Baron Funds Q2 Insight - Investing in Renewable Energy

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Jul 09, 2015

By James Stone, VP, Portfolio Manager, Baron Energy and Resources Fund; Rebecca Ellin, VP, Research Analyst

One of the keys to Baron's approach to investing in energy is to seek growth companies and growth opportunities brought about by changes in technology, trade flows, infrastructure investment, and capital intensity. This approach first led us to opportunities driven by technological advancements that helped to unlock new reserves and production from unconventional (mostly shale) resources in the U.S., and the concomitant demand for infrastructure to process, store, and transport products to markets from these new geographies.

In the past 18 months, our focus on growth has led us in a new direction within the energy industry: renewable energy, and in particular, solar energy. As with unconventional resources, we believe renewable energy is one of the most significant growth opportunities in energy today. Two major trends are driving the adoption of solar: (1) technological and other improvements that are making solar an increasingly cost-competitive source of electricity in many countries (grid parity); and (2) increasing consumer and geopolitical desire to reduce pollution, which encourages the use of renewables. The emergence of innovative financing models known as “yieldcos” is acting as an additional catalyst for the conversion to renewables by significantly reducing the cost of capital and enabling companies to raise more capital at these lower, also more attractive rates.

A decade ago, the solar industry was in a nascent stage, largely dependent on government subsidies to stay in business. Most companies that went public were commodity-type manufacturing businesses, focusing on price competition to sell relatively undifferentiated products or services, or engaged in a technology arms race with few clear winners. It was a challenge to find investment opportunities that met the Baron criteria: significant competitive advantage, strong long-term growth potential, experienced management, and attractive valuation. Recent transformative developments in the solar energy industry, however, are producing what we believe are excellent investment opportunities and we fully expect more to come.

Grid Parity Is Here

In the past few years, the cost of solar panels has plummeted, driven down by technological advances in photovoltaic (PV) cells and an explosion in solar panel manufacturing in China. The average solar panel now costs about 75% less than it did just five years ago, and the price continues to fall. The newest method for producing the PV polysilicon used in making panels takes a tenth of the energy than that of previous techniques. This shortens the manufacturing time, allowing faster and cheaper production of solar panels. In addition, the energy conversion efficiency of both PV and thin film technologies has increased significantly, further driving down the cost/watt for all forms of solar energy. In the past three years, the cost of installing utility-scale solar has fallen 57% in the U.S. and costs for residential solar has seen a similar decline in cost.

As the use of solar grows, solar businesses are also starting to enjoy the benefits of economies of scale. As solar companies add customers, costs associated with functions such as sales, marketing, regulatory and compliance do not increase commensurately. We believe customer acquisition costs will continue to decline significantly as customer awareness increases, soft costs come down, and more supportive policies are put in place. This creates a virtuous circle of lower costs driving greater demand.

The steep decline in cost means that solar energy in now at levels of grid parity in many regions across the globe, especially in emerging markets, where electricity costs tend already to be high. At least 30 countries are currently at grid parity on an unsubsidized basis, including Australia, Brazil, China, France, Germany, India, and Spain, according to Deutsche Bank Market Research. In the U.S., more than 14 states are currently at grid parity, and by 2016, that number is expected to climb to close to 47 states, according to the same research.

Growing Commitment to Renewables

While solar currently accounts for only 1.2% of electricity generation worldwide, the percentage is growing rapidly and is expected to accelerate. In 2014, investments in solar powered electricity projects rose 25% to $149.6 billion, representing a record high share of total energy investments. According to Bloomberg New Energy Finance, investments in electricity generating assets over the next 25 years may total about $12 trillion, of which renewable energy should account for $8 trillion, and solar for as much as $3.7 trillion of the total. This compares to only about $1.2 to $1.3 trillion for coal and nuclear, respectively. A key driver of the growth in solar continues to be the declining cost and increasing efficiency of the technology, as well as emerging technologies for energy storage that will further enhance the competitiveness of solar and other renewables in the electricity markets. It should also be noted that the growth opportunity in renewables should be largely divorced from the oil price outlook, as oil is scarcely used around the globe to generate electricity. Furthermore, over time, we anticipate that natural gas prices will continue to decouple from oil prices around the world as natural gas remains an important fuel source for power generation.

Across the globe, the appeal of renewables is building among governments and consumers, both at the residential and commercial levels. China, whose capital city, Beijing, has become notorious for its smog levels, has a target to install 100 gigawatts (GWs) of solar by 2020. India plans to install 100 GWs of solar by 2022. The European Union plans to increase renewables to 20% by 2020. To put this in perspective, the total solar installed base worldwide was only about 250 GW at the end of 2014.

