Introduction

At Massif Capital, we have long argued that renewables are a misunderstood source of electricity. From our perspective, the critical misunderstanding is in the use case. Well-meaning but misguided environmentalists, politicians, and a slew of business leaders have pushed for renewables everywhere, fundamentally misunderstanding the strengths, weaknesses, and limitations of the various technologies to extract energy from the environment.

The misunderstanding starts with the failure to understand the fundamental reality of extractive resources, which is what “renewable energy” is. The wind blows, the sun shines, and renewable technology converts that natural resource to electricity. Renewables combine two critical steps of more traditional natural resources like oil or copper: extraction and refining. Wind is harvested via a spinning blade and “refined” into electricity via a generator; solar is the same. Why is this important to understand?

It is essential to understand Solar and Wind as extractive industries no different than any other because it means that the “grade” of the natural resource being extracted is critical. Wind turbines make sense with enough wind; solar power makes sense with enough sun, but neither makes sense if the resource grade is too high or too low. The mere presence of copper in a drilling core is insufficient to justify building a copper mine; the fact that the sun shines or the wind blows in a particular location is inadequate to justify building a wind farm or solar park. The “grade” of the wind and sun must justify the project.

Where renewables differ from traditional extractive industries is that too high or too low a grade can hurt the sustainability of any given project, and here we are referring to sustainability in a holistic sense, as a concept with three dimensions: environmental, social, and economic; the absence of any one of those dimensions means something is not sustainable. To this holistic conception, a further detail must be added: economic sustainability means that a project's cashflows can sustain it; when a project's cashflows alone, without government incentives, cannot justify a project, it is not economically sustainable. Government incentives are not sustainable.

Another difference from traditional extractive industries that is critical to understand is that while a copper mine stands alone, power-generating assets do not. Their sustainability can only be fully assessed within the context of the entire electrical grid. As such, there must be macro and micro-level sustainability. Paradoxically, when the “grade” of the resource is too low, the primary concern is macro-level sustainability. When the” grade” is too high, the primary concern is micro-level sustainability.

What Happens When the Grade is Too Low

Typically, renewables have been assessed based on their Levelized Cost of Electricity (LCOE), but this variable often misses essential dynamics. The shortcomings of LCOE have been discussed widely elsewhere, so we won’t rehash the case. Still, one of the critical variables it misses is the cost of integrating a variable resource onto the grid, which tends to hinge on the price and availability of electrical system flexibility.

Put another way, the more flexible an electrical grid is, the less the cost of grid integration for renewables—the more inflexible the grid, the higher the price. The unfortunate reality is that grid flexibility is mostly a mirage. People want electricity when they want electricity. When the “grade” of the sun or the wind for an individual project is too low, the project may still find a way to justify its existence financially at the micro level, but it imposes macro-level costs that make it unsustainable.

Every variable or intermittent power source added to the electrical grid increases the need for more flexibility in the grid. Achieving flexibility and reliability is costly. While batteries have been a proposed solution to the flexibility and reliability puzzle, they are yet to prove up to the challenge. While battery prices have fallen, they are still costly for the utility-scale use case, so while assuming cheap batteries may appear justified, it is challenging to square with reality, especially given resource and manufacturing constraints. The assumption that grid build-out will be affordable, on the other hand, is just contrary to real-world experience.

Bringing it back to grade, as more variable energy sources are integrated into the grid, the more costly the grid integration becomes, regardless of the LCOE from any individual project, because more flexibility is needed to address increased reliance on variable energy sources. At a functional business level, this means the profit pool of the electrical system shrinks, reducing the economic sustainability of the entire system while also steepening the cost curve and increasing the marginal cost of electricity to consumers. Furthermore, the more marginal the resources being taped, the more flexibility and reliability infrastructure is needed because the system becomes less dependable at any given moment. Tapping lower “grade” resources increases system fragility.

The question then becomes, what constraining variable is needed to determine which renewable resources make sense to “extract” and which don’t? We would propose Energy Return on Invested Energy. For modern civilization, the efficiency of energy production necessary to sustain existing lifestyles is assumed to be in the seven to eight range, meaning for every unit of energy expended producing energy, one must get seven to eight units out. If we do not achieve that yield, we overconsume energy relative to our ability to produce energy. Another way to think about it is in terms of farm labor.

At one time, it took a large team of people to till, sow, and harvest a given plot of land; this meant those people had to be focused on farming; they could not spend time, for example, studying computer programming or electrical engineering. They had to work the land; with the advent of machinery, the number of people necessary to farm a plot of land decreased while the yield from the same plot of land increased, a double efficiency gain. The people not needed for farming could then spend their time programming computers. EROI measures this efficiency; the lower the EROI, the more resources are required to produce less energy, and the less free energy is available for other uses. 

