Alternative Energy - Powering a Brighter Future

GLOBAL ENERGY DEMAND HAS CONTINUED to grow and it is expected to rise by nearly one-third between 2013 and 2040. Power will continue to account for the largest portion of the total, increasing from 43% in 2015 to 47% by 2035, followed by industry at 28% and transportation at 17%¹ (see Exhibit 1).

In order to meet this increasing demand while addressing climate change concerns, the world is continuing to transition to alternative energy sources and improving energy efficiency. Despite the dramatic decline in fossil fuel prices since 2014, dedicated support from governments and strong commitment from private investors led to the largest yearly addition to global renewable power capacity in 2015 — 147 gigawatts — and the lowest-ever prices.²

In December 2015, during the United Nations Climate Change Conference, 195 countries signed the Paris Agreement to reduce emissions of greenhouse gases (GHG). An additional agreement was signed to double the budget for clean energy research and development among 20 countries, including China and India. These agreements brought the global community together to reach the goal of limiting to 2°C the increase in the global average temperature over pre-industrial levels. Furthermore, it marked the first time developing countries signed on to national emission reduction targets (see Exhibit 2).³

Private investors also stepped up their commitments to alternative energy during 2015. Large banks as well as venture capital and private equity firms have boosted their activities in the renewable sector, pursuing investment vehicles like green bonds⁴ amid further adoption of impact investing strategies.⁵

Going forward, we expect conventional energy — coal, oil and natural gas — to remain the dominant sources. Coal and gas are mostly used in stationary installations such as power generators and in industry while oil is used primarily in transportation. Despite the rapid growth of alternative energy, the majority of the world's electricity is still generated by coal and natural gas, and gasoline-powered vehicles continue to predominate. There's a significant shift, however, from coal to cheap and abundant gas driven in part by government policies to reduce harmful effects on the environment. In the United States, no additional coal-fired capacity is expected to come on line. European countries are closing down coal-fired plants, with the United Kingdom planning to shut down all its coal-fired plants by 2025.

We believe alternatives will continue to grow in importance, and we see the transition to a low-carbon environment and a balanced energy mix as irreversible. Along the way, alternatives will continue to overcome challenges, such as higher relative costs and the technical challenge of storage.

Alternative energy: Call for action
Environmental pollution is a critical public health issue for many countries. For example, in China the average number of haze days per year rose more than three-fold in the past 15 years.⁶ Governments are establishing new policies to try to ensure that economic growth will not override environmental protection, while corporations and investors are more committed than ever to act on climate change. In 2015, companies unveiled more than 8,000 initiatives to reduce GHG emissions globally.⁷ Even some conventional energy companies, such as BP and Shell, have pledged to play a bigger role in alternative energy production and to help control rising temperatures.

Some institutional and individual investors have committed to divesting from fossil fuels. Millennials, the largest demographic cohort in the United States, could play a critical role in curtailing the progression of climate change given their penchant for investing to make the world a better place.

In the past, economic expansion and levels of energy-related carbon dioxide have always been positively correlated. However, in 2014, for the first time, energy-related CO2 emissions stalled despite the global economy's expansion by 3%.⁸ This is a sign of commitment to deep cuts in GHG emissions and proof that a growing global economy does not rely on greater consumption of conventional energy.

BofA Merrill Lynch Global Research expects alternative sources to account for about 60% of total energy generation capacity by 2030 (see Exhibit 3). In 2014, renewables accounted for 50% of new power-generating capacity. In fact, including 2010, we have seen six consecutive years where alternatives have outpaced fossil fuels in net investment in additions to generating capacity.

The transportation sector accounts for 55% of global oil consumption.⁹ Although electric and self-driving cars are ubiquitous in popular media, the substitution of alternative technologies is not as advanced. The main challenges remain limitations to battery technology and affordability for mainstream consumers. On average, an electric vehicle can run for 60 to 120 miles on one charge;¹⁰ greater range requires more expensive electric vehicles such as Tesla models that are priced at more than $65,000. However, there has been significant progress in energy storage and hybrid technology in the past few years. Looking ahead, the market share for electric and hybrid vehicles is expected to grow from 3% in 2015 to 22% in 2025 (see Exhibit 4). Already, in Norway electric vehicles represent 16% of new car sales, up from almost zero five years ago and 40 times the global average. They've reached that level with help from a number of incentives, including taxes, toll road charges, free parking, municipal charging facilities and the ability for drivers to use bus-only lanes.¹¹

Solar is big part of the future
The solar power industry experienced record growth in 2015, adding 50 gigawatts (GW) of capacity, bringing the global total to about 230 GW.¹² Going forward, about $3.7 trillion is expected to be put into solar investments between 2015 and 2040.¹³ With costs for equipment, installation and services falling, we believe solar will continue to transition from a policy-driven to a business-driven industry (see Exhibit 5).

