Credit Crisis and Climate Change Investing

Credit Crisis and Climate Change Investing
(Abhishek Uppal, Clean Technology Private Equity 2009; Reference to DB Advisors Investing in Climate Change)

Credit crisis and funding
While the credit crisis has affected public equity market pricing in a dramatic way, the key underlying issue is the availability of credit.

Climate change investing includes the clean and renewable energy sectors such as solar and wind. Many companies in the solar and wind energy sectors face tough times obtaining the financing they need for projects now. Just as banks have been reluctant to lend to each other, they are also less likely to lend to renewable energy projects.

There is no doubt that in speaking to equity analysts, venture capitalists, and private equity investors that at the moment there is great concern about the financing options available to public and private companies. This is likely to continue until there is a global stabilization in the financial sector. As a result, some financially stretched projects and companies might not make it through this stage, or they will at least need re-pricing.

The long term support of demographic-driven demand, with regulatory support for clean energy, agriculture, and water, will mean that interest will remain strong in these sectors, and capital flow will become available early in any recovery.

What's been happening in climate change public equity markets during the credit crisis?
Over the past few months, climate change-related sectors have dropped in sympathy with general market conditions due to the credit crisis. September and continuing into October saw sharp corrections in many climate change sectors.

In terms of public equity markets, let us compare the climate change universe, as represented by the HSBC Climate Change Index, with the MSCI World Index since 2006. Following a strong 2006 to 2007 period, the index began tracking the general equity market's performance from its peak through early 2008. The climate change universe then suffered a more rapid fall as the credit crisis took its toll on anything related to housing or construction, energy prices dropped, and regulatory support such as the Investment Tax Credit (ITC) and Production Tax Credit (PTC) in the US wavered and Spain capped its solar building capacity.

Correlations with financial markets
Over the entire period of January 2006 through September 2008, the climate change universe (as measured by the HSBC Climate Change Index) showed moderate to strong correlation to the broad market, as well as energy and industrial stocks in general. Looking at the constituents, it is really only agriculture that has shown noticeably lower correlation to the MSCI World

The time period from Jan 2006 to November 2007 mostly saw a bull market in commodity and equity markets and a sharp rise in the climate change universe, as measured by the HSBC Climate Change Index. The outperformance by the climate change universe indicates that markets were responding to the broader economic demand of adapting to and mitigating climate change, generating excess returns. From November 2007 through May 2008, there was a correction and then a recovery for both climate change and equity markets in general, followed by a severe correction as the credit crisis really made its impact felt.

In relative terms, the climate change universe suffered a correction from May 2008 through September 2008. In terms of the drivers of these trends, it is useful to look at a correlation matrix on different time scales to determine which drivers had the most influence on stock prices in the climate change universe.

During the November 2007 to May 2008 period, the correlation with oil and commodities broke down, as the latter exploded in price and the influence of the credit crisis expanded and dragged on equity markets. From May onwards, the effect of the credit crisis was to re-establish the correlation of most of these factors. This response has the elements of a "liquidity squeeze" and a number of hedge funds that held renewable stocks liquidated early in September 2008. However, during the sell-off of the broader market, companies concentrated in sectors that are most affected by credit facilities and housing, such as industrials, construction, materials, and energy, have been hit the hardest.

The sector that is most likely to be influenced by energy and oil prices is the renewable energy sector. We would expect that prices for renewable energy stocks are positively correlated with oil as the oil price increases due to the corresponding improvement in the economic breakeven for renewable energies as traditional energy prices rise. However, as oil prices begin to drop, that correlation should breakdown as prices for renewables are buffered by the subsidies that support these companies. Any changes in the view on subsidies would of course affect this correlation.

Let us examine the correlation between oil prices and the market capitalization of the solar sector. Through the beginning of summer, 2008, the two are closely correlated. During this time period, the correlation is driven by the fact that as energy prices increase, the economic break even for renewables draws nearer. This drives the performance of renewable stocks upward. However, around the beginning of June 2008, concerns began to emerge in the solar sector that the Investment Tax Credit in the US might not be renewed and that there would be a step-down of feed-in-tariffs across Europe. The solar sector is heavily driven by subsidies, and the fear that subsidies could be eliminated meant the stocks did not have downside protection.

Overall, the credit crisis affected climate change equities through a number of parallel forces. First, the market experienced a general "liquidity squeeze," which increased the correlations between most asset classes and hurt industrial and construction related industries. Second, there were sector-specific uncertainties over some regulations. Third, there was the added headwind of a market focus on oil and energy price correlations as these commodities declined in value. Fourth, there was fear of the potential for credit markets to dry up and hinder project development in areas like wind and solar. These forces led in turn to a sharp correction in the climate change universe, particularly in September and going into October raising questions over valuations. In the long-term, climate change sectors should find support from government policies and the general economic impetus required to tackle climate change.

Valuations - Bursting some sector bubbles?
Prior to the credit crisis, there had been talk of whether "bubbles" existed in the climate change investment world. In the public equity markets, valuations as measured by the price to earnings ratio, P/E, are the obvious key measure of a bubble. At an overall level, P/E's, when aggregated across the universe, were not stretched dramatically and at no point approached the NASDAQ technology sector levels of 1999/2000.