When resource grade is integrated with EROI to assess, for example, globally available solar energy that delivers at least a 7.5 EROI, as was recently done by a team of researchers from Belgium and England, what is found is that in places like China, minimal land, often less than 2%, is suitable for solar, the same is true of the EU, where only 2% of the land, concentrated chiefly in Spain and Portugal, is appropriate. Yes, you can install solar in Germany (and they have installed a lot) or China (who has installed the most), and yes, those projects may have standalone economics given regional context to support micro-level sustainability, but at a macro level, they increase not only the cost of maintaining the electrical system but also put at risk achieving a more significant societal level macro sustainability at existing living standards.

What Happens When the Grade is Too High

A different issue arises when a resource “grade” is too high (or sometimes when just too many assets are deployed to harvest resources of too low a grade). When too much wind or sun shines, the grid is once again confronted with the need for increased flexibility, lest individual projects experience value deflation. Value deflation occurs when too many assets attempt to extract value from a single resource, resulting in a rapidly correlated increase in power output. All the solar panels generate electricity at the same time in the same place, overwhelming demand, or all the wind turbines spin at the same time, etc.

In essence, too much wind and solar power in one place at one time, usually occurring in areas where the “grade” is especially good, lowers electricity prices during hours when their output is highest. Assets thus produce lower revenues during their highest output hours.  Value deflation limits economic returns for wind and solar at higher deployment, as the revenue per unit of installed capacity has diminishing value in any given single region. In this case, the need for grid flexibility differs from the grid flexibility costs incurred due to higher grid integration costs discussed above in that increased grid flexibility measures such as batteries suffer from the same diminishing value issue.[2]

What Does this Mean for Investors?

The key takeaway for investors is that companies focused on deploying renewable assets must be assessed with a laser focus on location.

Does the company deploy assets primarily into a market experiencing value deflation absent government incentives, as is the case of a company like Sunrun, which mainly operates in California? If so, it is best to avoid that investment.

How much renewable penetration is there regionally? Renewables on the grid experience decreasing returns to scale. Being pitched a Wind investment in the Midwest where wind power is ample? Perhaps it’s best to pass. What about offshore wind in Europe? There is a lot of it, all in mostly the same place (the North Sea area), but there are also a lot of connections to a diverse array of electricity markets; this negates some of the crowding issues, so it's not as simple as just observing regional penetration. Equinor (Massif Capital Investment) is an example of a firm making money on offshore wind in Europe.

Does the company deploy assets into a high “grade” environment that results in high EROI, as in the case of many offshore wind assets? If so, then perhaps those investments, despite producing more expensive electricity, are sensible within the context of the regional grid with a diversified portfolio of power-generating assets. This is especially true when intermittent or variable resources represent less than 35% of the grid, a somewhat arbitrary line albeit one with some support as a tipping point for renewable generation grid integration cost inflection. These assets might be on the right tail of the cost curve, but that does not mean they cannot be sensible investments, especially given the bigger picture context in which they should be assessed.

Finally, this commentary is critical to understand when considering renewable energy developers. At the same time, it does not apply to the equipment manufacturers. While we like renewable energy development investments as a part of a larger business model and when properly located, most developers we have looked at do not fit that bill. Nevertheless, there is a government push to deploy, with ample incentives driving demand. As such, the obvious place to look for opportunities, especially at present, is up the supply chain at the equipment producers and the “picks and shovels” of the industry.

Footnotes

[1] We use “grade” throughout this piece instead of a capacity factor to draw the reader's attention to how similar renewable energy is to traditional extractive industries. Typically, “grade,” as we use it throughout this piece, would be roughly equivalent to the capacity factor, which is the term used to describe the actual electrical energy output of a generating device over a given period relative to the theoretical maximum electrical energy output over that period. We would note that one challenge with using the term capacity factor is that investors and those interested in renewables often talk about aggregated capacity factors, for example, the capacity factor of wind power in Texas or solar in Nevada. Although this makes more sense than discussing the average grade of, say, copper deposits in Chile, it is nevertheless a very imprecise way of discussing a critical variable to the three-dimensional sustainability of projects spread throughout geographic regions that, even in their relative similarity and small size can be quite large and quite diverse in the context of capacity factors.

[2] Every additional battery on the grid has decreased marginal value as its use scenarios become more critical and more seldom. This is easiest to understand in the extreme: imagine a scenario in which a city derives 100% of its power from renewables and has installed enough batteries on the grid to supply two weeks of power; the final battery installed to accomplish that goal is the most important, as it assures energy needs are met in the presence of a catastrophic energy shortfall, but it is also the least likely to be used and thus the least likely to generate any value. It becomes a battery and capital outlay that we hope never generates any value or return on investment.