confidence that they'll be maintained.
Germany is now peeling down its renewable incentives. It is not changing existing contracts, but new ones are relatively less attractive than they were, say, five or 10 years ago. But, again, that's because the cost of wind, solar and other technologies has come down so much. The country recognizes that it doesn't have to give as large an incentive. It's become a bit more directed.
"You're better off with a lower yield, which means lower risk coupled with a steady track record of increasing dividends."
Offshore wind is doing great in Europe, particularly in the North Sea and around Britain. In fact, Northland Power Inc. (NPI:TSX), another company in our group, is one of the biggest developers of wind in the North Sea. It plans to spend $3 billion on two individual projects, which are almost 1,000 MW in total. That's the next wave.
TER: Can you talk about a geothermal company?
JM: Yes. U.S. Geothermal Inc. (GTH:TSX; HTM:NYSE) is a junior producer. It doesn't pay a dividend. It could, but I don't expect a dividend until the company gets a couple more good projects online. It's generating about $7M in free cash flow. That's enough for the company to explore the sites it already has rights to, to determine whether it should spend money big time in developing those into generating sites. Seven years ago, there were about eight public junior geothermal companies. Now, just U.S. Geothermal is left standing. It took its time. It did not have the drilling failures that the others did. It also maximized the use of all incentives available to it.
TER: Is enhanced geothermal development a viable technology, in your opinion?
JM: Enhanced geothermal systems are still a science project, in my view. It's much like what is happening with shale gas. It involves fracturing. You identify a site that has plenty of heat beneath the earth, but doesn't have a natural flow rate of water. The fracking busts up the rock so that water can flow more freely and, thus, carry heat to the surface. Water is the conduit.
TER: U.S. Geothermal seems to think a selling point is that it has transformed from a development company to an independent power producer. What is the significance of that for investors?
JM: That's true. As I mentioned, of the eight public junior companies, U.S. Geothermal is the last one standing. So it timed things right, and did a good job. Eventually, I expect this to become a dividend-paying company.
TER: Do you think becoming an IPP will more likely result in dividend payments, not just development?
JM: I think, eventually, you want to pay a dividend if you're a power company. These 20-year take-or-pay contracts are ideal for cash flow predictability, and that is perfect for a dividend-paying company. You pay the dividend because you'll have a better valuation in the market than a non-dividend-paying company. While you're paying out much of your cash flow in the dividend, your access to capital markets is excellent, and you'll always get more favorable pricing than you would otherwise. Companies are actually able to grow faster if they become dividend paying, despite what you might think about paying out large sums of money from free cash flow.
TER: What do you like about Algonquin Power?
JM: In the last few years, Algonquin Power has averaged about a 10% increase in its dividend. It has one of the lowest payout ratios, which is one of my key risk measurements. It's below 50%. It is now balanced about 50/50 in terms of free cash flow coming from renewable energy and water, gas and electric utilities.
"Buy the IPPs with yields in the 4–6% range and a steady track record of increasing dividends."
Utilities are a great investment in terms of the predictability of their cash flows. They're slightly more predictable than the long-term take-or-pay contracts of the IPPs. The company buys well. Algonquin's utility assets are already existing, and they're all in the U.S. Its renewable assets are largely in Canada and the U.S. It's got a well-managed balance sheet. Good execution. It's just a solid company.
TER: What are the risks for a pure-play renewable energy provider like Innergex?
JM: The overwhelming risk to all of these IPPs and, in fact, all dividend-paying companies, is the interest rate risk. The IPPs are most highly correlated with the five-year Treasury bond, which in Canada stands at 90 basis points, and in the U.S. at 135 basis points. That's near all-time lows. But nothing stays that low forever. Historically in Canada, the average spread is about 400 basis points over the five-year Canada bond. If rates rise, so will yields on the IPPs, which in turn means the stock price falls.
Individual IPPs may have specific yield risk. A dividend yield of 8% and higher means the market fears a dividend cut, so do not buy these companies. You're better off with a lower yield, which means lower risk coupled with a steady track record of increasing dividends. The increasing dividend will mitigate rising interest rates over time and, eventually, skate you back onside. (Please excuse the hockey metaphor, but the playoffs are on.)
TER: What kind of merger and acquisition (M&A) activity would you expect to see in this space?
JM: We don't see much at the corporate level. The IPPs like to buy individual projects so they can fit the technology in the right location with their existing infrastructure. When you buy corporate, you're getting all sorts of extra assets and other items you don't want. I don't expect to see much M&A on the corporate level, but on a project level, that's where the market is.
A few of the smaller IPPs, like Boralex Inc. (BLX:TSX) and Capstone Infrastructure Corp. (CSE:TSX), might be likely targets on the corporate level. However, anyone looking at these companies will be making sure all the assets are in the right locations, and that the technologies fit in well with their present mix. EnerCare has been the target of a couple of board takeover attempts over the last few years, but the acquisition of Direct Energy's home service business seems to have quieted down that noise. Atlantic Power Corp. (ATP:TSX; AT:NYSE) is busy selling assets to get back onside with its lenders' covenants, but I have not heard of any interest at corporate level.
I think, eventually, the large U.S. utilities could become interested. Utilities hate risk, but they do have mandates to fulfill. They own coal and gas, so why would they want to buy power from wind and solar that they don't own? They want to own it instead, but the last thing a utility can do is build wind or solar, because its engineers are fossil fuel engineers. Utilities have to acquire the expertise as well as the assets. There may be a possibility down the road to buy some of the larger IPPs, but I'm not hearing about that right now.
TER: Given the low price of fossil fuels and the political resistance to decarbonization of the power industry, how should investors in this space proceed?
JM: The price of fossil fuels only impacts new or aspiring power price contracts. These contracts are set at 20-year take-or-pay, so the IPP sells all it can produce at a known price for 20 years. I would say buy the IPPs with yields in the 4–6% range and a steady track record of increasing dividends. If you want to look deeper, look at the payout ratio—I would say a maximum of 75%. A payout ratio below 60% usually means that a dividend increase is coming. It's better for sleeping at night to have a well-run stock with a dividend that rises, as opposed to a dividend at 8% that you might find cut in half next week.
TER: John, thank you for sharing your insights.
Senior vice president for research John McIlveen has been with Jacob Securities in Toronto, an investment bank focused on renewable power and cleantech, for eight years. He is a published business professor with a bachelor of commerce degree and a master’s degree in business administration. He has 28 years’ experience in public equities research, private equity and term lending. McIlveen was the first sellside analyst in Canada to focus solely on renewable power, and is consistently ranked a top performer by Bloomberg on accuracy of estimates and returns.
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