Sustainable investing

Europe’s path to future-proof power and the role of green bonds

October 17, 2024 - 9 min read

Written by Lucie Vannoye, CFA. Credit analyst, Mirova

In a nutshell

The average price for producing electricity is unlikely to climb any higher in the long term but will undoubtedly become more volatile. If governments want to make sure this volatility does not threaten the ramp-up of renewable energy, they must immediately create a market that offers power producers more visibility along with more robust grid and storage infrastructures.

The energy sector is not used to such high volatility and has found itself under the spotlight in recent months. The European sector’s credit spread returned to its Covid crisis levels in 2022 for a number of reasons: the risk of gas shortages triggered by the war in Ukraine, concerns that returns on renewable energy projects would be compromised by higher interest rates, and regulatory uncertainty exacerbated by political intervention. The spread then narrowed again and outperformed by a wide margin in the winter of 2023 before widening again in the summer of 2023 after US offshore projects first started getting pushed back.

Now, with the cycle of interest rate cuts having kicked off in Europe and gas reserves full, we are making the most of the respite to take a step back and review the sector.

Transition off to a successful start for the electricity sector

Companies operating in the electricity market were among the first to be disrupted by the energy transition, and the sector has made considerable progress over the past 10 years or so. In 2023, 44% of the electricity generated in the European Union was sourced from renewable energies, including hydropower, and the wind segment produced more electricity than the gas segment for the first time.¹ Nevertheless, the sector’s decarbonisation remains one of the centrepieces of a 2-degree scenario as it is responsible for about a quarter of the continent’s greenhouse gases.²

So it is essential for its decarbonisation process to ramp up. If the targets set out in the RepowerEU plan³ are to be met, renewables must account for a significantly higher portion of the electricity generated in the European Union by 2030. It seems all the more essential for the momentum to pick up speed as it will have to keep up with the increase in electricity demand, which may have fallen slightly in Europe since the start of the century but is expected to bounce back in the coming years. This has become a hot topic in the United States in recent months as the country is concerned about the amount of energy being consumed by its datacentres, the number of which is increasing as artificial intelligence permeates society – it is worth noting that a ChatGPT search is said to consume 10 times more electricity than a Google search.⁴ In Europe, on average, it is thought that growth in electricity demand (estimated at 30% between now and 2030) is going to be fuelled above all by increased adoption of electric vehicles and especially of heat pumps. Demand could grow by 60% to 85% between now and 2050.⁵

Investors first embraced the renewable energy segment some 15 years ago and, with crucial backing from governments, have managed to slash the cost of producing such energies: the present cost of utility-scale solar energy decreased 9-fold between 2010 and 2022, while that of onshore wind energy decreased 3-fold.⁶ These energies are therefore now able to compete economically with fossil fuels. The International Renewable Energy Agency took measurements that also factored in the loss of flexibility resulting from a high penetration of renewables in the energy mix of renewable energy in the energy mix; and despite a resulting decline in value, new capacity being built in Europe and the USA based on onshore solar and wind power is proving no more costly than their thermal equivalent. Is this not evidence that a sector’s transition can pay off rapidly after all? Besides, Orsted (BBB+)⁷ will this year no longer be the only European firm to have successfully converted all its oil production operations to renewables as Italy’s ERG (BBB-)⁸ became a solar and wind pure player. Does this mean that the sector is now able to get by without government support? We do not think so.

Will our liberalised electricity market survive the growing share of renewables in the energy mix?

Companies in Europe’s electricity sector are increasingly reluctant to maintain their merchant exposure⁹ in the power generation segment; this is because prices are increasingly volatile now that renewables are accounting for an ever growing share of the energy mix. These companies are therefore now contracting most of their renewable capacity as soon as project construction begins, either directly with companies, by means of PPAs (Power Purchase Agreements), or through the government, which proposes a fixed price and agrees to cover market volatility with CfDs (Contracts for Difference). The need for such contracts will increase as renewable energy grows. Will it then become possible to contract most of the market’s electricity? This change will undoubtedly require state intervention, something that has already begun in Europe with the Electricity Market Design Reform¹⁰ making it easier to arrange PPAs. A secondary PPA market is also likely to be set up, for instance as funds specialising in buying and selling PPAs emerge.

In addition, such high volatility is creating a need to invest in technologies that can counter it. These technologies break down into three broad categories:

interconnections between European countries to smooth out electricity supply and demand Europewide;
storage technologies, primarily pumped storage hydropower and utility-scale batteries;
demand control solutions, such as the use of home-installed batteries, controlled electric vehicle charging controlled heating systems and industrial systems.

