Show notes
While the war in Ukraine has had an effect on the current pricing in European energy markets, there is more to the story of why high prices could persist for years to come. Chief Cross-Asset Strategist Andrew Sheets and Head of European Utilities and Clean Energy Research Rob Pulleyn discuss.-----Transcript-----Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan Stanley's Chief Cross-Asset Strategist. Rob Pulleyn: And I'm Rob Pulleyn, Head of the European Utilities and Clean Energy Research Team. Andrew Sheets: And today on the podcast, we'll be talking about the outlook for European energy supply and demand, in both the near and long term. It's Monday, May 9th, at 4 p.m. in London. Andrew Sheets: So, Rob, we talked a lot on this podcast since March about the effect of the Russia-Ukraine conflict on energy in Europe. I want to talk to you today in part because there are some interesting implications over the long term in the European energy and power markets. But just to level set a little bit what's been going on in European power prices. Rob Pulleyn: Sure. For context, Andrew, what's been happening is that European power prices versus 12 months ago are up between 150 and over 300%, depending on which country. They're pretty much at all time highs or slightly off them from where we were earlier this year. Now, what does that flow through to customer bills in places like the UK? Year over year customer bills are going up 60% so far, other country's a little bit lower due to some market intervention. But this is the backdrop. Andrew Sheets: Now, you've been talking to a lot of global investors around what's been going on in Europe. What's your most likely case? What's your base case? And then what are some realistic scenarios around that? Rob Pulleyn: We outlined four scenarios in the new note. The base case is that we get close to the FIT for 55 climate plan from last year, which envisages 65% renewables penetration by the end of the decade. Now, this is a long way short of the Repower EU plan, which would envisage about twice as much again in terms of the renewable capacity and getting to about an 80% penetration by the end of the decade. And so we see significant growth in renewables. We think coal will be phased out more or less by 2030, but with more burn in the next few years, less gas until gas supplies can be diversified. In terms of market intervention, we continue to think this will be relatively benign for utility stocks because effectively governments need to find a way to help the customer, but also ensure that utilities actually invest in the new power system that governments want. Andrew Sheets: But Rob, under your central scenario where power prices are significantly higher, isn't there a feedback mechanism there? Aren't people going to look at their sharply higher utility bills and say, I'm going to use less electricity, I'm going to put in double glazing, I'm going to improve my insulation, I'm going to do all these things that mean I use less energy. Which would hopefully mean less energy gets used and the power price impacts would be less significant. How much can energy efficiency influence the story or not? Rob Pulleyn: Now you're quite right. Demand destruction, one way or another, is part of the equation here. There's many renovation tools or new technologies which are now significantly more attractive in economic terms, simply because gas prices and power prices are so high. And whilst previously we thought there'd be a slow burn on many of those routes under the guise of decarbonization, now under cold, hard economics, as you highlight these things should all accelerate. And if I was going to point to one area of incremental policy support, I think it's got to be green gasses like hydrogen. I think that's a genuine route to both diversify gas supplies and also decarbonize. Andrew Sheets: So Rob, how do you think about the interplay between the economic backdrop and these power prices? Because it's been the energy shock from the conflict in Ukraine that's driven power prices up, but it's also been something that's led people to worry that European growth might slow, which would reduce the demand for power. So how does that play out as you're thinking about these various scenarios? Rob Pulleyn: Sure, it's a great question, Andrew. And let's just start by saying that as it stands today, utility bills contribute around about one third to the inflation rate that we have at the moment. And therefore, if these power prices and gas prices will persist as they stand, then that inflation will also be reasonably persistent. Now, of course, there is still upside risk to power price and gas prices in several scenarios, particularly those where supplies are interrupted, which would then create higher inflation on top of the rates we currently have. This would therefore then flow into the bear case that our economists have for GDP growth. And so the economic impact would of course, be there. Ultimately, GDP is sensitive to the input costs and energy is one of the biggest there is. Andrew Sheets: Rob, I also want to ask you about where technology fits into all of this. There are both some exciting advances in energy technology. On the renewable side, renewable energy is getting more efficient. We're seeing some interesting advances in battery storage. When you are trying to model European power consumption out over the next decade, how much of a technological impact are you putting in your numbers? Rob Pulleyn: Yeah. So the easy one to talk about is renewables, which is currently about 38% of the European stack. The Repower EU would imply something around 80%, which coincidentally is actually also the German target. Fit for 55 has a plan of 65% across the EU by 2030. We're modeling 62%. So significant increase from where we are today. And of course, where we are with power prices at the moment, then investing in European renewables is actually looking very attractive. I mean, very simply put, the offtake price is increasing more than the input cost inflation. That should lead to, you know, the right incentives to build more of these things. We talked about green gasses earlier. Now, whether it be market forces, the gas price, whether it be government support, ultimately we think green gasses is going to be accelerated and that can certainly help the economy beyond the power generation sector. So within European gas demand, power generation is around about 30% of it. The other two thirds, broadly evenly split, are residential heating and industrial heating furnaces and processes. And certainly hydrogen could be, in the long term, a solution for those aspects. Battery storage is a question we get a lot, particularly from the states where actually we're seeing some quite, quite stunning improvements in battery uptake. In Europe that is relatively small scale, but something which could also dramatically increase across the decade. Andrew Sheets: So, Rob, with all of this in mind, what should investors be looking at in European utilities and energy? Rob Pulleyn: Our preferred beneficiaries within the narrow definition of utilities and clean energy would be to combine the defensive nature of networks with clean energy growth. Right. And I think ultimately that that will be a very powerful combination for what the market's looking for with a macro backdrop. Your benefit for green growth from all the policy support and from the high power prices, at the same time, retaining these defensive qualities that the market increasingly seems to have an appeal for. A slightly more optimistic take would be to try and get that real power price sensitivity through some of the outright power producers, whether that's nuclear, hydro or renewables. Those stocks should benefit from significant earnings upgrades over the next few years. Andrew Sheets: Rob, thanks for taking the time to talk. Rob Pulleyn: Well, has been great speaking to you, Andrew. Thank you very much. Andrew Sheets: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.