Sustainable Economics and Ecologics
At The Outset of 2014
Section I: Impact Investing 2013 Overview/2014 Outlook
THE Intergovernmental Panel on Climate Change reported in September 2013 that it is “extremely likely” that human activity was the dominant cause of global warming or about 95 percent certain — typically the standard of rigor in scientific accuracy.
Accordingly, in 2014 the principle that environmental and development issues are inseparable from business will continue to integrate with global commercial and social functions. Impact investing in 2013 was characterized by a sense of urgency for adapting precepts of wealth creation and stewardship to 21st century realities. This matched up with the year’s abundant, rational exuberance in asset markets. We expect a cautious optimism to persist in 2014 though much of the reality based upside from 2013 is likely already priced into market values. A correction then should not be ruled out, and those with short term objectives should consider capturing some profit. Looking further ahead, markets and society will increasingly reject notions that a Faustian bargain holds between employment and shared prosperity on the one hand and fresh air and healthy water supplies on the other.
There is, of course, more work to do. It became clear to many in 2013, in Shanghai, China for example, that regions with little to no regulation of pollution suffer poisoned water, air, and thus economic inefficiency. Wholesale deregulation of energy extraction then are at best short term fixes to long the term economic challenges of mitigating climate change and renewable resource stressors within the context of exploding energy demand across the globe. More troubling news issued from China at the turn of 2014 where the results of the world’s largest natural experiment in unsustainable economics are coming in, and they are nothing short of tragic.
An alarming glimpse of official findings came on Monday, when a vice minister of land and resources, Wang Shiyuan, said at a news conference in Beijing that eight million acres of China’s farmland, equal to the size of Maryland, had become so polluted that planting crops on it “should not be allowed.”….
One-sixth of China’s arable land — nearly 50 million acres — suffers from soil pollution, according to a book published this year by the Ministry of Environmental Protection. The book, “Soil Pollution and Physical Health,” said that more than 13 million tons of crops harvested each year were contaminated with heavy metals, and that 22 million acres of farmland were affected by pesticides.
A signal moment came in May, when officials in Guangdong Province, in the far south, said they had discovered excessive levels of cadmium in 155 batches of rice collected from markets, restaurants and storehouses. Of those, 89 were from Hunan Province {, where Ms. Ge farms.}
Carbon Footprints: US vs. China
Setting aside questions of Sustainability Indices, talk of bubbles have featured prominently in market analyses. An integral part of energy market analysis and policy planning increasingly requires careful attention to unburnable carbon.
Carbon Bubble Economics
The concept has occurs with increasing frequency, including a much discussed article in the Financial Times, as well as in the growing literature of sustainability investing. Although bubbles are best seen in retrospect, investors should always be alert to the potential, particularly after our experience just a few years ago.
The Carbon Bubble relates to the amount of our planetary fossil fuel reserve that is unburnable? As governments and energy firms ramp-up climate change mitigation strategies much carbon not currently used may well remain in the ground due to a pairing of decreased demand and significantly higher costs. In short as The Economist wrote: “Either governments are not serious about climate change or fossil-fuel firms are overvalued.”
Markets can misprice risk, as investors in subprime mortgages discovered in 2008. The value of oil, gas and coal companies depend in part on their reserves. What then of scenarios where reserves can never be dug up and burned?
Over the next decade date determined climate policies will likely converge on rules that leave a large portions of carbon in the ground. Analysis by The Non-profit Carbon Tracker along with the Grantham Research Institute on Climate Change at the London School of Economics finds that if global temperatures are not to rise by more than 2°C, the most that climate scientists deem prudent only ~t 1,000 gigatons of CO2 (GTCO2) can be released between now and 2050. The is the world’s so-called “carbon budget”.
Most of the reserves are owned by governments or state energy firms; they could be left in the ground by public-policy choice (i.e. if governments take the 2°C target seriously). But the reserves of listed oil companies are different. These are assets developed using money raised from investors who expect a return. Proven reserves of listed firms contain 762GTCO2—most of what can prudently be burned before 2050. Listed potential reserves have 1,541GTCO2 embedded in them.
So companies and governments already have far more oil, gas and coal than they need (again, assuming temperatures are not to rise by more than 2°C). Logically, the response to this would be for governments to leave their reserves untouched and for companies to run theirs slowly down, returning more of what they earn to shareholders. Neither of these things is happening. State-owned companies are taking an increasing share of total energy output. And in 2012 the 200 largest listed oil, gas and coal companies spent five times as much—$674 billion—on developing new reserves as they did returning money to shareholders ($126 billion). ExxonMobil alone plans to spend $37 billion a year on exploration in each of the next three years. Notably the firm is setting an internal price on carbon, much higher than than many other targets Presumably this effort is a hedge against policy actions which it opposes by and large.
Planning to extract more carbon fuel reserves at first cut seems illogical in the context of unburnable carbon. Perhaps companies are betting that government climate policies will fail. In this case they can burn all their reserves, including new ones, after all. Our best science tells that this his implies global temperatures soaring past the 2°C mark, if not restrained by technological advances, such as carbon capture and storage, or geo-engineering.
And indeed in the current policy landscape make such bets seem rational. On April 16th the European Parliament voted against attempts to shore up Europe’s emissions trading system against collapse. The system is the EU’s flagship environmental policy and the world’s largest carbon market.
This suggests the EY has lost their will to endure short-term pain for long-term environmental gain. Nor is this the only such sign. Several cash-strapped EU countries are cutting subsidies for renewable energy. And governments around the world have failed to make progress towards a new global climate-change treaty. So on the other hand, betting against tough climate policies seems almost prudent.
But that is not what companies say they are doing. All the big energy firms claim to be green. They say they use high implicit carbon prices to guide investment decisions. Nearly all claim to support climate policies. None predicts their failure.
Yet markets clearly are mispricing risk by valuing companies as if all their reserves will be burned. Investors treat reserves as an indicator of future revenues. They therefore require companies to replace reserves depleted by production, even though this runs foul of emission-reduction policies. Fossil-fuel firms live and die by a measure called the reserve replacement ratio, which must remain above 100%. Companies see their shares marked down if the ratio falls, even when they pull the plug on dodgy, expensive projects. This happened to Shell, for example, when it suspended drilling in the Arctic in February. And many energy industry analysts and actors have watched rapid draw down of valuations in US coal producers.
Worries about mispricing crop up more and more. Citi Research looked at Australian mining companies. It concluded that “investors who strongly believe in ‘unburnable carbon’ would find it more productive to actively tilt their portfolios” (i.e., sell fossil-fuel firms). HSBC Global Research argues that “if lower demand led to lower oil and gas prices…the potential value at risk could rise to 40-60% of market cap.” The 200 largest listed companies had a market capitalization of $4 trillion at the end of 2012, so this is a huge amount. HSBC added, “We doubt the market is pricing in the risk of a loss of value from this issue.”
Are Carbon Bubble Concerns are Overstated?
