Published on August 14, 2020

Following decades of investment and cost reduction, electricity from renewable energy should be cheaper than most existing fossil- and nuclear-fueled electricity within the next three-to-five years. We believe selectively investing in operators with scale and cost advantages in this sector should be rewarding given the increasing demand for clean energy.

For years, renewable energy companies have been considered risky investments that were too dependent on federal tax credits. However, we believe that renewables are entering a new phase that will fundamentally change energy markets.

Well-placed concerns about the environmental impacts of both fossil fuels and nuclear energy have increased demand for renewables. Meanwhile, a material reduction in production costs over the past several years has made renewables a highly cost-effective fuel source, even without federal tax credits.

While not all renewable energy producers will be profitable businesses, particularly in the near term, the combination of falling prices and growing demand bodes well for the industry (and for investors). As a rule, we favor companies that operate in markets with strong secular tailwinds, so we are very encouraged by the positive developments in the renewables sector.

Electricity Production: The Basics

According to the Energy Information Administration (EIA), 4.1 trillion kWh of electricity were generated in 2019 at utility-scale generation facilities in the U.S. Roughly 63% of this electricity was sourced from fossil fuels, including coal, natural gas, and petroleum, and another 20% came from nuclear energy. Renewables and other accounted for the remaining 18%, which was twice their contribution in 2000 (9% of the total).

This 4.1 trillion kWh of electricity generation has held steady since 2010, and we expect it to remain roughly flat for the foreseeable future as energy efficiency continues to improve, modestly offsetting rising demand over the long term. However, we expect the underlying composition of fuel sources to change dramatically.

Historically, coal and natural gas were the biggest sources of electricity generation in the U.S. because of the cost advantages and wide availability of both fuels. Nuclear accounted for most of the balance, with costs roughly in line with coal.

However, society increasingly has recognized the externalities related to fossil fuels—namely carbon emissions that lead to severe pollution and climate change—as well as the risks inherent to handling and disposing of nuclear material. This recognition, in addition to various regulatory frameworks imposed on the coal, natural gas, and nuclear sectors to manage the related costs and risks, have in turn led to demand for cleaner and safer sources of electricity, creating an opening for renewable energy.

Renewable energy sources consist primarily of wind, hydropower, and solar fuels. A key challenge over time has been producing renewable energy at a reasonable cost. From manufacturing solar panels and wind turbines, to building effective battery storage, the costs were often prohibitive and made the prospect of displacing fossil fuels seem unlikely.

Current State of the Industry

The cost dynamics of various fuel sources have changed dramatically over the past 10 years. In 2010, the EIA projected the unsubsidized levelized cost – the average cost over the life of a project – of electricity generation in 2016 to be roughly $100/MWh for coal, $80 for natural gas, $120 for nuclear, $170 for wind, and anywhere from $250-400 for solar. In other words, wind and solar were prohibitively expensive without tax credits.

Today, the EIA projects wind and solar unsubsidized levelized costs to clock in at $30-35 by 2025, below even natural gas. Multiple factors—including improved product design, innovative manufacturing techniques, and economies of scale in production—have driven the rapid cost declines.

When considering the cost advantages of renewable energy, combined with the substantial and invaluable benefits to the environment, it is evident that renewables will comprise a much greater portion of the grid’s fuel source in the future.

The EIA now projects that renewables will comprise almost 40% of electricity generation in the next 30 years vs. just 18% currently. Given the constantly declining costs to produce renewable energy, this estimate may significantly understate the future contribution of renewables to the electrical grid.

Furthermore, new technologies continue to emerge that could create added opportunity for renewables to displace fossil fuels and nuclear. For example, hydrogen-powered fuel cells and electrolyzers that produce renewable hydrogen could start replacing natural gas. While still early stage, this technology is gaining traction, and industry participants are pointing to potential commercialization by 2030 as costs decrease.

Promising Future, Limited Present

Renewables have been expanding rapidly, underpinned by the seismic shifts discussed above, and we are confident the sector has a very bright future. However, thus far few companies have been able to translate the growing demand into highly profitable financial results. We are carefully monitoring the space for attractive opportunities.

