Rates are coming down, but should the Energy Transition hope for a recession?

With the Fed’s recent 50bps cut (preceded by a few other central banks) and the expected further cuts of the ECB and other banks this year,  we appear to now be on the trajectory of easing monetary policy, and therefore hopefully fuel will be added back to the ET’s fire. But this highly strung world economy seems one shock away from a recession and the key question is whether this can be avoided.

It begs the question: will lower rates be enough to cure our FOMO or should the ET industry actually be hoping for a recession?

It’s a theoretical and provocative question but one that is worth thinking through; these infrastructure assets are long term investments after all and with the trend for merchant exposure on the up, even operating assets are increasingly exposed to the prospects of the economy at large.

Firstly from an energy sector perspective, recessions inevitably tend to suppress overall energy demand. Even with this and the most ambitious assumptions on energy efficiency, it seems likely the long term high growth super cycle experienced by the electricity sector, driven more recently by data centres and electrification, would continue. So we’d just have slower growth. The largest beneficiary of this would be new build renewables of course.

Outside of energy we could expect commodity prices to reduce, perhaps significantly if China’s economy is part of the recession. This will help unlock the equipment supply price shock that has hit certain parts of the sector, especially wind. Another major impact which I touched on earlier would be a much faster reduction in central bank rates and thus the cost of capital, improving the prospects of many currently mothballed/struggling sites. A wave of refinancing and a pick-up in M&A as asset valuations increase would likely attract new capital, awaken dormant capital and recycle more risky capital, further fuelling new investments. Fiscal policy would also become more accommodating and presumably ET will be one area governments prioritise when seeking to stimulate growth, although the realities of the Covid-19 debt burden is likely to severely restrict the impact of this.

It would not all be positive though as there is likely to be a number of constraining developments that will at least offset some of this additional momentum; higher numbers of distressed companies and assets (perhaps triggered by tighter credit conditions and slowdowns in other sectors) might lead to new constraints on the supply chain. Solar, with its perennial over supply would seem most vulnerable. Equally financial support to the sector (eg in the form of FiTs) will become increasingly challenging politically which will in particular limit a government’s ability to support the incubation of new technologies as they get up to scale.

Perhaps most critically though could be the impact of a general lowering of credit standing among corporates (and households) the world over. Beyond the indirect impact of lower electricity demand, this will impact the ET in two ways. Firstly, we would probably see a lower build out of C&I and on site power from firms with weaker financial resources as they – and potentially also retail investors – focus in on manging their underlying businesses, respectively their financial outgoings. Some existing marginal C&I may fall into distress. Secondly, for utility scale assets this will impact projects exposed to merchant offtake; existing assets will be impacted if minimum rating triggers for their offtakers are triggered and new build merchant projects will struggle, in part due to deteriorated credit rating conditions but also as corporates inevitably reduce the price they’re willing to pay for additionality.

Overall it’s very hard to say whether our FOMO would be fixed by a recession any more than an orderly return to monetary norms. We can however conclude the following:

1. Globally, and perhaps most obviously, it’s fair to say solar will continue its march forward regardless as will BESS, particularly in markets that are now saturated with solar. In the case of a recession we’d probably have fewer factories producing the panels though which might help normalise pricing a little bit;
2. Wind is harder to predict. With its higher capital intensity and lower commoditisation of production it would stand to benefit the most as long as suppliers stay afloat. A resurgent wind market would be great news, as we need more wind to compliment the higher deployment rates of solar. But in the US and Europe in particular, to make this a reality we’ll need policies that help ensure the supply of equipment; how this will differ if a recession arrives is hard to predict; and
3. We’re likely to see an increased focus back to non-merchant assets, both new-build and operating. The extent to which governments will support this will depend on many factors, including what their electorates are willing to see paid.

Perhaps the final remark is to highlight once more that renewable energy is a safe haven for investors during a more challenging economic environment and that surely, irrespective of whether an economy does tip into a recession or not, should be an important consideration in asset allocation strategies.