Economist Richard Tol sees little to worry about even if all oil firms values collapse to nil:
Fossil fuel companies are among the largest companies in the world, but their total market capitalization is small relative to the total stock market. Even if they were wiped out completely, the world economy would shrug its shoulders and move on. We have witnessed rapid falls in the stock market value of fossil fuel companies – of all companies as the oil price fell, or of particular companies as disaster struck – and we know from those episodes that the economic impact is limited.
1. Quantities of Unburnable Carbon Cannot Be Known With Precision
Quantification of climate risk within carbon-heavy assets derives in main part from the widely cited 2°C threshold for irreversible damage from climate change, and its resulting “carbon budget” as determined by the International Energy Agency. It indicates that at least two-thirds of fossil fuel reserves will not be monetized if we are to stay below 2° of warming. Serious consequences for investors in oil, gas, and coal would necessarily ensue.
The IEA’s calculation of a carbon budget depends on the parameter of climate sensitivity. Yet, the IPCC’s Summary for Policymakers includes an expanded range of climate sensitivity estimates, compared to the IPCC’s 2007 assessment, of 1.5°-4.5°C with a likelihood defined as 66-100% probability. It goes on, “No best estimate for equilibrium climate sensitivity can now be given because of a lack of agreement on values across assessed lines of evidence and studies.” The report indicates that recent observations of the climate — as distinct from the output of complex climate models — are consistent with “the lower part of the likely range.”
The draft technical report, Summary for Policy Makers, provides more detail on this. It further assesses a probability of 1% or less that the climate sensitivity could be less than 1°C. That shouldn’t be surprising since temperatures have already apparently risen by 0.8°C above pre-industrial levels.
2. Transition to Low-Carbon Energy Is Not Occurring At a Rate Sufficient to Threaten Today’s Investments in Fossil Fuels
From 2010 though 2012 global solar installations grew by an average of 58% per year while wind installations increased by 20% per year. Yet, they still contribute a small fraction of today’s energy production. History avers of abundant, significant risk for investors that extrapolate high growth rates indefinitely. Carbon Bubble skeptics also caution that investors should bear in mind the IEA’s 2012 World Energy Outlook. In short, demand will increase exponentially, and its not clear replacement for dirty energy seems capable of coming online fast enough. Behavioral shifts around energy consumption are also currently slow in coming. Notably, in its April 2013 “Tracking Clean Energy Progress,” the IEA warned, “The drive to clean up the world’s energy system has stalled.”
3. Not All Fossil Fuel Assets Have Equivalent Potential for Bubbles
Not all carbon-intensive assets are created equal. The vulnerability of an investment in fossil fuel reserves or hardware to competition from renewable energy and decarbonization does not just depend on the carbon intensity of the fuel type — its emissions per equivalent barrel or BTU —, but also on its functions and unique attributes.
Coal for example is rapidly loosing ground for a host of reasons in China and the US. New EPA regulations make it much harder to build new coal-fired power plants in the US. Fundamental, structural challenges are facing coal. ADD CHINA SMOG PICTURE HERE. Power generation now accounts for 93% of US coal consumption, as non-power commercial and industrial demand has declined. This leaves coal producers increasingly reliant on a utility market that has many other (and cleaner) options for generating electricity. That’s particularly true as the production of natural gas, with lower lifecycle greenhouse gas emissions per Megawatt-hour of generation, ramps up, both domestically and globally.
The takeaway — coal accounts for about half of the global fossil fuel reserves that Mr. Gore and others presume to be caught up in an asset bubble.
This is not so for oil:
At 29% of global fossil fuel reserves, adjusted for energy content, oil still has no full-scale, mass-market alternative in its primary market of transportation energy.
Electric vehicles offer more oil-substitution potential in the long run, though they are growing from an even smaller base than wind and solar energy. Their growth will also impose new burdens on the power grid and expand the challenge of displacing the highest-emitting electricity generation with low-carbon sources.
Meanwhile, natural gas, at 20% of global fossil fuel reserves, offers the largest-scale substitute for either coal or oil. In any case, it has the lowest priority for substitution by renewables on an emissions basis, and so should be least susceptible to a notional carbon bubble.
4. Fossil Fuel Valuation Models Are Weighted Towards Near Term Cash Flows
The most important factors in the valuation of any company engaged in discovering and producing hydrocarbons: discounted cash flow (DCF) and production decline rates most oil and gas companies valuations derive from risked DCF models where near-term production and profits count much more than distant ones.
So compounded decline curves typical of many large hydrocarbon projects mean that the first 3-5 years of a project account for more than half of its undiscounted cash flows. Hence, they will be highly sensitive to long-term uncertainties in aggregate. Industry professionals tell us that this is even truer of shale gas and tight oil production which yield faster returns and decline more rapidly.
Based on estimates of our own and those of others, the risk of a 10% or greater drop in global demand for oil or gas in the 2030s would not really impact on their price targets for companies, if balance sheet concerns are the only factor one considers. Yet, those that ignore sentiment and animal spirits do so at their peril.
Fund Balance Conclusions – The Probability of a Carbon Bubble is High Fossil Fuel Share Prices May Not Fully Account for Climate Risks
The instantiation of a carbon bubble in fossil fuel assets will ultimately depend on investor ignorance and bias against climate-response risks, presumably because companies haven’t quantified those risks for themselves. To the extent the latter condition is true, it represents an opportunity for companies seeking to capitalize on the boom in sustainable investing.
Eugene Fama was named as the 2013 co-recipient of this year’s Nobel Prize in Economics for the Efficient Markets Hypothesis (EFM). Many doubters of Carbon Bubbles point to how the Internet allows average investors access to most of the same information on this subject as Mr. Gore and his partners. Ye,t there are still sharp discontinuities: institutional investors and analysts, have the same resources to access even more information. One of his co-recipients and EFM skeptic, Robert Shiller, said, “I just want to be realistic about the world we live in.” Indeed, as the rampant collusion in LIBOR has shown, collusive and shadow banking practices are worryingly entrenched in the culture of marketmakers. From TABB Forum on LIBOR and money markets, which are indispensable to the flow of petrodollars:
At stake is the integrity of a market that affects the daily valuations of private and public money alike, from the $261 billion Sacramento-based California Public Employees’ Retirement System to the $237 billion Scottish Widows Investment Partnership in Edinburgh, from the $4.1 trillion BlackRock Inc. (BLK) in Manhattan, the world’s largest asset manager, to the $1.2 trillion Tokyo-based Government Pension Investment Fund, the biggest pension.
“This is a market that is far more amenable to collusive practices than it is to competitive practices,” said Andre Spicer, a professor at the Cass Business School in London, who is researching the behavior of traders.
The news about man-made climate change gets more dire every day. So in conclusion, as much as possible sustainable investors need to track their carbon exposure, to consider shadow banking, policy driven mandates on institutional investors, and the contingencies that not all market participants have the ability to see the same information at the same time. Such lack of access to actionable data on carbon fuel price movement will create noise in market signals. Fiducaries and investors need to ensure they are properly diversified and not completely decarbonized in the event of rapid movement to equilibrium, that is the bursting of a bubble.