Case Study: NextEra Energy, Inc. (NEE)

One renewables firm that has been consistently delivering strong performance is NextEra Energy, Inc., the largest electric utility in the U.S. and the world’s largest generator of solar and wind powered electricity.

NextEra’s regulated electric utility business operates under the Florida Power and Light (FPL) and Gulf Power banners. FPL is the largest electric utility in the U.S., creating a scale advantage that no other domestic peer enjoys. Because of its scale, FPL procures inputs—from renewable energy to equipment—at structurally lower costs than its peers. FPL also drives costs out of its operations in a way smaller players cannot, which allows the utility to offer among the lowest utility bills in the U.S. Highly efficient operations enable FPL to consistently earn returns on equity at the high end of the range allowed by regulators.

Importantly, capital spend should grow at 9-10% annually for the foreseeable future due to undergrounding and hardening projects. The company is able to reinvest in the business at incrementally lower cost, creating a flywheel effect, as the business gains further scale and reduces costs more, ensuring continued attractive returns for reinvestment.

NextEra periodically acquires other regulated utilities, like Gulf Power, which it will fully merge with FPL in 2022. FPL should be able to meaningfully improve operations at Gulf Power, while ultimately gaining increased scale and further bolstering its already considerable scale advantage.

The company’s renewables division, known as NextEra Energy Resources, is the world’s largest generator of wind and solar energy. The division’s unmatched scale has enabled 15% annual reductions in wind and solar costs and 18% annual reductions in battery storage costs since 2010. With the wind and solar market growing roughly 15% annually, NextEra has the opportunity to drive attractive growth as the global renewables leader with an unmatched cost advantage.

Given NextEra’s scale advantages across both its utilities segment and its renewables segment, we believe it holds a durable competitive advantage that is extremely difficult to replicate. The utilities segment should continue generating significant profit growth given its scale advantage and attractive returns profile. Meanwhile, the secular growth of renewables should provide an added multi-decade tailwind to growth. The net result should be earnings growth approaching 10% annually for the foreseeable future, with dividends growing modestly faster in the medium-term and in-line with earnings over the long-term.

Looking Ahead

We are extremely bullish on the future of renewable energy – market demand is increasing at the same time it is falling for fossil fuels. Energy markets are in the midst of a structural shift, and the trends are well established and accelerating. Through this transformation, we are confident that other attractive investment opportunities will present themselves. The challenge is identifying the strongest companies that are most likely to deliver consistent and attractive financial results.

Larry Cordisco

Co-Chief Investment Officer – Core Equity

Nael Fakhry

Vice President & Portfolio Manager

Written by

Larry Cordisco

Co-Chief Investment Officer – Core Equity

Larry Cordisco

Co-Chief Investment Officer – Core Equity

Larry Cordisco graduated from the University of California, Santa Barbara (B.A. in Political Science), Georgetown University (M.P.P.) and Columbia Business School (M.B.A.).

Before joining Osterweis in 2019, he was a Co-Portfolio Manager of the Meridian Contrarian Fund at Arrowmark Partners/Meridian Funds. Prior to co-managing the Contrarian Fund, Larry was an equity analyst for 11 years, most recently as Vice President of Investment Research for the Meridian Contrarian Fund. Before that he was an analyst within the technology group at Banc of America Securities. He was also a business and technology consultant for Accenture in San Francisco and began his professional career in the public sector as a District Aide for Congressman George Miller.

Mr. Cordisco is a co-lead Portfolio Manager for the core equity strategy and portfolio manager for the flexible balanced strategy.

Nael Fakhry

Vice President & Portfolio Manager

Nael Fakhry

Vice President & Portfolio Manager

Nael Fakhry graduated from Stanford University (B.A. in History, Phi Beta Kappa) and the University of California Berkeley, Walter A. Haas School of Business (M.B.A., C.J. White Scholar).

Prior to joining Osterweis Capital Management in 2011, Mr. Fakhry worked as an Associate at American Securities, a private equity firm, and as an Analyst in the investment banking division of Morgan Stanley.

Mr. Fakhry is a principal of the firm and a Portfolio Manager for the core equity strategy.

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