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Hydrogen (Part II)

Hydrogen (Part II)
– A Great Opportunity or Another False Start?

Foreword

This is Part II of our research on hydrogen. In the following, I will assume that you have already read Part I. In this second part, I will look at the other side of the coin – particularly why green electricity is more expensive than the green lobby likes us to think it is. I will also look at the implications for other energy forms, once we begin to roll out green hydrogen on a large scale (which will happen, I am convinced – only a question of time). Finally, I will present some ways you can invest in hydrogen at this early stage, even if the technology hasn’t been commercialised yet.

The true price of renewables-based electricity

Experts in the field continue to disagree whether electricity generated from renewables is more expensive than conventional electricity, but my sense is that, when they can’t agree, it is because they are comparing apples and oranges. Let me explain.

In the early days of renewables, construction costs were simply added to operating costs to get a picture of total costs, but it quickly became apparent that things are slightly more complex than that. Consequently, the concept of Levelized Cost Of Energy (LCOE) was introduced. LCOE measures lifetime costs divided by lifetime energy production and calculates the present value of the total cost of constructing and operating a power plant over an assumed lifetime. The methodology allows you to compare different technologies (wind, nuclear, natural gas, etc.) of unequal life spans and project size (source: US Department of Energy).

The problem with the LCOE approach, though, is that it doesn’t take into account when the electricity is produced. According to MacroStrategy Partnership LLP, with a capacity factor around 20 in Europe (more on that later), the implication is that renewables-based electricity is approx. five times the price of conventional electricity. One can therefore argue that, when comparing numbers in this manner, wind and solar are pretty much a valueless source of energy for a modern, industrial economy which depends on continuous and steady supplies.

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I should emphasize that this argument does not take into account the damage done to the environment and the implied costs thereof. Now, you may think that I am referring exclusively to the environmental damage from burning fossil fuels, but the environment is also damaged when using renewable energy forms. Nature is dependent on the energy we take (whether wind or solar), just like your car is dependent on fuel to drive. By taking energy from nature, we distort weather patterns and upset the delicate balance of everything. This is admittedly a very complex topic which is next to impossible to quantify, but it does emphasize the importance of thinking a little bit bigger than most of us tend to do when thinking of the environmental impact of various energy forms.

I should also point out that the true price of energy discussed in this paper does not take into account the technologies I discussed in part I. Those technologies will allow us to utilise the electricity coming from renewables much more effectively, which will bring down the true cost. Other emerging storage capabilities, such as grid batteries, are not taken into account either.

Having said all of that, let’s stay with the argument that, when measured in the manner referred to above, green electricity is about five times more expensive than conventional electricity. The implication of that is that renewables are not suitable to use when producing hydrogen. Simply put, you need a more reliable energy source for electrolysis to work efficiently. If people in the renewables industry could be persuaded to apply this methodology when doing their analysis, they would have to agree that renewable energy forms are not as attractive (economically speaking) as they appear to be, but they have a vested interest in not doing so.

Governments are no different. They have enthusiastically been promoting renewables and are too far down the rabbit hole to admit that the story is perhaps not as straightforward as they like to think it is – too much political capital has already been invested to start backtracking. This will only be resolved if a more cost-effective technology is introduced or through the upheaval that it will otherwise bring.

A German federal audit concluded only weeks ago that the switch to renewables has proved very costly, and that the risks to electricity supplies had been underestimated. Reforms are needed to fix a system that has left Germany with Europe's highest retail electricity prices, the audit concluded. The audit also warned of a looming energy supply shortfall, as utilities prepare to phase out coal and to turn off the last nuclear reactor in Germany.

As per the audit, there is likely to be a shortfall of 4.5 GW, equivalent to ten large coal power plants, on the German grid between 2022 and 2025. The audit stated that the German Ministry of Economics had been "too optimistic and its assumptions partly implausible", and that it had tip-toed around the worst-case scenarios, a view echoed by grid operators. There have been similar reports in the UK about the real cost of the energy transition; however, both in the UK and in the EU, governments carry on regardless.

