The Chinese government recently announced that electricity distributors will be required to purchase between 5% and 15% of their total energy supplies (depending on location) from renewable sources beginning in 2012. The policy change is intended to alleviate the country’s bizarre combination of enormous capacity for renewable energy production and dearth of proper transmission infrastructure. The quota system will force grid operators to invest in transmission infrastructure, particularly the construction of high voltage corridors between the renewable energy-rich northern and western portions of the country and the power-hungry coastal regions. In the long run, wind and solar farm operators, currently languishing in overcapacity as a result of inadequate grid infrastructure, will benefit enormously.
Background
China has invested heavily in renewable energy, however, much of the country’s renewable energy hubs are in the northern and inland regions, far from the most populous urban centers in south and the east. Although China subsidizes renewable electricity purchases for grid operators, electricity produced by coal-fired plants is still significantly cheaper and more reliable. Grid operators have no commercial incentive to purchase from renewable sources let alone invest in high-voltage, cross-country transmission lines to distribute it. The national government is essentially putting a floor on green energy purchases by enacting the quota system. Thus, struggling renewable energy producers may not be struggling for long.
A few well-positioned companies
1. China Longyuan Power Group Corp Ltd (HKG:0916)
Longyuan is an integrated power producer engaged in the construction and operation of both wind and coal-fired power plants. It is subsidiary of the state-owned electricity producer China Guidian Corporation. Longyuan is insulated from the negative financial effects of the grid problems plaguing renewables by its coal segment and by its manufacturing activities. Revenues at Longyuan grew 8.25% in the first half of 2012 over the second half of 2011 and, unlike many similar companies, net profits increased modestly over the same period. The company’s share price staged a modest recovery in past month but is down 26% in last six months. One-third of Longyuan’s wind generating capacity is idle. The renewable production segment is currently a drag on profits but as the government implements the quota system, the company says confident that it will be able to rapidly increase production to meet immediate demand in future periods.
Company Snapshot
| 52 Week Range | 4.47-7.20 |
| Open (9/14) | 5.28 |
| Mkt. Cap | 38.89B |
| EPS | 0.44 |
| P/E | 11.81 |
(Currency: HKD)
2. Huaneng Renewables Corp Ltd (HKG:0958)
Huaneng Renewables is a subsidiary of state-owned China Huaneng Group, the largest electricity producer in the country. Huaneng Renewables went public in 2011, listing in Hong Kong, and currently trades near the lower bound of its 52-week range. The company reported considerably worse first half results than Longyuan. Revenues grew a healthy 12% but operating profit fell 15% and net profit dove nearly 64% compared to the second half of 2011. Over the last six months Huaneng’s share price has fallen 54.6%. In its announcement of 2012 first half results, the company noted a challenging economic environment and attributed the drop in profits to “output constraints and low wind speed.” Management predicts a much more financially successful second half of 2012, noting that the new quota system will benefit the company.
Company Snapshot
| 52 Week Range | 0.87 – 2.32 |
| Open (9/14) | 0.97 |
| Mkt. Cap | 8.19B |
| EPS | 0.09 |
| P/E | 11.09 |
(Currency: HKD)
3. China Datang Corp Renewable Power Co Ltd (HKG:1798)
Datang Renewable is a subsidiary of China Datang Corp., which also one of the largest power generating companies in China. Datang Renewable was listed in Hong Kong in 2010. Like Longyuan and Huaneng, Datang reported a modest increase in revenue in the first half of 2012 (8.3%) yet also posted a horrendous drop in net profit (- 76%). Datang’s share price has fallen 44.6% in the last six months. The company’s report for the first half of 2012 attributed disappointing financial results to “severe grid curtailment and low wind speeds,” but also expressed confidence that the progression of the government’s 12th 5 year plan, the quota system, and the construction of much needed transmission lines will bolster financial results in the second half of the year as well as in subsequent periods.
Company Snapshot
| 52 Week Range | 0.71 – 1.69 |
| Open (9/14) | 0.76 |
| Mkt. Cap | 5.75B |
| EPS | 0.07 |
| P/E | 11.23 |
(Currency: HKD)
All three companies seem identical in both form and function and all three tell the same first half story: Grid efficiency constraints crimping results and confidence that government’s quota system will pad future returns.
Risks and Rewards
Unfortunately for these and other green energy producers, the quotas will not be fully implemented for a few years and the construction of transmission lines – including gaining necessary regulatory approvals – will also take time.
There’s also the risk that new entrants into the market, motivated by greater profit potential created by the quota system, will upset the prospects of existing companies. A related concern for current producers is further relaxation of China’s myriad regulations on foreign firms operating in the country. However, the considerable red tape crisscrossing the Chinese economic landscape will mitigate these risks – especially since the government is likely to protect the subsidiaries of state-owned enterprises.
Competition from alternative sources could also potentially reduce the positive effects of the quota system for existing solar and wind companies, depending on how the government chooses to classify debatably renewable energy sources, such as plasma gasification of solid waste. The competitive landscape will also depend upon which renewable sources the major green energy companies – and by implication their state-owned parents – choose to invest in over the next several years (arguably also to be decided by the national government). In short, the efficacy of the quota system and the system’s effects on the financial returns of current green energy producers will depend on future government policy decisions and implementation.
A Risky Long-term Energy Play
Mixed analyst sentiment regarding the prospects of Chinese renewable energy producers reflect considerable uncertainty regarding the long-term financial impact of the quota system in particular and the further development of the renewable energy sector in general. The quota system will not be fully implemented for several years, the policy effects and the necessary transmission line investments will surely face a number of regulatory hurdles and internal wrangling over location and funding. Because future profitability is more or less entirely dependent on government policy and because predicting changes in Chinese national policy is fairly difficult – especially with regard to specific provisions and implementation – investing in China’s green energy producers is a fairly risky play. Still, renewable electricity producers are on the verge of having a protected market for their sole product. The capital gains for investors could be enormous down the road.