Screening For Green: Sustainability in The Fixed Income Marketplace
In 2013 three companies become the first corporate Green bond issuers, Bank of America, Merrill Lynch, and Swedish property Group Vasakronan. All found solid demand and raised a combined total equivalent to around $2.6 billion. Market issuance in November increased the market size by 50%. Issuers and investors not traditionally interested in Green offerings are entering the marketplace thereby driving up demand. Proceeds from the bonds are used for projects aimed at curbing greenhouse gas emissions, adapting to a warmer climate, or supporting sustainable agriculture in China.
Key thought points for Impact/SRI and Green bonds:
- A slate of deals in November doubled the total raised in 2013 to ~$10 billion.
- The Climate-related bond market stands at $346 billion vs, the ~$2.3 trillion in investment grade bond issuance in the first 3 quarters of 2013.
- Universal standards and criteria are not in place for defining Green bonds; this market is currently just over $15 billion.
- A signal event for sustainable fixed income markets occurred in 2013 when French power group EDF reported its record-breaking 1.4 billion euro ($1.9 billion) deal was broadly similar to its non-Green bond issuance.
- Usage of the instruments to finance nuclear is controversial among many established SRI investors.
- Expectations are that more will follow.
Even with all the above taken into consideration, these instruments only form a fraction of the multi-trillion dollar global bond market. Yet, the entrance of issuers from the private sector marks an important expansion beyond the limited domain of development banks.
Interest among new buyers, corporate bond investors, and others is an inflection tipping point. While still a niche sector, pricing has revealed consistent demand and enthusiasm for ethical investing which means essential benchmarks of liquidity are forming for the nascent market.
Critics have held that the number of governments cutting their subsidies for renewable energy projects would curtail high demand for Green bonds. Evidently, even as subsidies wane, companies still want to use debt to finance their projects and accurate market assessments by issuers has delivered attractive pricing for many investors. As markets put more money behind Green bonds, Fund Balance sees a breakthrough for sustainable fixed income instruments that qualify as Socially Responsible Investing, or SRI, including but not limited to Green bonds.
In short, ethical investment in the fixed income domain is becoming ever more mainstream. As a result of the success of these issues, serious interest is being expressed from potential new corporate issuers in sectors such as utilities, telecoms, and real estate indicating a breakout from SRI themed investors.
For example, 60 percent of an issue the French firm EDF issue was taken up by SRI investors, some, such as Jupiter Fund Management, which invested for the first time in a Green bond as part of EDF’s issue, were not concerned about the label attached to it. Societe Generale reports that investor demand has risen over the last 18 months and been growing since the first corporate SRI bond was successfully launched last October by Air Liquide.
In conclusion, the main theme in sustainable fixed income is that management teams in a diversity of arenas increasingly place sustainability high on their priorities for long-term planning. We recommend same in their planning as they look to the second half of the 2010’s.
The Carbon Markets, Policy, and Technological Innovations
Physicist Jesse Henshaw observes, ” its not what you know but what your world is learning”. In the paper System Energy Assessment (SEA), Defining a Standard Measure of EROI for Energy Businesses as Whole Systems, co-authored with Carey King, and Jay Zarnikau, findings are presented that indicate a ” ~500% error in carbon and energy impact measures form not accounting for businesses working as whole working systems”.
Indeed, the world’s carbon budget may well be tighter than international policymakers and financial planners envision. With this in mind well functioning, publicly supported carbon markets, cap and trade mechanisms, and carbon tax regimens are of tremendous importance in addressing the challenges of climate change.
More firms than many might think are preparing for a price on Carbon. The Huffington Post reports:
Exxon posts its assumption on its website. Company spokesman Alan Jeffers said the company is also operating under the assumption that the price will increase to $80 a ton by 2040.
“We think that will be the net impact of the various policies that various government’s around the world impose in efforts to curb CO2 emissions,” Jeffers told The Huffington Post. “The risk posed by co2 emission in the environment, raising temperatures, climate change, etc., are motivating governments to take action to put a price on carbon, to try to tackle that issue. We want our planning for that to be as accurate as possible.”
Meanwhile, two firms that we follow at Fund Balance, Hess (HES) and Statoil (STO), are leading the industry in their commitments to sustainability and carbon mitigation under the OGSS’s Global Reporting Initiative. Their reports can be seen here and here. At Fund Balance, while we strive to help partners decarbonize portfolios, we also work to identify carbon firms addressing the challenges in bringing about determined yet appropriately measured transitions to a low carbon energy future.
Lastly, improving technology, declining costs, and increasing accessibility of clean energy have been quite ubiquitous in 2013. Key developments:
- Using thermal salts to keep producing power from solar at night
- Electric vehicles that power buildings (Nissan’s groundbreaking ‘Vehicle-To-Building‘ technology)
- Solar electricity hitting grid parity with coal.
- Advancing renewable energy from ocean waves and harnessing ocean waves to produce fresh water
- Ultra-thin solar cells from Alta Devices, a Silicon Valley solar manufacturer that are breaking efficiency records
- Cutting electricity bills with direct current power.
- Innovative financing bringing clean energy to more people. In DC, the first ever property-assessed clean energy (PACE) project allows investments in efficiency and renewables to be repaid through a special tax levied on property, which lowers the risk for owners. Crowdfunding for clean energy projects made major strides bringing decentralized renewable energy to more people — particularly the world’s poor — and Solar Mosaic is pioneering crowdfunding to pool community investments in solar in the United States. Washington, DC voted to bring in virtual net metering, which allows people to buy a portion of a larger solar or wind project, and then have their portion of the electricity sold or credited back to the grid on their behalf therefore reducing their bill.
Section II: 2013 Asset Market Overview — US Markets Finish Strong, Asian and EU Weaknesses Persisted
In 2014, higher economic growth rates with inequality effects via persistent constrained spending power of the US consumer will exact a noticeable fiscal drag in the US, while positive developments in 2o13 for US equity markets are for the most part priced into valuations and a correction should be on investor’s radar screens; uneven growth will be the trend in the EU; China addresses banking and credit market instabilities; the developing world sees demand for its resources continue to grow. Uncertainty around regulatory and tax policy will impact markets less than opacity about public sector investment levels.
Absent exogenous geopolitical shocks, US investors should expect continuity in build up of momentum from 2013 into 2014 but with more volatility, sideways directionality, and perhaps a correction. This momentum will be further dispersed via diminished purchasing power for US consumers whose wages are not reflecting the wealth effects seen in asset price surges or low interest rates available to the luxury class and blue-chip corporations, and so will not be able to fully participate in robust economic activity. Minimum wage gains will not impact the economy meaningfully until 2015. At the outset of 2014, the expiration of long-term unemployment insurance in US is predicted to shave .3% off the US economy according work by Mark Zandi, Robert Schiller, and others. Home price increase rates are slowing. This can be seen as an example of the velocity of money, or M2V, from the invaluable St. Louis Federal Reserve’s datasets and tools. M2V Stocks indicate persistent decreases in economic transactions in the US Economy.
