Wind and solar power have a major role to play across the global economy in the drive to net zero, with figures from the International Energy Agency (IEA)1 suggesting onshore wind capacity will grow by up to 70% in 2023, rebounding from two years of decline during the Covid pandemic.
Better resource efficiency is a key investment theme for the Sustainable Investment team. Within our key themes we look at companies that exemplify different sub themes – in this case, increasing electricity generation from renewable sources.
This is the second article in the series, you can read the other articles here:
Structural growth from sustainable investment themes
To decarbonise our economy we need to replace fossil fuels, with a likely substantial shift towards electrification. This will be especially pronounced in personal travel (using electric vehicles instead of internal combustion engines) as well as in heating (and cooling) buildings by using heat pumps instead of natural gas and oil boilers. For this decarbonisation through electrification to work we need the electricity on the grid to be low carbon.
The disruption from renewables (wind and solar) displacing fossil fuels in electricity generation is well under way and we anticipate it to accelerate over the next decade and beyond. As these renewables have increased in volume, there have been significant reductions in costs. In the case of wind, unsubsidised costs have fallen by over 60% since 2009, making onshore wind the most cost-effective form of new electricity generation on the planet.2 Offshore wind is also more economic and takes less time to build than new nuclear. There are regulatory drivers to decarbonise and we anticipate that global regulations to decarbonise our economy will tighten globally over the next decade.
Vestas – Driving the wind revolution forward
When it comes to companies taking a key role in this area, we believe Danish wind turbine manufacturer and service provider Vestas Wind Systems (Vestas) stands out.
Wind power is a renewable and low carbon source of energy and the company contributes to reducing emissions from the electricity grid by providing cost competitive wind-derived electricity. It is one of the three main players outside of China in this sector.
Vestas estimates that over the life of the turbines it installed in 2022 around 408 million tonnes of CO2 (cardon dioxide equivalent – a measure of greenhouse gas emissions) emissions will be avoided. In comparison, the sum of emissions from the company in 2022 (including scope 1 direct emissions, scope 2 indirect emissions and scope 3 supply chain emissions) was 8.3m tCO2e.3 This means in 2022 the emissions from making their turbines was nearly 50 times less than the expected avoided emissions over the life of those turbines.
The biggest driver of renewable adoption now is economics: that it is so cheap. We see structural growth in demand for wind turbines and their maintenance over the next decade and beyond. While this will vary for individual companies depending on the countries they operate in, we conservatively expect wind demand to grow at more than a 5% compound annual growth rate (CAGR) over the next decade.
Management quality
We think Vestas is the best managed business in its industry. Its western competitor Siemens-Gamesa has suffered from management problems and churn following the merger of Spanish Gamesa and German Siemens, while GE Wind historically did not have the focus from management in the large GE conglomerate. We believe these competitors look to Vestas as the industry leader to beat.
Vestas has been leading the industry in simplifying the manufacturing process and improving supply chains as well as providing efficiencies from increased scale of wind turbines (bigger turbines are more efficient in terms of how much electricity they can generate as compared to smaller ones). As well as innovating in wind turbine manufacture, it has also been innovating in improving the lifecycle of wind turbines to reduce the environmental impacts such as through partnerships to work out how to reuse turbine blades at end of life.
Business fundamentals and profitability
There have been many challenges for turbine manufacturers and wind developers to overcome over the past decade. First, a move away from fixed subsidies to a competitive auction (where the cheapest bid for a wind project won) meant the cost of wind dropped dramatically but so too did the cost of turbines.
In its focus to become the cheapest form of electricity generation, the turbine industry appeared to have little if any pricing power and profit margins went through a period of deep compression in the period from a peak operating profit margin of 14% in 2016 to 3% in 2021. This was further compounded over the past two years following Russia’s invasion of Ukraine and the subsequent supply chain bottlenecks which resulted in super-inflation, especially in steel epoxy composites used in blades as well as logistics costs. As a result, the operating profit margin was in -8% 2023.
Wind developers need certainty on costs when they order a wind turbine and agree a fixed cost for a turbine to be manufactured, transported, installed and maintained. Unfortunately for the turbine manufacturers, there is a significant delay between placing of a firm order and delivering the turbine; on average 18-24 months.4 The past two years have seen all wind turbine manufacturers lose money on wind turbines they have been delivering as they had to absorb the super-inflation and deliver the turbines. The response from the turbine manufacturers is to increase the prices of wind turbines – for the first time in a decade − as the whole industry realised that manufacturers had to make some profit to share the returns in the industry. Vestas has increased average selling prices for its turbines by over a third in the past two years. We expect margins for turbine manufacturers to recover as they work through their unprofitable contracts and the higher prices start to materialise and show up in normalised adjusted operating profit margins of around 5-10% for Vestas in 2025/6.
There have been other issues to contend with such as warranty costs which have been higher than normal (Vestas warranty costs have been elevated at around 6% of sales versus the longer term average of 2-3%). More recently, the profit warning and large provision for warranty issues with blades in new onshore turbines from competitor Siemens Gamesa has raised serious concerns about reliability of some of the newest turbine models in the industry. And finally, (bad news often comes in threes), this same super inflation has affected the economics of newer offshore wind projects with some high-profile offshore projects being mothballed as the numbers don’t add up (due to inflation and the high cost of debt). Again, this is related to pricing, with some winning bids for offshore being too low to make an economic return. We expect pricing of new offshore wind projects to rise to reflect this new economic reality while still remaining competitive compared to other forms of new electricity generation.
So far, so…bad? The market is focused on these negative issues and shares in these businesses, including Vestas, have been volatile and sold off hard reflecting these concerns. While these risks are real and need to be managed, we believe the market’s focus almost entirely on these concerns is missing the compelling longer-term opportunity when this industry has worked through and solved these issues – which we believe it will and this will be led by Vestas.
Valuation
Our investment thesis is that Vestas delivers improving margins as pricing better reflects its costs over 2024/5. We see compelling earnings growth in excess of 12% CAGR and on 20x forward price-earnings ratio, we see ample upside (above our 10% annualised upside hurdle) on a five-year view.
This is a good example of our investment process leading us to take a patient approach as we monitored business fundamentals and valuation rather than simply rushing into an investment due to its great sustainability drivers. We bought into Vestas in July 2022 using a smaller position size to help reflect and manage the stock’s higher volatility. We believe that being patient will reward investors in this business over the medium term as Vestas delivers on its strategy and decarbonises our electricity system in the process.
KEY RISKS
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