The implications for other energy forms

Assuming at least one of the new technologies discussed in Part I will be commercialised at some point, we can begin to treat CO2 as an asset rather the liability it is at present, but that is far from the only advantage. The true cost of green electricity will also be dramatically reduced, the reason being that the electricity supply can be better managed whatever weather conditions are like. This will allow most countries to further increase wind and solar capacity without running into the intermittency problems they are faced with today,

The introduction of these, new technologies is therefore also good news for manufacturers of wind mills and solar panels. The rule of thumb in recent years has been that you shouldn’t allow more than 50% of your electricity to come from renewables. The introduction of Power-to-X and/or Air-to-Fuel will allow you to go a fair bit higher, but it should never be anywhere close to 100%. Renewable energy forms are quite simply too unreliable for that to ever happen.

Allow me to make one additional point on wind and solar. As I said earlier, the capacity factor when producing electricity from either wind or solar in Europe is about 20. In plain English, that means that the total output from wind and solar combined is about 20% of the theoretical maximum output. To make it even simpler, think of the capacity factor from solar being zero when the sun doesn’t shine. The ~20 capacity factor in Europe is the weighted average of wind and solar. In Europe, the capacity factor of solar is only 12, whereas it is 26 as far is wind is concerned.

The obvious implication of that is that, over time, electricity generation from renewables in Europe will gravitate towards wind. Solar is too expensive in most European countries to make much sense, and hydro is both very expensive and, environmentally, quite unfriendly. The best argument in favour of solar and hydro is probably that, without those two to compliment wind, intermittency and variability problems are even worse. From an investment point-of-view, this means that, at least in Europe, one should favour investments in wind over solar and hydro.

If renewables are too expensive, and the ultimate objective is a more sustainable climate (which it is), then the most obvious option left on the table is nuclear. Nuclear has a bad reputation, but that reputation doesn’t not take in account the next generation of conventional nuclear – SMR fission – which is far safer than nuclear as we know it today – nor does it take into account fusion energy.

A fusion reactor cannot melt down, nor is nuclear waste a significant problem. A fusion reactor leaves only modest amounts of nuclear waste, which can all be recycled within 100 years. Best of all, it is incredibly cheap to produce electricity this way. Half a bathtub of water (seawater will do) plus the lithium contained in one laptop battery will produce enough electricity to satisfy the needs per capita in the UK for 30 years. In other words, introducing fusion energy will reduce the marginal cost of electricity to virtually zero, making it far more likely that the technologies referred to in this paper will eventually prevail.

Investment considerations

There can be no doubt that the hydrogen market will grow significantly over the next many years. According to at least one source (Financial Times), what is now a $150Bn market globally will, 30 years from now, be a $600Bn market (Exhibit 1), and I should point out that this estimate doesn’t even incorporate the opportunities which I have outlined. From an investment point-of-view, this means that companies which offer solutions to the problems I have referred to in this paper stand to benefit from substantial tailwinds in the years to come.

Exhibit 1: The hydrogen opportunity now and by 2050
Source: Financial Times

Only one problem – investors are already all over the hydrogen opportunity. Companies such as ITM Power with a giga-factory in Sheffield, Ceres Power with rapidly expanding hydrogen fuel cell production capacity in Germany or AFC Energy – another hydrogen fuel cell manufacturer – have done tremendously well more recently (Exhibit 2) and are now trading at ridiculous earnings multiples. This makes me reluctant to invest in dedicated hydrogen companies unless they go through a meaningful price correction.

Another option – admittedly one with less upside but also a far safer one at current price levels – would be to invest in those companies that continue to buy up the specialists in the field. Take for example the German industrial gases company, Linde, which bought a 17% stake in ITM Power in 2019 or the Italian energy infrastructure operator, Snam, which recently paid £30Mn for an undisclosed stake in ITM Power.

Exhibit 2: % change in share price of various hydrogen companies since mid-2019
Source: Investors' Chronicle

An altogether different option would be to establish a portfolio of blue-chip companies which have recently demonstrated a commitment to hydrogen, even if the exposure is not yet meaningful. In this category, you’ll find names like Shell Royal Dutch, Toyota, Chevron, Vattenfall, Mitsubishi, Ineos and Hyundai Motor Company, all of which have made some sort of move towards hydrogen in recent months.