2013:Q3: 1.571 Ratio; Last 5 Observations; Quarterly, Seasonally Adjusted, Updated: 2013-12-20 2:01 PM CST
Note: The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy. Source: Federal Reserve Bank of St. Louis.The broader energy market will continue to be characterized by abundant LNG, tight oil, the arrival of renewable energy sources as key components of the US energy mix meaning self-sufficiency for North America and making it a more attractive place to invest. Upward pressure on the USD will be counterbalanced by low interest rate biases for at least the first two quarters. Yet, here again is a bright spot, as we point out in our solar section and broadly speaking for the sustainable category, falling prices for renewable energy and green consumer goods which provide very significant, if mostly overlooked benefit, to an ever larger percentage of the US population.
Companies that focus on smart cost cutting with renewable energy, investing in product and market research, hiring new people, and advocating for smart regulation aimed at targeted reductions of dependency on fossil fuels will be poised to benefit their investors into 2015. All the while acting in the best interest of their respective nations and as good corporate citizens.
Asset Market Outlook 2014
Asset markets have positive price momentum at the threshold of 2014. That momentum helps identify assets that are performing well now. Conditions and measures indicate that the underlying trends for these specific subsets of these assets will continue into 2014. Our analysis also comports with the findings of the Pew Foundation: acute income inequality negatively impacts economic growth. Like the hangover from sugar rushes, ambient toxicity is the result of short term economic choices that ultimately sacrifice the long term resiliency of economies’ basic foundation, our shared ecology.
In Europe equities posted mixed performance, with gains in Germany, Sweden, and the Netherlands offset by weakness in the UK, Italy, and Russia. Asian equities were also mixed, where strong gains in Japan, China and Hong Kong were countered by weakness in Australia, India and the Philippines.
US yields rose across most maturities on the improving US economic outlook. Curtailment of US Federal Reserve stimulus efforts now seems imminent by 2016 even with the Fed’s plan to measure tapering bond purchases with continued downwards tweaks on interest rates.
European yields were little changed following recent ECB policy action of lowering rates. The US dollar posted mixed performance, gaining against the Japanese Yen while falling against the British Pound Sterling. The Dollar was little changed against the Euro though this could change if interest rates in Europe fall on expected enduring faiblesse. Though we believe the contrarian case that France will surprise on the upside in terms of economic strength.
The Dollar’s strong gains against Emerging Market currencies including the Indian Rupee, Australian Dollar and Brazilian Real may be partially responsible declines in metals and commodities. Moderating expectations for inflation will ensure fixity for this trend of modest declines into 2014 across silver, aluminum, gold and platinum. Recent sharp gains in LNG will moderate somewhat in 2014, but we do not foresee the beginning of a bust cycle in the US until at least 2015. These is due to continued expectations of tight oil combined with economic growth and lower costs for feedstock. We expect more pressure to be exerted on developing nations to extract resources with little regard for the well being of their natural capital, i.e. fresh and and clean water supplies, as they race to build out electricity infrastructure and earn export income with international trade.
We expect pronounced volatility for oil as political developments to ease sanctions in Iran impact its price which in turn will drive increases in US natural gas exports. Agricultural commodity gains were led by soybeans, rice and coffee, which were offset by declines in sugar, hogs and corn.
Hedge funds gained in late 2013, with a November 2013 gain in Global Hedge Fund Index (HFRX) posting a gain of +0.55% for month, while the HFRX Absolute Return Index rose +0.45%.
In 2013 much was made of so-called policy uncertainty, yet the fiscal cliff met with a collective shrug from the world’s markets, despite public hand-wringing on the part of US creditors nations such as China.
Whither Policy Uncertainty?
Fund Balance does not see impending consequences for policy uncertainty in bond prices and in the stock market. Nor are entrepreneurs demonstrating a reluctance to invest due to lack of clarity regarding future tax and regulatory events. If such uncertainty was so grievous, liquidations by entrepreneurs of their current stock positions for a song should be the norm, and they instead shift assets to the Cayman Islands and the like. Thus, under hypotheses invoked by austerians and bond vigilantes, one would expect the stock market to be low when uncertainty regarding government policy is high while the opposite was true in 2103. Furthermore, this internal logic would entail expectations of interest rates on government bonds trending high as well since one way uncertainties about future policies get resolved is via inflation.
The events of the last three years has refuted these hypotheses and their logic. Rather, most business decision makers indicate that considerable business uncertainly stems from the amount of chaos inherent to the US budgeting process in 2014 and 2105. After all, Walmart acknowledges that SNAP reductions hurt its bottom line, telecommunications firms earn revenue from the surveillance state, and the military is the world’s largest procurer of oil, the production of which itself is heavily subsidized by US Taxpayers. As Economist Bradford DeLong points out:
The markers that would indicate that enterprise was being hobbled by uncertainty about government policy per se—those markers just are not there. This seems to me to be a side issue—another argument that is based on political wishes rather than on economic evidence.
A Note on the Role of China in Relation to the US Economy.
The Peoples Republic of China faces the self-imposed generational challenge of moving over three million people a year from subsistence farming in the countryside to industrial and service employment in the cities. Apart from the questions of how to integrate sustainability into this process, consistent with sustainable investment goals, how might this impact their appetite for US debt? The only way to do this is to purchase U.S. government bonds so that the Bond sellers will have renminbi which are used to buy exports from China.
Contrary to conventional wisdom, this is not a pure free-market transaction. China’s State Council is not acting for profit-maximizing economic reasons although its actions are completely plausible and realistic. As one observer noted, “China’s State Council wants, more than anything else, to maintain full employment in Shanghai. Otherwise their heads are likely to end up on pikes.”
In short, no acceleration of the State Council’s planned shift to reliance on domestic demand from exports in maintaining near full employment in Shanghai is at hand. China is not going to suddenly or even meaningfully reduce U.S. government bond purchase in 2014. The risk is far too high for the Chinese economy and to the futures of its leaders within the Council than it would be to the US economy. For the PRC seems keen to embrace the monetary policy management principals (measured by their actions, not words) of the its trading partners in the EU and US. As the New York Times, in coverage of China’s shadow banking system and internal tensions between vested interests and the Council’s desire to deleverage with higher interest rates, wrote:
That approach involved the central bank’s turning to posts on China’s Twitter-like social messaging service, Sina Weibo, to chasten banks to “make rational adjustments to the structure of their assets and liabilities, and improve their liquidity management using a scientific and long-term approach….
While policy makers say they are worried about upsetting the delicate mechanisms of the current banking system, public criticism continues to grow, even within China’s elite. That suggests further market-oriented experiments could be coming soon.
“Banking in China has become like a highway toll system,” Yao Jingyuan, the former chief economist at the state statistics agency, said late last week during a speech at Nanjing University, according to numerous Chinese news reports. “Banks charge every time money goes through them.”
“With this kind of operational model,” Mr. Yao added, “banks will continue making money even if all the bank presidents go home to sleep and you replaced them by putting a small dog in their seats.”
A Note on Technology and Labor Markets In The US
Fund Balance holds that increased inequality in the US economy, 70% of which is comprised of consumer spending will continue to be a drag on sustainable growth in 2104. Moreover, can the US economy remain vital and growing in the face of inequality and its doppelganger, automation? Oxford researchers found that 45 percent of America’s occupations will be automated within the next 20 years implying that nearly half of U.S. jobs are vulnerable to computerization.
