Renewables and Russia – A Tailwind for Turbines

Summary

• The EU is hugely exposed to Russian energy – not just in gas but nearly all fossil fuels.
• The exposure hinders it from pursuing foreign policy goals. The divestment of Russian energy will be a major policy pivot going forwards.
• Simply replacing the supply of Russian gas energy with other sources may be practically difficult (due to infrastructure) as well as geopolitically unattractive.
• Longer term, a concerted increase in renewables spend is highly likely.

Market Implications

• The market currently looks to be underpricing the potential upside to renewables demand even without accounting for the likely policy shift ahead.
• We see value in overweighting European renewables on the back of strong future demand supporting bottom lines.

The Russian Invasion of Ukraine Changed the Paradigm

Europe has united in its horror at Russia’s invasion of Ukraine. Outrage has been sufficient for Germany to reverse its policy of pacifism and for Finland and Sweden to consider joining NATO. In monetary terms, it has driven an unprecedented commitment to send aid. However, the EU’s reliance (and spending) on Russian energy has emerged as an obvious limiting factor to the steps it can take.

The importance of Russian energy exports to the EU is proven by its exclusion from sanctions. It is important to Russia, too, with oil and gas accounting for over a third of Russian government revenues. That is why, as we had predicted, Russian gas flows to the EU actually rose through the invasion (Chart 1). And (as we had also predicted), the spike in EU gas price was relatively short-lived versus more fundamentally affected commodities such as wheat (Chart 2).

EU Exposure to Russian Energy Limits Independence

The EU cannot continue without a substantial change. There is a clear strategic need for the EU to rid its dependence on Russian energy. Gas has been a high priority, with plans raised by the EU and IEA to significantly reduce dependency this year.

The problem goes beyond there, though. Dependence on Russian energy extends across virtually all fossil fuels [see here for our analysis on the topic]. In 2020, Russian supply accounted for 40% of the EU’s natural gas usage, 36% coal, and 27% oil. By our calculations, the EU depends on Russia for around 30% of its total energy usage.

By country, Germany, Poland, the Netherlands and smaller EU states depend most on Russia in this regard (25-40% energy coming from there), while France, Spain and Belgium are less dependent (<15%).

Decoupling From Russia Is Essential

The dependency on Russia is driving national policy already, with Germany adding two new LNG terminals aimed at contributing around 570 GWh/d of capacity (around 40% of Germany’s Russian pipeline capacity). Current plans see a path to become independent from coal and oil this year, but natural gas will take until 2024. Green Economy Minister Robert Habeck, meanwhile, continues to oppose extending nuclear usage.

Italy has focused on boosting gas imports from Azerbaijan and Algeria, while flagship utility company Enel has cancelled plans to convert its two largest coal power plants to gas.

Poland, on the other hand, is stuck searching for alternatives to Russian coal. A switch to EU-mined coal is possible given the EU has its own substantial coal deposits. But right now countries seem more willing to delay plans to end coal than reopen closed mines. That could leave a painful supply/demand equation.

The problem is the sustainability of the solutions and the limitations of current infrastructure. LNG is the easiest like-for-like replacement for gas. But there are questions as to its supply. And to be a solution for the whole bloc, it would need to enter infrastructure in regions that have existing capacity to redistribute. The UK, Germany and Spain should be fine on that front given they already act as hubs. The difficulty is in the bloc’s east, which has limited or zero access to the open sea and may lack sufficient infrastructure to receive gas travelling eastwards (Chart 3).

The Solution Must be Domestic – Renewables Offer That Much

Renewables are politically attractive as a replacement for gas- and coal-powered electricity. There are functional difficulties, and alone they cannot resolve the issue, but we believe that the shift in that direction is now inexorable.

That it lacks its own large, attractive, low-carbon energy source restricts the EU going forward. 60% of its energy comes from abroad. Even if the bloc manages to substitute away from Russia, this issue stands. Right now, a large portion of the EU’s oil imports come from countries with poor human rights records (Nigeria, Algeria, Kazakhstan), countries with internal conflicts (Iraq and Libya), and participants in recent inter-state wars (Saudi Arabia and Azerbaijan). Clearly, simply shifting to other geographies is not the answer.

