European Energy Policy and the Future of Renewables in the EU

Since the nuclear disaster of Fukoshima, the European energy sector has been under significant political pressure to shift energy production from nuclear to renewables. Germany was the first large EU economy to dictate the closure of its nuclear plants progressively for the year 2022. This decision will heavily impact the economy in terms of costs that will ultimately transfer to society. In fact, energy analysts expect that the cost of the measure will burden the economy with 40 billion Euros and 45 million tons of additional CO2 emissions. Nonetheless, politicians across the EU hope that the development of renewable energy sources –like solar and wind- will complement the energy mix in a sufficient way as to comply with the growing energy demand.

Since the last decades and as a direct consequence of the signing of the Kyoto protocol, Europe has become one of the regions with the lowest CO2 emissions. Approximately 30% of the world’s CO2 emissions come from the EU, however EU countries assume almost 80% of the cost of the world’s CO2 emission reduction policies. While in the EU the cost of each ton of CO2 produced is approximately 17 Euros, the rest of the world does not pay a single euro for it. In stead, countries like China and India are growing at astonishing rates and are relaying on CO2-emmiting mineral sources of fuel for energy.

As a consequence of the expected future of nuclear energy in the EU, a substitution effect can be observed nowadays in the market. Investors have started to shift resources towards alternatives sources of energy like solar, wind and even gas. However, the energy outlook of the EU and the expectations of a new –green and safe- energy mix, does not ameliorate the problems of overcapacity and decreasing margins that solar and wind energy producers have been experiencing lately. The reason of the decreased profitability comes from one major factor: government policies that once assured a “prime” price for KWh of electricity produced are now expected to be progressively reversed as a consequence of downstream saturation. Lets take solar energy as an example. Even if the differences in the governmental policies are significant (feed-in-tariffs of 110 Euros/MWh in Germany vs. 290 Euro/MWh in Spain), the solar energy producers are having trouble even with the decreased costs of their main raw material (poly-silicon) and the improvements in solar cell technology. In fact, the estimated average return in terms of IRR of new solar energy farms is barely above 10%. But how is it possible that with decreasing raw material costs, new technologies allowing higher efficiencies and significant government subsidies still in place, the ROI of solar energy producers is significantly declining? The answer is wide but has its root in the initial motivation for capacity installation … easy money!

Guaranteed cash flows over a long periods of time (average 20 years) trough government feed-in-tariffs for electricity combined with large growth opportunities, have derived in overcrowding of downstream energy producers in the market. Furthermore, upstream manufacturers (solar cell manufacturers) have also “smelled the cash” and have integrated downstream production to their business, exacerbating the problem even further. The promise of guaranteed cash flows at premium price also provided the wrong signal to energy producers that have developed their projects at astonishing debt-to-equity levels averaging 80%. In fact, overcrowding of solar energy producers in the EU is not expected to disappear in the short run. As long as the barriers to entry are low and the expected revenues artificially high, new companies will keep on entering the market. However, optimal financial planning and cost reduction is the less important aspect of solar producers trying to obtain the 20-year long, guaranteed premium price-per-KWh incentive provided by many EU governments. Nonetheless, if these companies had different motivations and would develop their projects under strict methodologies aimed at decreasing costs and increasing profits, there would be a better outlook in terms of cost-per-KWh for the consumer.

Solar and other sources of clean energy could become more profitable in the near future and an important part of the EU energy mix even without large government incentives. The so-called “grid-parity” -the point where alternative sources of energy can compete with traditional sources in terms of costs- is far from been reached if the excess capacity persists and the technologies and cost efficiencies are not effectively transferred to the consumer. Furthermore, if the governmental subsidies are not effectively utilized, the persistent of pervasive signaling will be present in the industry providing further incentives for highly indebt projects and lower cost efficiencies. The misuse of government incentives and unsound financial discipline of private holdings has resulted in higher costs for the EU consumer that will ultimately pay the price for the European energy revolution. It is expected that in the following years, EU citizens will pay some of the highest electricity prices in the world.

Electricity Storage: the holy grail of the renewables industry

It seems that despite the new Smart Grids (a new type of grid that leverages on communication technology, allowing to save energy by better managing supply and demand) without a cheap and efficient mechanism to store energy, the role of renewables as a major component of the world's energy mix is still far from reality.

The intermittence of renewable energy sources (like wind and solar) is still a major factor that calls for a technological breakthrough that would allow to store energy in times of low demand and advance towards the replacement of fossil fuel energy generation.

Check out this article on FT.com here

Esther Duflo - Ending Povery

Esther Duflo, MIT economist and co-founder of the Poverty Action Lab, asks why the worlds poorest people tend to stay poor. Duflos pioneering research applies randomized trials, used extensively in drug discovery research, to development economics. What she discovers are strategies for transforming current approaches to development policy.

Source: Youtube

Which countries have had most, and least, GDP growth per person since 2001?

In a technology driven world, natural resources rich countries seem to have the best conditions for economic growth. The chart below makes me think about the accuracy of the capital accumulation model of growth (Solow Model) and it's relevance today.