In the U.S., 29 states and the District of Columbia have enacted regulatory programs known as Renewable Portfolio Standards (RPS) mandating that electric utilities produce or purchase certain levels of power from renewable sources. The legislation typically sets a renewable energy target between 10% and 30% of total energy capacity by a specific date. Nine other states have non-binding goals supporting renewable energy. California has the most aggressive RPS program, calling for one-third of electricity to be generated by renewables by 2020. Earlier this year, the California governor proposed expanding that goal to 50% by 2030.

Large corporations are also increasingly turning to renewable energy to power their operations. According to a survey conducted by Ceres in late 2012, 60% of Fortune 100 companies and more than two-thirds of the Fortune Global 100 have set a renewable energy commitment, a greenhouse gas (GHG) emissions reduction commitment, or both.

For many companies, electricity is one of the largest operating expenses, and renewables can help significantly reduce long-term operating costs. In addition, the use of renewables can help companies achieve GHG emissions reduction goals, demonstrate leadership on corporate responsibility, and hedge against volatility in conventional fuel markets.

Early adopters such as Intel Corporation (INTC, Financial), Nokia Oyj, and Keurig Green Mountain, Inc. already source 100% of their electricity from renewables. Other companies are moving in that direction. A number of major retailers with large flat rooftops ideal for solar, including Wal-Mart Stores, Inc. (WMT, Financial), IKEA, Kohl’s Corporation, Macy’s, Inc., and Walgreen Co., are installing rooftop solar. Across other sectors, corporations ranging from Campbell Soup Company, General Motors Company, and The Procter & Gamble Company to Cisco Systems, Inc. and Verizon Communications, Inc., are converting to renewable energy to power all or large parts of their businesses.

With governments, corporations and individual consumers increasingly turning to renewables to meet their electricity needs, we think the markets may underestimate the projected impact of the solar revolution on the utility industry. Many commentators seem unduly focused on the disruptive effects of solar and overlook the opportunities that large solar projects bring to the utility value chain. Contrary to popular belief, solar is not primarily a residential phenomenon. In 2012-13, 80% of solar installations were utility-or large-scale projects. While the prospects for small scale distributed solar generation look favorable, we are equally, if not more, enthusiastic regarding the outlook for commercial and utility-scale solar markets.

We believe solar demand is set to grow strongly in the U.S. and emerging markets as a result of ongoing solar electricity cost reduction and supportive government policies. As noted, Bloomberg New Energy Finance and other experts are forecasting that renewable energy and in particular solar projects will garner the lion share of new investment in electricity generation with strong growth in all three end markets – utility scale, commercial & industrial, and residential. In the next 25 years global power-generating capacity is set to transform, shifting from two-thirds fossil fuel-based to 56% zero carbon-emissions. Many existing nuclear plants are nearing retirement age. Solar projects are far quicker, cheaper, and less problematic from a political and regulatory perspective to construct. Similarly, many coal plants are being retired for age, efficiency and environmental reasons. Solar’s comparatively clean environmental profile is especially compelling in emerging markets like China and India, where air quality has become a significant quality of life concern. In fact, in markets heavily dependent on coal for electricity generation, the ratio of coal-based wholesale electricity to solar electricity has already dropped from 7:1 four years ago to less than 2:1 today, according to Deutsche Bank Market Research. That ratio could likely approach 1:1 with the next year, according to the same report.

Global Gross Annual Capacity Additions by Technology, 2013-30 (GW)

Investing in Renewables

Our first meaningful foray into investing in renewable energy was SunEdison, Inc. (SUNE, Financial). Formerly known as MEMC Electronics, a semiconductor manufacturing company, SunEdison has transformed itself into a renewable energy project developer with a global sales and installation capability. SunEdison is now the world's largest renewable energy development company, and it has a large inventory of existing generating assets and future development projects. In 2014, it expanded beyond solar into owning and operating wind assets as well, further expanding its total addressable market.

In 2014, SunEdison also created TerraForm Power, Inc. (TERP, Financial) to own and operate renewable power generating and transmission assets, principally solar, with long-term power purchasing power agreements that are expected to deliver stable cash flows to be paid out to investors as dividends. TerraForm is a yieldco, an innovative financing structure that operates as the renewable energy equivalent of the master limited partnerships (MLPs) used by conventional energy companies. Yieldcos are growth-oriented public companies created by a parent company that bundle long-term contracted operating assets to generate predictable cash flows. The recurring dividends that result are similar to bond payments but like MLPs, yieldcos are traded like a stock.