While many hiring managers argue that there is a fundamental skills mismatch between employers and job applicants in the US, the story is more complex, with inequality and regional differences being key plot lines. For example, Economist Paul Krugman pointed to unemployment by occupation
looking at changes in unemployment rates from the 2007 business cycle peak to the unemployment peak in 2009-10, and then the subsequent decline; it looks like this:
It’s the same as the geographical story: the occupations that took the biggest hit have had the strongest recoveries.
Still, rapid advances in technology do represent a serious potential threat to many jobs historically performed by people. Google’s Eric Schmidt eerily talks of humans needed to prepare to compete with machines for jobs as the firm has been on an acquisition spree for robotics firms.
A recent report from the Oxford Martin School’s Programme on the Impacts of Future Technology attempts to quantify the extent of that threat. It concludes that 45 percent of American jobs are at high risk of being taken by computers within the next two decades.
The authors expect this replacement in two phases. First, computers begin to replace in vulnerable fields like transportation/logistics, production labor, and administrative support. Jobs in services, sales, and construction sectors may also vanish in this first phases. Then, the replacement rate will decelerate due to bottlenecks in harder-to-automate fields such engineering. This “technological plateau” will precede a second wave of computerization, driven by deep learning. Systems derived from these innovations will compete for jobs in management, science, engineering, and the arts. They conclude that the rate of computerization depends on several other factors including regulation of new technology and access to cheap labor.
Utilizing standard statistical modeling techniques the researchers analyzed more than 700 jobs on an online career network including the skills and education required for each. They noted:
Our findings thus imply that as technology races ahead, low-skill workers will reallocate to tasks that are non-susceptible to computerization—i.e., tasks that required creative and social intelligence….For workers to win the race, however, they will have to acquire creative and social skills.
Established estimates are that one in four private-sector jobs in the US now pays less than $10 per hour, well below a standardized living wage for the US. Compared to better-paying positions, these jobs rarely feature regular schedules, health care coverage, paid vacation time or sick leave — the essentials of middle-class work. In other words, employment increasingly is not a guarantee of life above the poverty line in the US. Indeed, according to census data, more than one in 10 Americans who work full-time are still poor.
Section III: Solar Stocks 2014
Fund Balance Here Comes The Sun ETF Performance for 2013:
One of the most widely held ETFs, the Guggenheim Solar ETF (TAN in the chart above), returned 131.3% YTD and –54.96% over the last 5 years.
Solar power investments performed tremendously in 2013. Commercial users of solar power such as Walmart, GM, Staples, and Walgreens are just now scratching the surface of what is possible in terms of balance sheet energy cost saving and carbon footprint reductions. Current installed solar production is minimal compared to overall energy consumption, though a paucity of data which is closely held by most suppliers and users, makes gauging returns on capital and cost efficiencies inexact.
From an asset management point of view, as the solar power industry matures buying opportunities become more difficult to spot. We urge growth investors to hold and build positions in companies with long term stable cash flows and to keep some powder dry for nascent prospects in smart-grid, storage, and supporting software and services such as Power Secure International which returned ~130% in 2013. Investors will short time horizons are advised to explore capturing some profits in the first quarter of 2014.
As 2014 unfolds, potential interest rate increases from reduced monetary stimulus as well as policy uncertainty stemming from upcoming expiration dates for tax credits early in 2016 will guide discrimination between long term positions and short term ones in solar power.
New solar Photovoltaic (PV) installations grew at a rapid pace in 2013 to 36 GWs. The cost competitiveness of this electric power source shows rapid improvement as well. While utility-scale PV installations are not yet cost competitive with fossil fuel power plants, commercial-scale installations have attained cost parity in that generation costs of power from solar PV is comparable to the retail electricity prices that commercial users pay in key economic regions.
In the US, demand will continue to pick up in 2014. Still just 5 states have 82% of all US solar installs. In immature markets in the Southeast, with Georgia showing leadership in both its initiatives as well as its withdrawal of tariffs, which are still in place in other states. We see large opportunities here. Their tariffs on solar generation amount to a penalty on home based solar power generation while voters and stakeholders are taking notice. Leading markets in the Northeast and Western United States remain robust and highly competitive. Hawaii also has stuck with its plan for widespread solar usage in order to wean itself from fossil fuels for residential and many types of commercial power. All of this reinforces a key trend: Over 2014 consistent growth will continue as the cost of solar comes down and the cost of other energy sources goes up.
California continues to lead the solar PV charge, installing 455 megawatts in Q3; North Carolina moved into the No. 3 spot in total PV installations with 23 percent growth. Nevada moved from 17 to 5 and Vermont from 21 to 12 in the rankings.
Commercial-scale installations could reach ‘‘grid parity’’ in about ten years, if the current federal tax incentives for solar power were to expire at that point rather than sooner.
Impact investors should look to solar stocks in 2014 that are performing well at its outset. Fund Balance expects a continuance of 2013 trends in the near and mid-term. The same can be said for the broader array of underlying macroeconomic conditions. Throughout 2014 demand driven by system prices will slow somewhat after market absorption of significant 2013 price reductions on the heels of the industry wide buffeting in 2012.
The Price Story
Price stability helped solar market growth while capacity and supply shrunk as companies went out of business (Suntech Power and LDK Solara are two examples). Demand however steadily picked up. A long awaited EU-China solar trade agreement bodes well for international price stabilities. Chinese manufacturers are not signaling plans for expanding or upgrading solar plants until at least 2015 as even its best manufacturers continue to shrink bloated balance sheets. As Chinese banks appetite for solar risk subsides after the three voracious years shrinks, we expect steady mostly unchanged supply levels from China in 2014.
In the a US in 2013, increasing demand for solar power and stable pricing in the second half of 2013 provided strong support to manufacturers. Once struggling to break even, SunPower (NASDAQ: SPWR), Canadian Solar (NASDAQ: CSIQ), JinkoSolar (NYSE: JKS), and Trina Solar (NYSE: TSL) are now profitable and richly valued.
Trends look in their favor though volatile short interest is high. Has the market priced this trend into their asset prices and valuations?
Overall then, gross margin trends over the past year for these companies improved rapidly as a result of the aforementioned better pricing as did cost reductions from 2012 when the industry was in a far worse position.
If demand hits many analyst’s upper range of 46 GW in 2014 and as little new capacity is scheduled to come online in 2014, these growth trajectories will continue upwards. For example, SunPower’s 350 MW expansion will not come online until 2015. Margins for producers with scale will continue to improve and sustain market valuations albeit attached with worries of irrational exuberance.
The highest quality suppliers have seen the biggest benefit so far and we think that is where the gains will be this year as well. We think the smart bet is on a profitable company making even more money as the industry improved than a high risk debt ridden company turning things around.
