Renewables and the Cost of Capital
Conventional Wisdom has (or has had) it that investments in renewables return “mid single digits”, while those in upstream oil and gas, “mid teens”. You do not have to agree exact numbers to accept that, to the extent this characterization has any validity, it represents a meaningful difference in expectations.
So, when a company says it is going to reduce its “mid teens” returning share of investments by some 40% (1 million boped) over the next 10 years, and maintain its growth with investments yielding “mid single digits”, what does this imply ?
OK, bp doesn’t quite say that; it acknowledges a difference in the headlines but says that it can address the difference through broadening its presence in the energy value chain, and by delivering energy as a service. As of today, at least, the market is intrigued, but uncertain of the company’s ability to do this (or even if the business model is capable of achieving the stated result).
However, the debate around this does not seem to address some more basic questions about investment and returns. CAPM would have that the return on an expected cash flow stream (or business / market segment) should reflect the systematic risks of that cash flow or business / market segment. Which then immediately raises a question with respect to the investment in renewables, as to whether the “mid single digits” is below what returns should be to be consistent with this theory, and whether that level of return does in fact reflect the risks involved. If the former, what is the business case for investment (“capitalizing” learning curve to exploit first-mover advantage ?) or, alternatively, is market sentiment ignoring a lower risk profile and, as a result, a prospective change in the company’s risk profile ? Certainly a company with lower variability in its earnings expectations (all else being equal) should be valued based on a lower discount rate, and be callable of returning higher levels of cash flow to its capital providers without compromising its future business.
There is a further aspect to all this that also does not seem to be discussed; namely, is “mid teens” either the correct or the appropriate future expectation for upstream oil and gas investments, and "mid single digits" the appropriate equivalent for renewables ? To assume so presumes a constant external environment. If, however, the expectation is for the one to have improving conditions with regard to regulation and access to capital, and the other to have a continuing tightening of the same conditions, then the baselines for each need examining.
I suspect both need further examination. However, like the sage advice to “buy low and sell high”, it may be instructive, but it is all about the timing ….