Cleantech’s Unsung Heroes

January 24, 2010

Some clean techsectors are overhyped, while others have unrecognized potential

by David L. Levy

dollar sectorsWhen most people think about clean energy, solar and wind are the first things that spring to mind. Markets for these renewable energy sources have exhibited rapid growth of about 25-30% annually, and these sectors have attracted the lion’s share of venture capital funding and investor interest. They also tend to dominate the various Exchange Traded Funds (ETFs) that track clean energy. Yet the clean energy economy extends far beyond renewable energy technologies, including everything from power controls and storage, carbon software and trading, and energy efficiency. In transportation, while auto companies chase expensive dreams of electric cars, more economically viable opportunities lie in mass transit, bicycles, and innovative car rental services such as Zipcar. Clean energy is also generating a vast range of engineering, professional, and financial services. The transition to a clean energy economy will therefore change the employment landscape (see Green Jobs Booming and Training the “Green and White” Collar Workforce). At the same time, it’s creating new investment opportunities to rival electronics and biotech. The best investment opportunities are the unsung heroes that lie in the more cloistered parts of the evolving cleantech economy.

There are two core principles involved in understanding which green sectors have the most potential and which are overhyped. The first is that successful investing requires better insights than the average market investor. Share prices for many cleantech companies already reflect the expectation of rapid growth – companies (or sectors) have to outperform these expectations to generate significant returns. Second, the market is not rational – the efficient market thesis does not hold. This means that share prices do not accurately reflect all the information out there. To complicate matters, these two principles are somewhat contradictory: What is the point of better knowledge, if the market is arbitrary?

Well, the market is not completely arbitrary – to some degree, it’s Predictably Irrational, to use the title of Dan Ariely’s book. Investors exhibit herd behavior, leading to macro market distortions – share prices (and P/E ratios) can expand in frothy bubbles or become mired in gloom, with prices detached from underlying profits and cash flows. There are similar distortions at the sector and individual company level. When a new sector is fashionable, investors pile in, the media provides glossy rationalizations, and even policymakers can jump to support the ‘next big thing’. Many investors don’t care about underlying value and try to ride these waves of momentum, but this market-timing strategy requires nerves of steel and considerable luck.

Eventually, reality catches up and capital move on. Interest in fuel cell powered vehicles, for example, has collapsed while biofuels are on the wane. But distinguishing ‘reality’ from conventional wisdom is a considerable challenge, even within the expert community. Ford and GM’s disastrous experiments with electric vehicles in the 1980s and 1990s created a firm belief in the US auto industry there was no future for electric vehicles of any kind, even hybrids. The institutionalization of this view led US car manufacturers to scoff at the prospect of Toyota and Honda introducing hybrids (HEVs) in the late 1990s, and now the hobbled US companies trail far behind (see my 2002 paper on the auto industry and climate change). Similarly, the failure of concentrating solar thermal pioneer Luz in 1991 put the sector in the freezer for over a decade. For HEVs,  the technologies were premature for commercialization, but CST suffered from capricious public policy and the association with low-tech solar hot water (hard to patent the technology) in comparison with high-tech solar PV.   

Tom Konrad, of fame, recently presented a model clean energy investment portfolio that tries to identify undervalued sectors with the best prospects. It is notable for the absence of solar, and the dominance of efficiency, transportation, and electric grid.

Konrad portfolio 2010

In fact, the portfolio substantially diverges from the current market cap of various clean tech sectors given in a BofA Merrill Lynch Global Research report. Solar and wind dominate the pie chart, with each having about one-third of the total market cap. Popular clean energy ETFs are similarly overweighted  in solar and wind.

Konrad market cap by sector Nov2009

Konrad assesses each sector in terms of several criteria:
1. How big a role will this sector play in our energy future?
2. How large is the market cap of current firms in the sector?
3. Is the industry likely to be disrupted by new entrants and technologies?
4. Are there underlying enabling technologies that will benefit from the sector’s growth, or constraints that will hold it back?

By these criteria, wind and solar PV are poor investments because although they can play major roles in our clean energy future, they already have large market caps – the growth expectations are already “baked in”. Wind at larger scale is constrained by the lack (and cost and planning issues) of long distance transmission. Even worse for solar PV, the sector is at risk from technological disruption and new entrants, particularly from concentrating solar thermal (CST) or new variants of solar PV.

Konrad identifies transmission, smart grid, and storage as the key enabling technologies for the clean energy infrastructure, which have been somewhat overlooked but now seem ready to catch a wave of investor attention. Despite the recent success of lithium ion battery producer A123’s IPO, Konrad is pessimistic about plug-in vehicles due to their cost and inherent limitations of the technology, leaving automotive batteries highly vulnerable to disruptive innovation (also see John Petersen on this).

Konrad’s basic approach is very sound, especially for those who prefer a sectoral approach to the risks of individual stocks. It provides a useful framework for discussing particular technologies. For example, I would favor CST as a sub-sector because of its prospects to scale up at reasonable cost, the lower technological risk compared with PV, and the prospects for integrating thermal storage (also see this on SolarReserve). The offshore wind sector could also benefit from the $125 billion plan to build up to 25 GW of capacity, for which initial contracts were announced in early January.

I’m less sanguine than Konrad about the prospects for mass transit and high-speed rail, at least in the US, as it requires a level of governmental investment and coordination that seems unlikely in the current financial and political context. I fully concur regarding the outlook for efficiency. A McKinsey report points to the economic attractiveness of efficiency investments and a vast market potential of over $500 billion in the US over the next decade. Pike Research recently issued a report supporting a positive outlook, projecting that the Energy Service Company (ESCO) business in the US would increase from $5.6 billion in 2009 to nearly $20 billion by 2020. Utility demand side management programs are a major stimulus for this growth. The Pike Research report also noted opportunities at the intersection of energy efficiency and information/communications technology.

Although this is not the place for a discussion of particular stocks and mutual funds, it’s worth noting that investing in efficiency tends to be tougher than other sectors, because there are few public pure-play companies or dedicated ETFs. On the one hand, there are many small privately held companies, and on the other, some very large industrial companies for whom energy control systems and services are a relatively minor part of their business, such as Honeywell International and Siemens. The situation is similar with clean energy related professional services and software. Pike Research estimates that the market for carbon software management and services was a modest $380 million global market in 2009, but is poised for growth of more than 40% a year. This neglected part of the clean energy market has a few small players, but is increasingly dominated by the large accounting, management consulting, and enterprise software companies.

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