The Bear Case for Solar
On the risk side, at present and into 2014, the primary risk factors for the sector are three fold:
Firstly, standardization and securitization will continue to improve in the financing of new solar assets. Tax equity will remain in place for residential installations. Utility scale investments will get more competitive. Complex deal structures which result from legal and consulting costs along with an absence of standardization will continue to increase costs of capital. Financing will primarily be available to utilities that can roll-out new solar power capacity at large scales. Technical risk while ever present, has lessened as well in the present innovation cycle, though we project it to continue as a cost driver.
Secondly, in the late 2014 electricity rates will likely experience upward pressure from scaled back government incentives and new supply constraints. Policy uncertainty (as discussed in Section II) will continue to show wide variability state by state. This should be measured against a more steady and coherent pattern of modest policy support expansion via Solar Energy Renewable Certificates (SRECs). Some encouraging signs in regions with long-standing policy and legacy, vested economic interest led resistance to renewables will unfold in 2014. Georgia is one example. Looking out on the 3-5 year horizon, the Solar Investment Tax Credit (ITC), scheduled to expire in 2016, is one of the most important policy mechanisms in the deployment of solar energy in the United States. A rapid scale-back of ITCs will detrimentally impact the US solar power industry. Hysteresis in the form of backlogged capacity from rapid capex retrenchment are still noticeable in Germany, the US and China. This should abate in 2014 as well.
Thirdly, cost per watt averages are dropping while costs for skilled labor are not. Some observers think that labor costs are problematic for the industry growth prospects. And indeed automation is on the rise in manufacturing and maintenance. The Fund Balance view is that these concerns are overstated as increases in labor costs will primarily allow more consumer discretionary income as well as increase energy demand. That said targeted automation will be an opportunity and bring lower prices to market. Nonetheless we see a the broader lift from increased minimum wages in key markets as engendering more equitable wages and growth. This will more than offset higher costs in the supply chains and increase on-grid peak demand/delivery ratios.
By comparison, the endogenous challenges in 2014 for the solar industry over the past three years really converge on the fundamental economic concepts: supply and demand and inflation. With 70 GW of solar module capacity available in the market and only about 32 GW installed in 2012, this imbalance brought plunging module prices and the culling of many solar panel manufacturers worldwide.
The Breakthrough Institute published a thought-provoking comparison of nuclear and solar for US mid and long term energy demand. It concludes that nuclear is the essential component of the US low carbon energy mix, and further that solar advocates have gotten ahead of reality in terms of technology and usage growth rates. Notably, the study acknowledges that policy changes around unburnable carbon, i.e. a possible carbon bubble, are not factored into its analysis.
Buy, Sell, or Hold SolarCity?
A case in point is the bearish view of SolarCity (SCTY) held by many market participants. Bulls argue that SolarCity is a distributed power “killer app” poised to disrupt traditional power grid revenue models. Contrarians aver that SolarCity is far too dependent on SRECs and other tax incentive supports. Roughly one in five SolarCity shares are being shorted while its stock surged ~340% in 2013.
Still, the short thesis is that SolarCity is not profitable now, and it has little hope of achieving that in the foreseeable future as its strong growth will stall when the current 30% investment tax credit presently in place drops to 10% come Jan. 31, 2016. Bears also note that most states limit net metering, which allows property owners to sell the energy they don’t use back to their local utility at above-market rates. California, SolarCity’s largest market, could reach that limit by late 2014.
Worse yet, doubters and short sellers point to SolarCity’s assumed discount rate of 6%, unusually low for such a young firm given that the typical 10% rate in net present value assumptions. Plugging this 10% rate in yields a much lower valuation than reflected by the current market price.
With all this in mind, we rate this firm a hold over the short-term with a recommendation to accumulate on dips. A close eye on revenue growth is thus advisable. The viability of its relationship with TESLA, and of course, its ability to transform away from potential over dependency on subsidies bear monitoring as well.
Even still, as the runaway bull market for solar continues into 2014 expect story stocks like SCTY which trade on perception as much as potential and current fundamentals to move upward in sync. SCTY (and other market leaders with scale) enjoy the keyword effect of “disruptive potential” and a “modern day Thomas Edison” in Elon Musk as chairman along with astounding growth in terms of megawatts deployed. SCTY had 109% growth overall and 151% growth in the residential segment for Q3 2013 versus last year Q3 2012. As an example of falling costs, SolarCity’s operational costs/watt has come down over the past quarter from $0.80/watt in Q2 to $0.59/watt and this looks poised to continue.
SCTY’s high stock price will allow faster growth by allowing its stock to be a currency to buy companies, which if executed well, will also deliver higher growth and a higher stock price. So,the positive cycle will then continue.
Finally, insiders are not selling their shares rather they are buying. Chairman Musk purchased over 200,000 shares and CEO Lyndon Rive purchased over 100,000 shares in SolarCity’s most recent secondary offering.
Fund Balance Outlook: Market Growth for Solar Power
Our 5 year view for the solar power market in the US depends on the following contingencies:
How soon solar can replace coal in the US energy portfolio and to what extent can it compete with Liquified Natural Gas (LNG) in the US energy portfolio?
Other key questions: to what extent may the US be nearing the end of the golden age of natural gas? An observed and familiar pattern may be forming of 2 year boom/5 year bust cycles in energy for LNG — yet with LNG on trend for growth in the US energy mix for decades to come, barring unforeseen regulatory and societal interventions, past may not be prolog in this case. Furthermore a new study reports findings that hydrofracking uses less water than coal. They estimate that the water saved by switching from coal to natural gas is 25 to 50 times greater than the amount of water used in fracking to extract the shale gas in the first place.
Will solar achieve grid parity with LNG in the next decade? As noted above, likely yes. Will it surpass LNG or nuclear as a constituent of the US energy mix? Very likely not. All being roughly equal and despite a 72% drop in gas-directed drilling since its peak of 1,054 rigs in Sept. 2009, U.S. dry production of LNG will continue to grow through 2014 with modest busts preceding larger booms into the end of this decade.
Yet here again, history never repeats itself the same way twice. For example, an early signal of trouble for LNG supply is the passing of the nation’s strictest ordinance restricting of Hydraulic Fracturing or “fracking” by the city of Dallas, in the heart of the Barnett Shale boom economy. Fossils in general have considerable increasing fuel price risks. Even with further lowered LNG prices and un-utilized LNG capacity, strains of local aquifers and water sheds will continue to inform the regulatory arena.
What Does Reactive Power Mean For Renewable Energy Asset Stewardship and Investment Strategy?
From a top down perspective, the DNA of the energy sector is digital and edge of grid. It will involve the convergence of solar, grid operations, and storage. Growth of these multiple revenue streams from distributed energy generation means a high-penetration PV future. Further opportunities will arise as electric car infrastructure merges with solar storage to supplement battery advances.
The electrical grid has a fundamental need for reactive power and, in some cases, the requirement to avoid instabilities via reactive power feed-in. A new generation of inverters satisfy this requirement, making reactive power available even outside of normal feed-in periods. By utilizing reactive power during the day – and at night – utilities leverage the use of existing equipment and avoid stand-alone solutions, resulting in performance improvements. We expect to see ample opportunities for ethical capital stewardship in this area.