I should also mention Ørsted – one of the best hydrogen ideas I can think of. Ørsted (formerly DONG) is a Danish company that built the world’s first offshore windfarm in 1991 and has since become the global leader in offshore wind with a 24% market share outside China (source: Investors’ Chronicle). As you can see in Exhibit 3 below, Ørsted has now exited fossil fuels completely with offshore wind accounting for most of the company’s EBITDA these days.

Exhibit 3: Ørsted’s EBITDA by division (DKK billion)
Source: Investors' Chronicle

More recently, Ørsted have announced plans to develop one of the world’s largest hydrogen plants on the border between Belgium and the Netherlands (see here). Given the track record of this company and its management, I would be very surprised if it doesn’t end up as a leading provider of green hydrogen solutions.

Early this year, the shares peaked at about DKK 1,350 per share but has since dropped by about one-third and can now be acquired for c. DKK 905 (Exhibit 4). The shares are not cheap (a P/E multiple in the high 20s or low 30s depending on which numbers you look at), but they are not trading on the absurd multiple levels dedicated hydrogen companies do.

Finally, I should also mention that there is a relatively broad catalogue of private equity (PE) and venture capital (VC) funds with exposure to hydrogen and other green energy forms. Tying up your capital for a number of years may not be an option but, if it is, you should look at the opportunity set provided by PE and VC. This is probably where you’ll find the highest returns. We are happy to assist if you need some handholding.

Exhibit 4: Performance of Ørsted on Copenhagen Stock Exchange (last 5 years)
Source: tradingview.com

Final few words

Before you jump to any conclusions, I should point out that hydrogen has been the “energy of the future” for so long that a healthy degree of scepticism is warranted. There have been so many false starts that many are barely raising an eyebrow when I utter the words “green hydrogen”. Having said that, the fact that big international conglomerates like the ones mentioned earlier have started to throw serious money after green hydrogen suggests to me that a future without fossil fuels may arrive sooner than many realise.

According to the International Energy Agency (IEA), production of low-carbon hydrogen (i.e. a mix of blue and green hydrogen) will rise dramatically over the next few years (Exhibit 5). Technology improvements have not only made hydrogen fuel cells more efficient; they are also far more durable than they used to be.

Exhibit 5: Low-carbon hydrogen production
Source: IEA

When installed in an EV, hydrogen fuel cells will convert hydrogen into electricity, thereby fuelling the car. Last year, there were only about 25,000 fuel cell EVs on the road globally (source: WSJ), but that is expected to increase dramatically over the next few years with China, Japan and Korea being at the leading edge of this trend. According to Pictet (see here), hydrogen fuel cell vehicles should achieve total cost of ownership parity with diesel vehicles within 8-12 years.

Elon Musk is fond of saying that “fuel cells = fool cells”, but I would urge you to ignore him. He may not fancy hydrogen fuel cells, but you should bear in mind that he has a vested interest in not liking this technology. Given the massive commitment he (and Tesla) has made to lithium-ion batteries, why would he suddenly endorse a competing technology? Down the road, fuel cells could potentially wipe out demand for lithium-ion batteries as a way to store energy – a technology he is betting the farm on. It is a complex issue, difficult for mere mortals like me to understand, but all the information I have on hydrogen fuel cells suggests that it will be a key technology in the years to come. You can read more about it here.

One final point: none of the new technologies mentioned in Part I of this paper can yet compete with fossil fuels cost-wise. Therefore, to implement them now would amount to a serious misallocation of capital and thus lead to (even) lower GDP growth. It is an undeniable fact. Having said that, do we have a choice? Sticking to fossil fuels will allow humanity to keep ‘travelling on first class’ but, assuming climate change is not that many years from being irreversible – and more and more climate scientists have started to make that point – the destination you are travelling towards may be somewhere you don’t want to go. As one of my compatriots once said (in a different context): “we may be on the way to hell, but at least it is on first class”.

Niels C. Jensen

21 May 2021

PS. I would like to thank Andy Lees of Macro Strategy Partnership LLP again for providing invaluable advice on this topic. You can read more about Andy and his company here.

About the Author

Niels Clemen Jensen founded Absolute Return Partners in 2002 and is Chief Investment Officer. He has over 30 years of investment banking and investment management experience and is author of The Absolute Return Letter.

In 2018, Harriman House published The End of Indexing, Niels' first book.