Across the Climate Change Pool, the P/E ratios are clustered in the 5 to 15x range. This has shifted further to the left since the end of 2007, with the highest frequency now at 10-15x instead of 15-
20x. The pool of outliers at the 35x+ range also decreased substantially year-to-date in 2008.
On a price / earnings basis, the climate change sector does not appear to be overvalued. Relative to the MSCI World, the earnings multiples are not significantly higher across the sector. Interestingly, there are many stocks grouped in the 5-10x earnings range, representing potentially strong value in the small to mid cap range along the supply chain of the key sectors.

Wind and solar - Valuations were stretched
However, certain sectors of the climate change / renewable energy space did exhibit elevated valuations prior to the credit crisis correction.

The leading wind companies reached 25-35x forward earnings at the peak late last year. In the context of wind's historical performance, this is hardly a bubble, but they were certainly at the high end when confidence in the market was challenged. The recent correction has seen a drop to the 15-28x range.

The leading solar companies' multiples demonstrate much higher valuations in the 20-80x range at the end of 2007. First Solar, a thin film solar PV company (NasdaqGS: FSLR), reached highs of 248x monthly P/E during the time period. In this sense, there was more of a bubble mentality in the solar sector and the correction has been severe, with forward earnings multiples heading to the 10-20x range. The solar correction started in Q407, earlier than wind. Now, P/E's have begun to retreat to levels more in line with the larger market.

As of yet, there has not been a good test of falling oil prices when subsidies have indeed protected the renewable stocks on the downside. However, the US congress has passed the renewal of incentives (ITC/PTC), so any downside may be met by some resilience from renewables over the longer term.

Eventually stock prices will respond to their underlying earnings. At this moment, analysts and companies are reassessing the short-term outlook given the financing constraints. Assuming that more highly regulated markets have more secure earnings potential, the market-led downturn potentially creates a significant value opportunity across the wind and solar sectors for the medium and long term.

What's been happening in cleantech private markets?
The credit crisis will certainly affect the funds available to companies and projects in the venture capital private equity space. Some will be stressed through this current phase; some may need re-pricing. However, the good news is that the sector went into this crunch with strong capital flows and, if anything, more of a fear of bubbles, with market participants reporting strongly competitive demand for deals.

Venture capital and private equity investment in cleantech has soared over the past several years. Investor demand for access to emerging early-stage companies has been at an all time high, and press releases indicate that new funds have been entering the market across all stages of the capital investment spectrum. Indeed, given recent memories of similar circumstances in the tech boom, investors had been nervous about the possibility of a speculative bubble developing in the private markets.

However, a major difference between the recent influx of capital to cleantech sectors and previous investment booms is the asset heavy nature of the new cleantech companies. Clean energy companies require significant capital to finance the construction and operation of utility scale power plant installations or biofuel plants.

Let us compare clean tech and Information Technology (IT) in terms of the total venture capital investment flow to both streams. Even in the trough after the IT bubble, IT venture capital remains many times larger than current clean tech venture capital.

The relative size of the clean tech market to IT venture capital indicates that discussions of overwhelming amounts of capital flowing to this sector are heavily exaggerated. In light of the long term economic demand for the sector, the increasing flows of capital are warranted at the climate change investment level. Additionally, many VC / PE market participants report that the sector is still too young to adequately assess the impact of new capital flows and caution that the possibility of speculative bubbles is more appropriately assessed at the level of individual sectors within the larger theme of climate change investing.

New Energy Finance reported that in 2006 venture capital funds deployed only 73% of available capital. We expect the soon to be released totals for 2007 to show a similar level of deployed capital. That means that following the credit crisis, equity capital now has an opportunity to look for the very best investments as debt investors fund less over the coming months. However, as equity in effect replaces debt more during the crisis, projects will require higher returns. This means that only the highest quality projects are going to be able afford increased equity financing and move ahead.

Sector specifics: Wind, solar, and biofuels showing increased late-stage confidence from investors
While the overall clean tech private investment market has not shown signs of a consistent and wide spread bubble, the sub-sectors of the theme have from time to time seen large capital inflows chasing projects. All areas have shown increases in capital deployed over the past several years; however three sub-sectors stand out as having shown particularly differentiated levels of investment: wind, solar, and biofuels. Indeed, wind and solar have seen stretched valuations in the public markets over the past year.

Reviewing the breakdown of solar, wind, and biofuels venture capital and private equity investing from Q1 2007 through Q2 2008, all of the sectors show the beginnings of a shift from high early stage investing to an increased dominance by later stage investment and expansion capital, often coming largely from private equity investors. This shift towards investment in later stage rounds is encouraging for the stability of the longer term trend. Later stage investing, while still risky, represents a greater faith on the part of investors that an underlying technology is ready to begin the transition from early-stage development to commercialization. While there has been plenty of capital looking for a home, there have also been plenty of projects available, though not always at a moderate valuation.

Wind and solar specifically show large increases in the amount of private equity buy-out activity that has been taking place. Even more than expansion rounds, this type of investment is a sign that investors have been confident in the readiness of technology to be expanded, listed publicly, or shopped to strategic buyers. However, within late stage wind investing, some market participants state that the sector was getting stretched. Obviously the credit crisis supply implications mean that project success will now be more focused, and investors will be looking for higher returns to compensate for capital availability.