Looking westward, too, is not ideal. The US is a long-standing ally of Europe, but current polling suggests that in two years, European leaders could face a White House occupied by former President Donald Trump or a Trump-like figure such as Florida Governor Ron DeSantis. With that, again, the EU’s capacity to pursue its own path may be inhibited.

Renewables are no silver bullet, though. Europe added 17GW of wind capacity and 26GW of solar in 2021, the highest rates ever (Chart 4). It could add as much as 52GW combined this year, but even this record amount would fall seriously short of EU renewable aims and hardly offset Russian energy dependence.

Wind farms run at 20-50% efficiency (lower onshore, higher offshore), while solar panels run 10-20% (based on sunlight hours, cloudiness, and sun angle). This means that the 52GW of new capacity in 2022 would offset somewhere around 70,000-150,000 GWh of gas and coal, a small portion of the over 2mn GWh Russian gas and coal imports account for.

In short, if, as it claims, the EU develops through crises, the momentum behind the green shift needs to build. Foundations are taking shape. Already, the issue has shifted from one backed by green/liberal parties to one founded on geopolitical pragmatism. Russian President Vladimir Putin has united Europe in a way even climate change could not.

Long European Renewables

LNG routes and the reopening of coal present near-term investment opportunities. But longer term, these are less sustainable (both politically and environmentally). Expensive energy and the new political desire provide strong momentum to increase renewables spending.

Wind looks attractive given its higher efficiency and the amenable conditions that Northern Europe’s temperate climate presents (where the fiscal firepower is). The markets do not, however, seem to be pricing this in. Industry estimates predict an additional 23GW of wind energy being added per year out to 2026, with a 9GW upside if the EU is to meet its 2030 renewables target. Even its lower figure for 2022 would constitute a 30% rise from 2021.

By contrast, the market currently expects top-line revenue growth for Europe’s largest wind turbine constructors to be roughly flat into 2023 from 2021 levels (Chart 5). We expect top-line growth will be able to beat market expectations over the next two years on this basis.

Capacity constraints in production and the rising price of turbine costs will provide a headwind to feed through into the bottom line. Rising input costs are a worry ahead, but we believe this is largely priced in. Taking our own composite measure of wind turbine input prices (based on weighted steel, copper, aluminium and resin price), we see that while this has correlated with gross-margin suppression, input prices are less deleterious than in 2021 (Chart 6).

Even assuming the sector’s gross margin stays suppressed at 15%, the growth in the top-line from the increased installation demand should overcome this. We pencil in a 20% rise in wind company revenues across the next two years. We see this as conservative given it undershoots expected installation rates, there is sizeable upside from an acceleration of EU renewables spending, and elevated electricity prices should support turbine selling price.

We find the market has substantially underpriced the potential upside in bottom lines (Chart 7). Based on our expectations, we find forward-looking clean sector PEs are average to low versus the rest of the market (Chart 8).

On this basis, we recommend overweighting European clean energies companies versus broader European stock, with the expectation that the next two years should see considerable top-line growth. Investors can do this through clean energy ETFs, as we detail below.

Clean Energy ETFs

Within this analysis, we have considered an aggregate of European firms embedded into the wind energy supply chain (Siemens Gamesa Renewable Energy SA, Vestas Wind Systems AS, Ørsted AS, EDP Renováveis SA). While we focus on wind, these company valuations have moved roughly in line with broader European clean energy ETFs and, to an extent, global clean energy ETFs.

To trade this view via ETFs, First Trust Global Wind (FAN) and iShares Global Clean Energy (INRG) may be appropriate choices given their relatively high exposure to European renewables companies (Figure 9).

US Renewables Are Less Attractive

Meanwhile, the example US-focused ETF (First Trust Nasdaq Clean) in Figure 9 has already seen strong outperformance since the invasion. As we have recently written, a lack of US government commitment to green energy has caused us to switch from ‘overweight’ to ‘market weight’ in US clean energy. 

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.