The electrical grid has a basic need for reactive power. Obverse to this need is a requirement to avoid instabilities via reactive power feed-in. Learning curves are slow with utilities, and this will impede higher rates of solar uptake in utilities and so load shaping and peak shaving will be the primary growth areas for reactive in the near term for solar.
Early stage growth opportunities for longer stewardship planning will present themselves via the adoption as the IEEE 1547 standard:
[A] tight underfrequency protection setting of 59.3 Hz which poses a risk for grid stability. In case of an underfrequency situation,[3] e.g. after a major loss of generation, the situation may get worse when a multitude of distributed energy resources (DER) disconnect simultaneously. IEEE 1547-2003 demands also an obligatory overfrequency disconnection at 60.5 Hz. With a rising share of distributed generation there is a possibility of triggering a non-linear oscillator in the multi GW range within the transmission grid. In Europe, this problem with similar standards has already been addressed by ENTSO.
In addition to inverters and microinverters, more compact and efficient heliostats are being used used for daylighting and heating. Instead of many large heliostats focusing on a single target to concentrate solar power (as in a solar power tower plant), a single heliostat usually about 1 or 2 square meters in size reflects non-concentrated sunlight through a window or skylight. A small heliostat, installed outside on the ground or on a building structure like a roof, moves on two axes (up/down and left/right) in order to compensate for the constant movement of the sun. In this way, the reflected sunlight stays fixed on the target (e.g. window). An example of this is Genzyme’s corporate headquarters of in Cambridge, Massachusetts, which uses heliostats on the roof to direct sunlight into its 12-story atrium.
Finally, Fund Balance expects to see more and more focus on behind the smart inverter standards and behind the meter software applications to complement significant opportunities in storage. For many, storage is about physical and lifeway security, not just sustainable economics and this demand is being met as we are seeing availability of economical storage such as 300MW pump storage systems.
At Fund Balance we are cautiously optimistic for 2015 and 2016 that these and doubtless other technological innovations will surprise on the upside as smart grid applications begin to instantiate themselves at the point of usage be they residential, commercial, or utility-based.
Conclusion:
2013 will go down as a record-shattering year for the U.S. solar industry. It created thousands of American jobs, saved much needed income for U.S. consumers, reduced pollution nationwide, and lessened societal dependence on unstable/unburnable foreign energy supplies. The Fund Balance view is that the surface is just being scratched in terms of this our industry’s enormous potential. Parenthetically, we think this true of of Impact and Sustainable Investing as well.
The residential market continues to see the most rapid growth of any segment in the U.S. PV market. Through Q3, residential PV installations were up 49 percent year-over-year, driven largely by progressive state renewable energy initiatives.
Will a solar energy bubble form in 2014? Likely not. For Fund Balance and the market at large, 2013 was a great year for investment in solar companies, both operationally and in value creation. We forecast steady demand grow in 2014 indicating that long term investment and asset stewardship planning should center on holding tight in the periods of profit-taking.
It is dangerous to short stocks and sectors in a bull market without a near-term trigger. In 2014 the market will be focused only on growth metrics and solar is delivering. While growth will slow as tax incentives are reduced in late 2015 into 2016, falling solar costs will eventually make the rooftop solar companies profitable.
The distributed power market, led by SolarCity and SunPower will continue to present opportunities. Big institutions such as Goldman Sachs and Total are in. Access to cheap capital will remain in place for the time being as the market prices in a rising interest picture. Cautions should be used in assessing smaller companies due to lack of such factors, though they may make good acquisition targets.
For the broader market:
-
PV installations reached 930 megawatts in Q3 2013, up 20 percent over Q2 2013. This represents the second-largest quarter for solar installations in U.S. history.
-
The utility solar sector represented more than half of new PV capacity installed, but the residential market also showed impressive growth with 12 percent expansion over Q2.
-
The non-residential market remains flat; however, Fund Balance is not alone in anticipating a robust resumption of growth in 2014.
-
2013 is likely the first year in recent history in which the U.S. installs more solar capacity than Germany.
Blended average PV system prices fell 4.2 percent in Q3 2013, reaching a new low of $3.00 per watt.
-
The U.S. will install 4.3 gigawatts of new PV in 2013, up 27 percent over 2012 with the the 392 megawatts Ivanpah CSP project scheduled to begin delivering electricity to the grid before the end of 2013.
In general firms need to:
- Innovate around the permanent benefits and use the subsidies as a bonus
- Stay attenuated to key regulatory leadership such as California’s Rule 21, Georgia’s Advanced Solar Initiative, and Hawaii’s broad embrace of Solar as a fossil fuel risk mitigator.
-
Assess regulatory certainty/uncertainty in the marketplace which is often as important as value propositions
-
Mind customer aquistion costs which are still high in US; $.49 in US; $.07 in Germany
- Consider using interest rate hedges
Solar was the second-largest source of new electricity capacity in the U.S. in 2013, trailing only natural gas, according to GTM Research: “As solar continues its march toward ubiquity, the market will require continued innovation, efficiency improvement and regulatory clarity. But already the groundwork has been laid for a mainstream solar future.” In sum with solar Fund Balance anticipates more booms than bubbles.
.
Section VI: Protecting Our Vital Resource — Water Resource Management: Fund Balance Coverage In 2014
Fund Balance now covers covering water management and services firms with our Water, Water, Everywhere proprietary ETF.
A world population on track to surpass to 8 billion by 2030 fixes global demand for fresh water as a tremendous challenge. Factoring in climate change, aging infrastructure and contamination issues yields projections for a 40% rise in water demand by 2030 hardly seem a stretch. With 71% of all water withdrawal used for agriculture, potential shortages and mismanagement would result in acute impairment of food production and trade.
The growing strain of our shared fresh and saltwater resources is clearly making its way into the public conciousness. Household consumer brand Brita points out in recent advertisements that using its products dramatically reduces the number of plastic bottles than end up in the ocean and fresh watersheds. A key point since such low rate of plastic are ever reused or recycled, rather they end up disrupting the foundations of the global food web.
Sustainable and integrated management methods will be needed to balance those of private interests that own the rights to water resources and to steward publicly held natural capital resources, which are themselves vital to the common future for private interests as well. In addition, developers of waste-reducing irrigation systems, as well as creators of more potable water such as sea-water desalination technologies, will require thoughtful capital sourcing and deployment in order to scale up. Here, as in the renewable energy efforts, fossil fuel extraction zones and their attached ambient toxification of fresh water sources further indicate growing conflict between dirty energy and the essential component of all life and thus economic activity.
The two dominant economic/ecologic complexes in the U.S, Texas and California , while states like Georgia are in conflict for resources with neighbors both due to issues of drought and water rights. The world’s largest soon to be consumer/producer, China, struggles with drought and flooding. Another key linkage between the water resources industry and energy is that by 2035, the International Energy agency predicts that global electricity generating capacity will reach 9,481 GW to meet accelerating demand. There will thus be huge opportunities and requirements in integrating sustainability with water management and waste water treatment.