Equatorial Guinea -a country that has largely exploited its oil reserves in the last decade- seem to have the highest GDP per capita growth. On the other hand, largely devastated countries with a social conflict and lack of institutions like Zimbabwe and Haiti, have the lowest measure of GDP per capita.

Check out this interesting chart from The Economist:

Source: The Economist On-Line at: http://www.economist.com/blogs/dailychart/2011/06/gdp-growth?fsrc=scn/fb/wl/dc/haresandtortoises

An Elementary Overview on the Relationship Between FDI and Country Risk

Foreign direct investment (FDI) has received a vast research attention that focuses on both its determinants and consequences. In recent years, the debate among academics and policymakers has shifted from whether or not countries should attract FDI to how countries can attract and reap the full benefits that come with FDI. Since most developing countries have limited access to international capital markets and loans received by multilateral institutions are usually insufficient to cope with the capital requirements, FDI can become a significant source of financing. In this respect, FDI is considered to be less prone to financial crisis since –typically- direct investors have a long-term perspective when engaging in a host country. In addition to the risk-sharing properties of FDI, it is widely believed that FDI provides a stronger stimulus to economic growth in host countries than other types of capital inflows. Furthermore, FDI has significant spillover effects in the economy in the form of employment, managerial skills and technology that are particularly beneficial for developing countries. Nonetheless and despite the dramatic increase in FDI flows worldwide during the last decades, many developing countries have failed in their efforts to attract FDI.

Investment profitability is of prime importance in the decision making process of foreign investors. Investment decisions are based on the relationship between risks and expected returns, within a particular environment and in a determined period of time. In high-risk environments, the risk-adjusted rate of return on capital must be reasonably high in order to attract FDI. However, investors are more concerned about the volatility of returns on their international business transactions and take into consideration several factor associated directly with the country they are investing in. For the long-term investor that assumes larger investment duration in a foreign country, the underlying financial position cannot be liquidated rapidly, generating a greater exposure to the different risks that can potentially affect the expected future cash flows. In this sense, foreign investors are more interested in a holistic assessment of risk that encompasses all the different variables that can impact the stream of expected revenues.

Country risk is a wide concept that encompasses many risk-related aspects of an investment decision. There are different methodologies that include many different variables depending on the depth of the analysis. However, most assessments assign a particular weight to the country’s political and macroeconomic characteristics. Also, other aspects like, financial stability, operational risk, infrastructure development, legal framework, taxation burden, openness to trade and security issues play a significant role.

When investors assess political risks, usually they try to measure the establishment of a specific political system (like democracy and political stability for example). They look at the government’s leadership influence on society and at the division and performance of the different branches of the government (think about the separation of power between the executive, legislative and judicial branches). Also, the investor should be aware of how well the different opinions of the population are fairly represented trough opposition parties. This is particularly important in developing countries where political ideology usually divides the population into socio-political classes.

Economic risk is directly associated with the choice of economic model that is prevailing in the country. A free-market model that is highly compatible with the global markets is preferred by foreign investors, while a regulated and centralized model where the government intervenes in the economy is considered more risky (In fact, government intervention is taken as a barrier to entry to FDI). Fiscal policy is regarded as an indicator of the role of the government in the economy and as a thermometer of government efficiency. For example, budget deficit to GDP is an indicator that measures the capacity of the government to sustain its policies and manage the administration. Monetary policy on the other hand, it's the main instrument for price stability and policymakers are usually concerned about maintaining low levels of inflationary volatility. Investors prefer low volatility since it’s easier for them to forecast their future returns. The industry-structure of the economy in terms of diversification is also very important to evaluate the country’s capacity for absorbing effectively external shocks. For example, a country with a low industrial diversification is highly vulnerable to foreign shocks (like oil price increase) that could affect the cost structure of the sector and consequently reduce GDP. Also, the responsiveness of the internal market demand, household consumption and saving patterns, the velocity of the business cycles, the current account balance, the internal labor market structure and the levels external debt are also closely observed to assess the economic riskiness of the country.

On the other hand, the appropriate -and internationally compatible- legal framework that includes the necessary business legislation and protection of private property is necessary to attract FDI. Furthermore, the level of transparency and influence by third parties in the execution of the law is a major aspect of the legal risks measured by investors. Legislation should also be fair in terms of the established tax burden to foreign business activities and the tax collection system should be accountable to perform its duty effectively.

Operational risks include the existence of the appropriate physical infrastructure to foster business operations as well as the level of corruption and red tape that is present in order to operate in a particular sector. Lastly, investors are adverse to crime, insurgencies, terrorism, civil war or any other form of violence or security treat that may harm their business activities in the country.

As it can be seen in this brief overview of country risk, investors have an incrementally complex task when they try to make a long-run investment decision in a foreign country. The analysis should use different sources of reliable data and expert knowledge of the different aspects of the risk measurement. In fact, specialized risk agencies are taking the lead in providing the necessary reports and risk rankings for the different countries and sectors of business interest for investors. However, the unpredictability of many events shifts the risk burden back to the investor who will ultimately make an informed decision considering his expected returns under the presence of the various country risks. 


Sources:


R. Ribeiro (2002) "Country Risk Analysis" Minerva Program (Unpublished)


Goldman Sachs (2001) "Global Emerging Markets - Portfolio Strategies"