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Will Clean Power Plan Reversal Hit Alternative Energy Stocks?

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President Trump’s plans to shift focus to traditional energy businesses such as coal, oil and gas and his skepticism around global climate change have cast a shadow over the future of solar companies. In Mar 2017, Trump signed an order to repeal the Clean Power Plan. This move is expected to benefit companies relying on coal while solar stocks are likely to take a hit.

More recently, Trump walked out from the Paris climate agreement, compounding the woes of the clean energy industry. As a result, U.S.-based alternative energy companies are expected to be affected.

In fact, comparative analysis of the alternative energy industry’s historical Price/Earnings (P/E) ratio reflects a relatively gloomy picture that might be a cause for investor concern. The industry currently has a trailing 12 month P/E ratio of 42.76. This level seems unfavorable when compared with what the industry saw in the last 12 months. The ratio is much higher than the average level of 14.57 and is the highest over this period.

Moreover, the industry seems overvalued when compared with its broader industry Oil/Energy sector’s P/E ratio of 30.21 in the same time period.

While the long-term potential of the space is undeniable, the industry is faced with a number of near-term challenges that will likely keep these stocks under pressure. We discuss some of these below.

The Trump Effect: The present U.S. administration doesn’t have a friendly stance toward alternative energy sources. In June, President Trump announced his decision to withdraw from the Paris climate agreement. Trump’s walkout decision in his controversial speech clearly reflected his belief that climate change is a ‘Chinese hoax.’

Many fear that whatever progress the U.S. has made last year toward pollution mitigation and renewable assets expansion in accord with the Paris agreement will now be in vain. Under the accord, the U.S., along with other 159 nations, had pledged to cut its greenhouse gas emissions 26 – 28% below 2005 levels by 2025. In fact, the agreement was signed largely on account of a preliminary understanding between the U.S. and China – the two largest carbon-emitting nations.

In March, Trump signed an executive order to roll back the Clean Power Plan – Obama's signature climate policy to curb carbon emissions to 32% below 2005 levels by 2030 at coal-fired power plants. The Clean Power Plan had mandated emission reduction goals for the states in order to ensure that the Environmental Protection Agency’s overall target was achieved.

The annulment of the Clean Power Plan will lift the ban on coal leasing on federal lands, scrap regulations to curb methane emissions from oil and gas production, and lead to reconsideration of "social cost" of carbon emissions in all regulatory actions. The move will definitely hurt the clean energy space.

We will see how the policy landscape evolves, but the focus will likely be on incentivizing the coal and natural gas industries. Since 2014, as utilities closed a large number of aging coal-fired generators, wind and solar have been the two biggest sources of electricity in the U.S. The aforementioned policy changes will likely reverse this trend in the coming years.

China Factor: China’s solar industry is not immune to the ongoing slowdown in its economy. According to the Organization for Economic Co-operation and Development (OECD), China's economic growth is likely to slow down to 6.5% this year and further decline to 6.3% in 2018. Gross domestic product, or GDP, of the world’s second-largest economy grew 6.7% in 2016 — the weakest in the last 26 years. Considering these numbers, it is clear that the decelerating trend is likely to continue in the near term.

The country’s economic situation has sparked apprehensions that the government could shift asset resources away from investments in renewable energy in order to fuel its stock market. One of the most prominent effects of the economic slowdown in China has been relatively weak demand for electricity.

At the end of 2015, China had set a target of installing 150 GW of solar energy by 2020. But in 2016, the figure was cut by 20% to 110 GW. Though the Asia Europe Clean Energy Advisory (AECEA) raised optimism by stating that the figure could exceed the revised target, uncertainties continue to persist.

In fact, despite being the world’s largest solar market, China is expected to see a decline in solar installations to 17.5 GW in 2017, well below its expected number of more than 30 GW.

Again, China's solar industry faces challenges ranging from potential tariffs abroad to insufficient grid connections at home. The U.S. has been competing with China and India to become a market leader in an industry where production costs have plummeted, favoring producers of scale. In China, solar generation has been hindered by wastage or curtailment.

These factors might have led Yingli Green Energy Holding Co. Ltd.’s (YGE - Free Report) shares to plummet about 36.1% over the last year. Again, shares of JinkoSolar Holding Co., Ltd. (JKS - Free Report) tumbled 16.9% over the same period.

Fed Rate Hike:  On Mar 15, the Federal Open Market Committee raised the federal funds rate by 25 basis points to 1%. Fed lifted the key interest rate citing an improving labor market and greater confidence in consumers. Currently, one more rate hike is expected by the end of this year.