In 2014 Fund Balance will cover and track the following group of firms:
- Consolidated Water Co. Ltd. — develops and operates seawater desalination and water distribution systems
- Ecolab — manufactures and distributes cleaning and sanitizing products, and provides pest elimination services
- Energy Recovery Inc. — Energy Recovery develops and manufactures energy efficient recovery devices and pumps used in desalination plants
- Watts Water Technologies — designs and manufactures water control, conservation, and quality checking systems
- Parker Haneffin — Parker has long recognized the connection between the health of our company and economic, environmental and social factors.
- Siemens — Sustainability commands an established basis in their business culture and planning and is a key pillar of its corporate culture.
- Xylem designs, manufactures and markets applications for water and waste water management and recycling
We will work to understand and to show our partners where the biggest opportunities are in water and waste water treatment and to provide clarity on regulatory variables and higher reuse targets, as well as power plant operators in the key markets. These are fast growing markets with distinct treatment solutions geographical requirements/microfluctuations, market drivers, and technology trends. You can pinpoint the regions with the best prospects for your businesses, and as such, they are significant opportunities for application of integrated management, sustainable financing, and natural capital stewardship.
Section V: LED Market Overview
The LED lighting market is hot and very competitive. From relative newcomers like Cree, Acuity Brands, and OSRAM, to well-known brands Koninklijke Philips and GE Lighting, the fight for market share is intense. Growth potential is high. Our recent research projects the LED market to grow CAGR between ~45% through 2016. Consequently, risks of oversupply and subsequent profitability declines in the face of downward price pressures bear watching for investors in smaller firms and/or ones with slim margins.
One of the key factors contributing to this market growth is the declining Average Sales Price (ASP) of LEDs. The global Chip on Board LED (COB LED) market has also been witnessing the increasing demand of COB LED in general lighting applications. However, the fluctuating global economic conditions could pose a challenge to the growth of this market.
The key vendors dominating the COB LED market space are Citizen Electronics Co. Ltd., Cree Inc., Nichia Corp., Osram Opto Semiconductors GmbH, Philips Lumileds Lighting Co., Samsung Electronics C o. Ltd., and Seoul Semiconductor Co. Ltd.
Demand for LED lighting will surpass that of LED backlight during the beginning of 2014, according to a recent report by J.P. Morgan:
- LED product ASP drops have contributed largely to increased consumer usage.
- Current payback time for commercial luminaries A19 and PAR28 has already been reduced to a year or less while LED bulb price has room to drop 30 percent by 2015.
- Penetration rate in 2013 will reach around 11 percent up over 5 percent last year, projected at LED 20 percent before 2015.
- The LED lighting market is more dispersed than the LED backlight market where consumers are highly concentrated. The top three global lighting manufacturers Philips, Osram, and GE make up 30 percent of the global market share.
- This dispersed nature of the LED lighting market will bring more revenue and bargaining space than LED backlight products in the past.
This is sure to attract more consumers to replacement LED bulbs via it economic and ecologic benefits.
- Specifically we see LED lighting market development trends and lighting product strategy and the market share situation in different areas.
- 3030 LED has highest lm/$ and is widely distributed in the market and most preferred.
- 5630 LED: high current spec applied in bulbs and downlight products
- 5630 LED: limited room for further price cuts as 5630 LED price closes to production costs
- LED Manufacturers will continue to speed up COB product development.
A Brief Case Study Revolution Lighting Technologies
Revolution Lighting Technologies (RVLT) is a firm emblematic of the wider LED narrative for new entrants. With revenue of $15 m, net income loss -S19.53m and their market cap is $259.96m the market for their shares appears way ahead of itself. Yet this new firm is wisely using its pricey stock to make acquisitions to challenge bigger players with market caps measured in the billions of USD.
Sales momentum proceeds unabated. New York’s largest commercial property company, SL Green Realty (SLG) is one of the company’s key customers. SL Green has awarded two orders this year – an order for 1,000 LEDs for a Times Square commercial property in March followed by an 8,000 LEDs order in December after large purchases in 2012.
RVLT started 2013 with an acquisition of California-based LED solutions provider, Seesmart Technologies for $20 million. Revolution’s bankers liked Seesmart’s distributor count of more than 50 and potential project value exceeding $1 billion.
As one of the smallest players in the industry, RVLT’s exposure to any potential price war could hurt the already vulnerable stock value. And, signs of one are already visible, with both Cree and Philips now offering sub-$10 LED lamps. As prices fall, RVLT has few good options but to follow suit, which will directly hit its strong gross margins from 2013.
As awareness about energy efficiency ever-growing in nations across the globe, the LED lamp investment thesis has great prospects. RVLT may be well poised to capitalize on these trends. But, with nil profits and cash flows, shareholders need to be wary of dilution from additional equity issue to raise capital for funding growth. In sum, at the outset we thought that valuation was fanciful for the long and mid-terms and still do which is why we did not add it to our Leading the LED Motif over 2013. Though we did miss the tremendous upside in 2013, we think the fundamentals make the probability of a pullback in 2014 very high and a strong sell-off not unlikely.
- Revolution YTD return: 470.83%
- Cree YTD return: 88.31%
- Acuity YTD return: 65.16%
- Koninklijke Philips: 42.3%
Fund Balance sees excellent opportunities in the private equity, early stage space LED manufacturers. One start-up firm we work with closely projects $19 mil net income in its first year. Our Year 3 sales are projected to be $19 mil with net income of $700K on a $ 2.5 mil raise.
The OLED Market:
Light-emitting materials will encounter rapid change in 2014. From Smartphones to touchscreens they are key to the future of human-computer interaction. These materials are consistent with sustainable investment and business development goals as these materials consume less power than standard LED products and share in the durability.
Active matrix organic light-emitting diode (AM-OLED) entered the display panel market when Samsung Display started operating its large-scale mass production facilities in 2008. Since then, Samsung Display has been the leader in the AM-OLED market expansion. In particular, AM-OLED displays have been well received by smartphone manufacturers, achieving noticeable growth in products ranging from the high end of 3 inch to 4–5 inches.
By 2014, Samsung Display but also LG Display, AUO and Japan Display Inc. (JDI), are set to boost AM-OLED panel production or initiate mass production. Given that, light-emitting material makers are expected to compete in a more advanced market environment with increased demand and a broader base of customers, after the first part of this decade where they had depended wholly on demand from Samsung Display.
In 2013, the AM-OLED light-emitting material market stood at around $350 million based on demand from mass production lines. In 2014, the market size is forecast to rise by about $100 million to $450 million thanks to demand growth from the existing and new AMOLED mass production lines.
Three main points are of interest for sustainable investors in 2014:
-
Organic light-emitting layer structures and development plans of AMOLED panel makers are on schedule for 2104
-
Market trends and forecasts of the 10 main individual materials are very encouraging
-
Supply chains are strong an and market share will expand by material/company and in 2014 based on orders and vendor forecasts
Conclusion:
The LED/OLED market will grow and expand in 2014. Opportunites will abound for established markets and technological innovators that can compete on price and power consumption reductions. The Fund Balance Leading The LED ETF outperformed the S&P, and we are not currently looking to make additions or rebalances, though we will continue to look closely at start-ups and monitor industry wide ASP trends.
Leading the LED 2013 performance for 2013:
