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German energy policy is making headlines, but the real news happened in 2007

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The expanding role played by renewables in meeting the growth in energy demand can provide investors with a powerful signal of the future valuations of incumbent utility companies, as testified by the fortunes of German power generators.

Germany’s energy policy is in the news again as the long-awaited recommendations of the Coal Commission have just been published.[1] The Commission was set up in June 2018 after the government was embarrassed by its admission that it would fail to meet its 2020 target for reducing greenhouse-gas (GHG) emissions. One of the major reasons for this failure is the continuing importance of coal for power generation. In 2017, coal accounted for 40% of Germany’s electricity generation, and 25% of its total GHG emissions, making coal-fired power generation the largest single source of Germany’s carbon pollution.

The Commission was therefore tasked with establishing the timeframe for phasing out coal in Germany’s power mix with a view to ensuring that it would meet its longer-term emissions targets and thus enable Germany to play its part in meeting the Paris Agreement target of restricting global warming “to well below 2°C above pre-industrial levels and pursuing efforts to limit the temperature increase to 1.5°C”.[2]

The Commission’s core recommendations are that 25% of Germany’s remaining coal-fired generation capacity (13GW out of 43GW) be removed from the grid in 2022, with a further 13GW going by 2030 and the remaining 17GW by 2038.

However, beyond the obvious interest that the Commission’s findings will have to those investors following Germany’s energy policy closely, there is a much broader lesson that all investors can learn from Germany’s energy transition towards a zero-carbon future. The lesson is simple, but powerful: whereas for policymakers, climate risk is all about system rates of change, for investors, climate risk is all about marginal rates of change.

Disruptive change

Climate change has already elicited a global policy response to promote renewable energies, thereby prompting a virtuous feedback loop that is driving down the cost of renewables and making them ever more competitive with fossil fuels. If the Paris Agreement’s temperature targets are to be met then policymakers will need to do all they can to accelerate the momentum of this feedback loop, and where necessary complement it with other measures (the announcement on 26/01/19 that Germany is set to phase out all its coal-fired power stations by 2038 is a good example of such complementary measures).

However, the crucial point for investors is that whether the necessary system change is achieved in time to meet the Paris Agreement’s temperature targets or not, the marginal changes we are now observing every year in the global energy market potentially put large swathes of equity value at risk over the next few years. This is because what matters for equity valuations is which energy sources dominate the growth in demand, not which sources dominate the overall level of demand.

The experience of the German utilities over the last decade bears this out. It is the marginal change in the composition of the German power market every year over the last decade rather than the annual system change in the composition of demand that explains why the German utilities E.ON and RWE have lost ~80% of their market capitalization since 2008.

In a mature market with a fast-growing, low-cost new entrant (renewables) the equity market will price in the decline of fossil-fuels far quicker than their market share will actually fall.

Understanding this difference will therefore be vital to managing the risks that the policy and technology response to climate change – or what is commonly now referred to as the energy transition – poses to portfolio returns to other energy sectors.

In particular, the oil & gas (O&G) and automotive sectors are increasingly exposed to the same kind of disruptive change that the German utilities have faced over the last decade.

German utilities’ experience shows investor risk is all about the marginal rate of change

Equities are priced on expected discounted cash-flows, and for energy companies expected future cash-flows depend on market expectations of future volumes sold and prices achieved. In the German power market up until 2008, the largest incumbent power generators, E.ON and RWE, had a diversified mix of conventional power plants consisting mainly of fossil-fuel (i.e. coal and gas) and nuclear capacity, but these incumbents were not investing in renewable energy at all over 2002-2008.

As shown in Exhibit 1, over 2002-2008 the German power market grew by roughly 10%, with total output rising from 503TWh to 553TWh over the period.[3] However, demand for conventional power generation (nuclear and fossil fuels) peaked in 2006 at 480TWh, and for both fossil-fuel fired generation generally and for coal in 2007 (at 315TWh and 250TWh respectively). Demand overall then peaked a year later at 553TWh.

Exhibit 1: German electricity production by fuel source, 2002-2018 (TWh)


Source: Fraunhofer Institute

This means that nearly all of the demand growth over 2002-08 has been captured by renewable energy sources. Indeed, and as can be seen in Figure 1, of the total 50TWh increase in demand over these six years, 47TWh was captured by renewables, and only 3TWh by conventional power sources. It also means that since 2008, as renewables have continued to grow relentlessly, the market share of conventional generation, including fossil fuels, has inexorably declined.

Moreover, the fact that renewables have short-run marginal cost (SRMC) of zero means that in addition to taking market share from the incumbents they also dramatically reduced the power price over the last decade (Exhibit 2). As a result, conventional generators have faced the double squeeze of lower volumes and lower prices.

Exhibit 2: German baseload power price, January 2008 – January 2019 (EUR/MWh)


Source: BNEF as of January 2019

But here is the crucial point: when demand for conventional generation peaked in 2006, renewables accounted for only 12% of total demand; when demand for fossil-fuel fired generation peaked in 2007, renewables accounted for only 15%, and when demand overall peaked in 2008 renewables accounted for only 16%

Exhibit 3: RWE share price, January 2008 – January 2019 (EUR/share)


Source: RWE as of January 2019

Indeed, even after the last 15 years of spectacular growth in renewables, conventional generation – nuclear and fossil-fuel based capacity combined – still accounts for the lion’s share of generation, with 325TWh of total output in 2018 (60% of the market) versus 219TWh for renewables (40%). This is precisely why the German Government is having to accelerate the phase-out of coal to help it achieve its longer-term emissions targets – the current rate of system change is simply not fast enough to meet those targets.

But that is of little consolation to the shareholders in RWE and E.ON over 2008-18, who have seen the value of their shares drop by nearly 80% over the last decade after peaking in January 2008 (Exhibits 3 and 4).

Exhibit 4: E.ON share price, January 2008 – January 2019 (EUR/share)


Source: E.ON

The moral of the story: keep a close eye on renewables’ share of global energy-demand growth

As we have seen, the equity market started to price in the end of conventional power generation in Germany as soon as it peaked 10 years ago, even though at that time it still accounted for over 80% of the market.

In the same way, it would be of little consolation to shareholders in the oil majors if the share of oil and gas in the global energy mix in 2030 were still above 50% but demand had peaked before that and prices had started falling owing to the continuing rapid growth of low-cost renewables.

On that note, it is worth contemplating that in 2017, while fossil fuels still accounted for 85% of total system demand and renewables for only 3.6%, renewables already accounted for 30% of the growth in energy demand (70mtoe out of 250mtoe of demand growth).[1] As soon as renewables account for 100% of the growth in energy demand, the demand for fossil fuels will have peaked.

The German utilities are a pointer as to what could happen after that.

This article appeared in The Intelligence Report – 30 January 2019

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[1] See BP Statistical Review of World Energy, June 2018

[1] The Coal Commission’s report was published on 26 January and is available here (in German only).

[2] This quote is from Article 2 of the Paris Agreement.

[3] All figures for the German power market are from the Fraunhofer Institute energy statistics database.

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