There are two main technologies for converting solar energy into electricity — photovoltaics (PV) and concentrated solar power (CSP), with PV being less expensive and more widely used. It is gaining competitiveness due to declining costs versus conventional energy and life-time CO2 emissions about 10% of those of coal-fired power.¹⁴ From the consumer's perspective, once the initial fixed cost has been covered, there is little more to pay since solar cells are expected to last more than 25 years.¹⁵

The International Energy Agency has projected that solar power could provide 20% of the world's energy demand by 2030. Going forward, China, the United States, Japan and India are expected to drive demand for solar power (see Exhibit 6). China is committed to increasing the use of renewable energy sources; in 2015 it surpassed Germany to become the world's largest solar PV generator, reaching a capacity of 44 GW.¹⁶ In the United States, last year, for the first time, solar PV installations surpassed new natural gas capacity. The growth has been helped by a federal income tax credit for residential and commercial properties.*¹⁷ Japan has the third-largest solar PV production capacity with output accounting for 3% of its total power generation in 2015. The country doubled its renewable energy capacity in the last three years, with solar PV accounting for the majority of the increase.¹⁸ India's Prime Minister, Narendra Modi, has proposed raising solar capacity to 100 GW by 2022.¹⁹ The proposal is driven by severe air pollution from heavy use of coal-fired power.

Wind — costs should fall further
Wind power experienced a record year in 2015 with capacity reaching 433 GW, a 17% rise from the year before (see Exhibit 7).22 The Global Wind Energy Council has predicted that the number of wind power installations will double in the next five years.²³

China, the U.S. and Europe continue to drive the growth. In the European Union (EU), wind capacity at the end of 2015 was enough to cover 11% of electricity consumption in a typical year. Denmark was a pioneer in developing wind power and met more than 32% of its electricity needs with it at the end of 2014 (see Exhibit 8).²⁴ The Danish government aims to increase the share to 50% by 2020. The U.S. added 8.6 GW of capacity in 2015, bringing the total to 74 GW.²⁵ New markets in Africa and Latin America are expected to emerge in the next decade.

Power from onshore wind generators is relatively inexpensive; in some areas it is even cheaper than electricity from coal and gas.

Massive increases in capacity should allow onshore wind generators to achieve economies of scale and attract additional financing. Technology improvements in turbines, better sites and cheap financing make it the least expensive renewable source of electricity other than hydro power. We expect the cost to fall even further assuming greater efficiency in manufacturing of wind turbines, which would support the long-term demand for wind power. The cost of offshore wind power, on the other hand, remains significantly higher than electricity from fossil fuels and onshore wind.

Wind, like solar, is at the mercy of nature and its reliability varies by location. Developing a means of enabling excess power to be returned to the grid is key. Additionally, wind turbines require regular maintenance through their 20-to-25-year life, so high-quality service could facilitate further adoption. Another constraining factor is damage to wildlife from the rotating blades and electromagnetic fields.

Overall, solar PV and onshore wind are the most competitive forms of alternative energy given their lower costs and more mature technologies. They are likely to dominate additions to global generating capacity over the next 30 years.²⁶ However, storage for back-up power is one challenge both sources face. In addition, as solar and wind generators are connected to the electric grid, system operators must manage output to prevent unanticipated fluctuations in voltage and blackouts.

Hydro has advantages and drawbacks

Concerns with climate change and declining variable costs are driving further adoption of hydropower. About 28GW of new capacity were added in 2015, bringing total global capacity to approximately 1,064 GW. The addition was less than for both solar PV (50 GW) and wind (63 GW).²⁹

Like solar and wind, hydro power is valued for its low emissions. With hydro it is also easier to adjust output in accordance with changes in demand. Another benefit is that reservoirs can offer energy storage as well as flood control and drought protection. On the flip side, the cost of new plants can be high and dam safety becomes a major concern with extreme flooding. Moreover, research shows hydro projects can have serious impacts on ecosystems and hydrology, blocking fish migrations and changing the temperature and chemical composition of bodies of water. In the long run, we predict solar PV and wind power will surpass hydro due to these constraints.

Nuclear poses risks
People tend to have mixed feelings about nuclear power. It benefits from high energy density; the amount of energy released in a nuclear reaction is 10 million times that from burning an atom of fossil fuel, resulting in a high capacity to generate power. However, rising concern with radiation risks and management of waste have turned some countries away from nuclear energy, especially after Japan's Fukushima Daiichi accident.

Conclusion: Going forward, Emerging Markets will drive energy demand, while developed countries see stable or declining consumption. Conventional sources are expected to continue to dominate the energy mix, with natural gas the "bridge" fuel as the world moves toward a low-carbon economy. Given concerns with climate change, we believe the world has reached a tipping point for renewable energy. Governments, corporations and investors are acting together to enable the transition. We believe that solar PV and onshore wind will likely become the predominant low-carbon energy sources given improving technologies and declining costs.

Alternative energy investments tend to be volatile and call for a relatively long holding period. Investors can target energy efficiency technologies such as storage, lighting and the smart grid and look to blue-chip companies with a significant presence in these technologies, reducing downside risks. A diversified approach through managers specializing in impact investing is preferred.