Corporate Structure of a Yieldco

The structure of yieldcos has been around for a long time but was first applied to renewable energy only in 2013, when the energy giant NRG Energy created a yieldco that included renewable energy assets. In less than two years, 13 more yieldcos have launched. Developers of renewable energy projects have found that yieldcos are their least expensive cost of capital. Like MLPs and real estate investment trusts (REITs), developers structure yieldcos to maximize tax loss carryforwards and use depreciation to minimize the tax bill at the corporate level and avoid double taxation, in order to maximize returns for investors. Yieldcos also allow developers to separate the risk profile of different aspects of their business, providing investors with an attractive pure play opportunity to invest in de-risked renewable power generation cash flows.

As growth investors, we take positions in yieldcos that we expect to increase in valuation. However, the 3-6% dividend payment on yieldcos is also attractive, especially to fixed income investors in search of yield. Many yieldcos plan on growing their dividend by more than 15% over the next 3-10 years. Yieldcos also provide investors with geographic and customer diversification by bundling projects from different regions of the U.S. and the world, with different end markets.

SunEdison plans to retain a substantial portion of its developed solar projects and drop them into TerraForm, rather than sell the projects to third parties as it did previously. This change will more than triple SunEdison’s retained value for each project due to the substantially lower cost of capital of TerraForm and SunEdison’s ability to capture the residual value of each project. We think this change will enable SunEdison to create substantial value for shareholders, as well as increase its participation in the rapidly growing market for solar power.

SunEdison has announced its plans to form another yieldco called TerraForm Global, Inc., to be focused on renewable power plants in emerging markets. The company is purchasing wind, solar, and hydro assets in developing nations to drop down into the new yieldco. Baron participated in a private placement deal by TerraForm Global ahead of its IPO. Given the virtually open-ended opportunity in countries and regions such as China, India, the Middle East, and South America, we believe others will soon follow SunEdison’s move into emerging market-focused yieldcos. We expect to see more yieldcos forming overall as each successful yieldco IPO and increase in share price creates confidence in the strategy among other developers.

We have also invested in Abengoa Yield plc (ABY, Financial), a yieldco created by the Spanish multinational Abengoa, S.A. focused on renewable electricity generation and transmission in North America. We expect most of the growth at Abengoa Yield to come from the acquisition of developed renewable electricity generating and transmission assets in the form of “dropdowns” from its parent company, or the acquisition of similar projects from third party developers.

Conclusion

We believe that renewable energy, and in particular solar energy, is one of the most significant growth opportunities within the energy industry today. Declining costs have shrunk the economic gap between solar and conventional sources of energy, and solar energy is now at levels of grid parity in many regions in the U.S. and across the globe. We expect the economics of solar to continue to improve as a result of a continued decline in the costs of solar panels, balance of system (all PV system components except panels), and financing. In addition to lowering the cost of capital, the innovative financing structure of the yieldco has served to de-risk renewable assets and increase the appeal of pure play renewable opportunities for investors. While the percentage of energy from renewables is still relatively small, we believe the growth rate over the next several years and likely beyond could be quite meaningful. Therefore, we have increased our commitment to this segment of the energy industry in the past 18 months and our investments in renewable energy represent around 10% of the Baron Energy and Resources portfolio. We continue to look for additional investment opportunities in this sector.

You should consider the investment objectives, risks, charges, and expenses of the Funds carefully before investing. The prospectus and summary prospectus contain this and other information about the Funds and can be obtained from the Funds’ distributor, Baron Capital, Inc., by calling 1-800-99BARON or visiting www.BaronFunds.com. Please read them carefully before investing.

The discussion of market trends and companies throughout this report are not intended as advice to any person regarding the advisability of investing in any particular security. Some of our comments are based on current management expectations and are considered “forward-looking statements.” Actual future results, however, may prove to be different from our expectations. Our views are a reflection of our best judgment at the time of the publication of this report and are subject to change any time based on market and other conditions, and we have no obligation to update them. Investing in the stock market is always risky. Baron may not achieve its objective. Portfolio holdings may change over time.

Portfolio holdings as a percentage of net assets as of June 30, 2015 for securities mentioned are as follows: SunEdison, Inc. – Baron Opportunity Fund (2.5%), Baron Fifth Avenue Growth Fund (2.0%), Baron Energy and Resources Fund (3.5%), Baron Global Advantage Fund (5.6%); TerraForm Power, Inc. – Baron Asset Fund (1.3%), Baron Opportunity Fund (1.4%), Baron Focused Growth Fund (2.0%), Baron Energy and Resources Fund (1.9%), Baron Global Advantage Fund (2.8%); TerraForm Global, Inc. – Baron Opportunity Fund (1.1%), Baron Fifth Avenue Growth Fund (1.9%), Baron International Growth Fund (1.1%), Baron Emerging Markets Fund (1.0%), Baron Energy and Resources Fund (3.0%), Baron Global Advantage Fund (4.1%); Abengoa Yield plc – Baron Small Cap Fund (0.2%), Baron Energy and Resources Fund (1.4%). Portfolio holdings may change over time.