Baron Funds insight for the second quarter 2015 – Investing In Renewable Energy.

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Baron Funds: Investing in Renewable Energy

James Stone, VP, Portfolio Manager, Baron Energy and Resources Fund; Rebecca Ellin, VP, Research Analyst

One of the keys to Baron's approach to investing in energy is to seek growth companies and growth opportunities brought about by changes in technology, trade flows, infrastructure investment, and capital intensity. This approach first led us to opportunities driven by technological advancements that helped to unlock new reserves and production from unconventional (mostly shale) resources in the U.S., and the concomitant demand for infrastructure to process, store, and transport products to markets from these new geographies.

In the past 18 months, our focus on growth has led us in a new direction within the energy industry: renewable energy, and in particular, solar energy. As with unconventional resources, we believe renewable energy is one of the most significant growth opportunities in energy today. Two major trends are driving the adoption of solar: (1) technological and other improvements that are making solar an increasingly costcompetitive source of electricity in many countries (grid parity); and (2) increasing consumer and geopolitical desire to reduce pollution, which encourages the use of renewables. The emergence of innovative financing models known as “yieldcos” is acting as an additional catalyst for the conversion to renewables by significantly reducing the cost of capital and enabling companies to raise more capital at these lower, also more attractive rates.

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A decade ago, the solar industry was in a nascent stage, largely dependent on government subsidies to stay in business. Most companies that went public were commodity-type manufacturing businesses, focusing on price competition to sell relatively undifferentiated products or services, or engaged in a technology arms race with few clear winners. It was a challenge to find investment opportunities that met the Baron criteria: significant competitive advantage, strong long-term growth potential, experienced management, and attractive valuation. Recent transformative developments in the solar energy industry, however, are producing what we believe are excellent investment opportunities and we fully expect more to come.

Baron Funds: Grid Parity Is Here

In the past few years, the cost of solar panels has plummeted, driven down by technological advances in photovoltaic (PV) cells and an explosion in solar panel manufacturing in China. The average solar panel now costs about 75% less than it did just five years ago, and the price continues to fall. The newest method for producing the PV polysilicon used in making panels takes a tenth of the energy than that of previous techniques. This shortens the manufacturing time, allowing faster and cheaper production of solar panels. In addition, the energy conversion efficiency of both PV and thin film technologies has increased significantly, further driving down the cost/watt for all forms of solar energy. In the past three years, the cost of installing utility-scale solar has fallen 57% in the U.S. and costs for residential solar has seen a similar decline in cost.

As the use of solar grows, solar businesses are also starting to enjoy the benefits of economies of scale. As solar companies add customers, costs associated with functions such as sales, marketing, regulatory and compliance do not increase commensurately. We believe customer acquisition costs will continue to decline significantly as customer awareness increases, soft costs come down, and more supportive policies are put in place. This creates a virtuous circle of lower costs driving greater demand.

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The steep decline in cost means that solar energy in now at levels of grid parity in many regions across the globe, especially in emerging markets, where electricity costs tend already to be high. At least 30 countries are currently at grid parity on an unsubsidized basis, including Australia, Brazil, China, France, Germany, India, and Spain, according to Deutsche Bank Market Research. In the U.S., more than 14 states are currently at grid parity, and by 2016, that number is expected to climb to close to 47 states, according to the same research.

Baron Funds: Growing Commitment to Renewables

While solar currently accounts for only 1.2% of electricity generation worldwide, the percentage is growing rapidly and is expected to accelerate. In 2014, investments in solar powered electricity projects rose 25% to $149.6 billion, representing a record high share of total energy investments. According to Bloomberg New Energy Finance, investments in electricity generating assets over the next 25 years may total about $12 trillion, of which renewable energy should account for $8 trillion, and solar for as much as $3.7 trillion of the total. This compares to only about $1.2 to $1.3 trillion for coal and nuclear, respectively. A key driver of the growth in solar continues to be the declining cost and increasing efficiency of the technology, as well as emerging technologies for energy storage that will further enhance the competitiveness of solar and other renewables in the electricity markets. It should also be noted that the growth opportunity in renewables should be largely divorced from the oil price outlook, as oil is scarcely used around the globe to generate electricity. Furthermore, over time, we anticipate that natural gas prices will continue to decouple from oil prices around the world as natural gas remains an important fuel source for power generation.

Across the globe, the appeal of renewables is building among governments and consumers, both at the residential and commercial levels. China, whose capital city, Beijing, has become notorious for its smog levels, has a target to install 100 gigawatts (GWs) of solar by 2020. India plans to install 100 GWs of solar by 2022. The European Union plans to increase renewables to 20% by 2020. To put this in perspective, the total solar installed base worldwide was only about 250 GW at the end of 2014.

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