The federal funds rate is a benchmark interest rate that determines the rate for financial institutions to lend to each other. A rise in this rate translates to higher borrowing costs for banks that pass on these raised costs to consumers in the form of higher interest rates on loans, mortgages and other financial products. Since financing is an inherent requirement of the alternate energy sector, rising interest rates are a major growth deterrent for this space.

While companies in this space have been benefiting from a low interest rate environment so far, rate hike makes this industry far less appealing. This is because the resulting increase in cost of capital will increase cost of operations for the alternate energy companies, thereby reducing their profitability.

Subsidy Rollback: While the U.S. government provides the Investment Tax Credit and Production Tax Credit to support growth of alternate energy, several other large nations are planning to lower subsidies provided to renewable energy operators.

Per recent media reports, China’s National Development and Reform Commission has hinted at a cut in Feed-in Tariffs (FiT) from the present rates. Though the changes in tariffs have yet to be made official, the aim is to reduce FiTs by roughly 3-4% per year so that onshore wind might reach grid parity by 2020.

In Feb 2016, Japan’s Ministry of Economy, Trade and Industry (METI) proposed an 11% cut in solar FiT. Recently, Japan announced plans to cut FiT rates annually to reach the level of household electricity rates of 20.5 cents per kilowatt-hour (“KWh”) by 2019. The FiTs in 2017 will be 23.9 cents per KWh, then reduced to 22.2 cents per KWh in 2018 and finally will reach the target set for 2019.

Similarly, in Aug 2015, the UK government had hinted at an 87% reduction in support for domestic solar and an up to 82% cut in FiTs for commercial rooftops. Again, Germany is expected to cap subsidy payments after the generation capacity reaches a certain target.

Rolling back subsidies will lead to an increase in the cost of energy produced by renewable sources. This surely hurts the prospects of renewable energy across the globe.

Anti-Dumping Duties: The move from the U.S. Department of Commerce (“DOC”) to impose import duties on solar panels and other related products from China and Taiwan could escalate the U.S.-China trade conflict.

The decision addresses one of the main charges in a petition brought by SolarWorld Industries America, a German solar manufacturer with major operations in the U.S. A complaint lodged by SolarWorld brought to the fore a loophole that the Chinese solar product makers were exploiting to evade duties imposed by the Department of Justice in 2012.

The higher tariffs came at a time when the solar industry was on the whole recovering after a two-year supply glut.

The Commerce Department in Dec 2014 set anti-dumping duties at about 52% on most module imports from China and at 19.5% on most imports of Taiwanese cells. It has also slapped 39% anti-subsidy tariffs on most China-made panels.

New Emerging Technologies: The alternative energy industry remains an emerging sector with a steady focus on the lowest-cost technology. This may prove disastrous for existing companies riding the solar boom should a cheaper alternative emerge. The industry also has to deal with cost-competitiveness from traditional means of electricity generation.

Limitation of Quantity: It is difficult to generate large volumes of electricity from renewable sources compared with traditional fossil fuel generators. Solely depending on renewables would either require a reduction in consumption or ramping up of energy facilities. In order to tackle current energy problems, it is necessary to strike a balance between different power sources.

Renewable energy is largely dependent on weather. Hydro generators require rains to fill dams to supply flowing water. Wind turbines need strong winds to move the blades, and solar generators require clear skies and sunlight to gather heat and generate electricity. When these resources are absent, in the event of weather fluctuations, it hampers the amount of electricity generated. This problem can be solved with energy storage, which leads to additional costs.

High Costs:The current cost of renewable energy technology is also far more than traditional fossil fuel generation cost. This is because it is a new technology and hence has very large capital cost.

Conclusion

Globally, China leads the world in total electricity generation from renewable sources, helped by its increased allegiance in recent times to the alternative path. It is followed closely by the U.S., India, Brazil and Canada.

All leading solar cell manufacturers are looking for opportunities in the emerging markets. These markets primarily comprise the Asia-Pacific region with China, India and Japan being the key destination for the global solar giants. The long-term outlook on the whole looks bright. This is especially true as global warming and high fuel emission issues have proven how indispensable clean energy sources will be for the future.

However, the global economic turmoil, China's economic slowdown and the consequent subsidy rollback in the prime global solar markets are major headwinds for the renewable energy industry on the whole. Also, Trump’s focus on reviving the coal industry instead of encouraging alternate energy is a serious concern for all renewable energy companies.

Again, if we are to expand renewable manufacturing infrastructure worldwide to fight the climate crisis, the U.S. as well as the Chinese manufacturers should try to settle their dispute before the industry at large is damaged. Measures to reduce the inflow of Chinese solar panels may hamper the battle against climate change.

We remain apprehensive of Zacks Rank #4 (Sell) stocks like Azure Power Global Ltd. (AZRE - Free Report) . You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

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