The way in which interconnections will be financed is clear as funding will be provided by each country’s transmission system operators depending on the use they each make of these interconnections. It will then be reinvoiced to users, i.e. included in their system use tariffs. The financing of storage capacity, on the other hand, is less obvious as it requires a great deal of capital. The IEA reckons that global electricity storage capacity will have to increase 6-fold by 2030, with batteries accounting for 90% of this increase and hydropower for the rest.¹¹ Batteries will be used primarily for daily electricity storage – there are still technical limitations on the use of such technology for longer storage periods – which is crucial for countries where solar power plays an important role in the energy mix. Power producers are still rather reluctant to invest in batteries as it can prove difficult to obtain a return on such investments solely through electricity storage operations. To speed up the development of these batteries, they will have to be incorporated into renewable energy projects from the outset with contracts that cover production and storage, or offer a payment for guaranteed storage capacity as it is capacity or payment for guaranteed storage capacity, as is already the case in Mediterranean countries like Italy, Spain and Greece. Last of all, where consumption control solutions are concerned, investments will have to be made in collecting and managing electricity usage data from power distributors. However, it will be up to the regulator to decide on the incentive and/or payment schemes to be introduced for private users who agree to modify their own consumption patterns according to network availability.

The sector offers a whole range of opportunities that will have to be financed in a more responsible manner

Thanks to society’s electrification, the energy sector today clearly enjoys bright growth prospects in renewables, storage and grids alike; and, as long-term investors, we seek to tap into this momentum. We want to ensure that our investments have a positive impact on the environment while also limiting the long-term reputational, regulatory and financial risks faced by our portfolios, so we invest only in companies that present a credible decarbonisation pathway. In addition, our ESG Research team applies an exclusion policy that includes quantitative elements.

For instance:

We screen out any company investing in new coal-fired production capacity; if they have existing coal capacity, they must adhere to certain thresholds and, above all, have a plan in place to exit coal by 2030 for those operating in OECD countries;
We screen out companies exploring new oil or gas fields and also those that derive more than 5% of their revenue from shale oil or gas.

You can find out more about our exclusion policy here: www.mirova.com/en/research/understand.

Mirova wishes to assist energy companies that are in the process of transitioning. It therefore makes use of green bonds, which are effective as they ensure that our funds are utilised only to finance projects that deliver a positive environmental impact. This is a particularly straightforward choice as the Utilities¹² sector boasts the highest penetration rate¹³ of

labelled formats (at close to 50% in 2023¹⁴) and the greenium¹⁵ is therefore limited if not non-existent.

To take our European bond investments, creditors seem to be emerging from this period of volatility feeling reassured. Firms are facing higher interest rates and their margins are under pressure, so they are having to choose between growth momentum and solid balance sheets; many of them have opted to slow down their expansion in renewables. To name just a few examples among Europe’s main renewable power producers, EDP planned to add 5GW per year, a figure that has now been scaled back to 3GW; Iberdrola has revised its objectives downwards from 4GW to 3GW; and Enel has also downsized its capacity addition plans from 6.3GW to 3GW to protect its credit rating, which S&P placed on negative outlook back in November 2022.¹⁶

While investing primarily in European utilities, we do keep a close eye on any opportunities that might arise in the USA as they are all the more attractive since the IRA¹⁷ was introduced. We could, for instance, mention a number of recent reverse Yankee bonds¹⁸ issued in the sector, including by integrated utility Duke Energy and by a Texan power grid operator. The latter made use of the green bond format, which is the first time a US utility has issued such a bond on the euro-denominated market since Southern Power back in 2016. And others are sure to follow suit: although ESG is no

longer as popular among certain US politicians, it looks all the more necessary today. Unfortunately, California’s massive wildfires are just one episode in a series of extreme weather events that are becoming increasingly frequent, and they are bound to end up affecting the economy.

¹ Source: https://ember-climate.org/insights/research/european-electricity-review-2024/

² Source: https://www.eea.europa.eu/signals-archived/signals-2022/infographics/what-are-the-sources-of

³ RepowerEU: the European Union plan aiming to make Europe less dependent on fossil fuels and speed up the transition to green energy.

⁴ Source: Le Monde, may 2024.

⁵ Source: Eurelectric, 5 April 2024 (sector association which represents the common interests of the electricity industry at pan-European level).

⁶ Source: https://www.irena.org/Publications/2024/Sep/Renewable-Power-Generation-Costs-in-2023

⁷ Credit Rating and Credit Analysts | Ørsted (orsted.com)

⁸ Fitch affirms ERG’s BBB- rating and stable outlook

⁹ Exposure to the fluctuating daily spot market price of electricity as a result of the plant having no publically guaranteed long-term remuneration agreement in place.

¹⁰ Electricity market design (europa.eu)

¹¹ Source: https://www.iea.org/news/rapid-expansion-of-batteries-will-be-crucial-to-meet-climate-and-energy-security-goals-set-at-cop28

¹² Utility: organisation that produces or delivers electricity, natural gas, water and related services to the public.

¹³ Penetration rate: GSSB issuance as a share of total issuance. Bloomberg data, at end-December 2023.

¹⁴ Bloomberg data, at end-December 2023.

¹⁵ Greenium: a contraction of green and premium, it corresponds to the yield differential between a green or sustainable bond and a hypothetical conventional bond issued by the same issuer and with the same characteristics as regards maturity, coupon, degree of subordination, etc.

¹⁶. Source: Mirova. Data at end-June 2024

¹⁷ RA (Inflation Reduction Act): a US law that seeks to tackle inflation by reducing the deficit, lowering prescription drug prices and investing in domestic energy production while promoting clean energy.

¹⁸ Reverse Yankee bonds: debt securities issued by US entities. They are denominated in foreign currencies, mainly euros and pound sterling.

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