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Investing in China green: proceed with caution PDF Print E-mail
Written by James Ockenden   
Feb 06, 2011 at 05:24 PM

Dark days ahead for
China's renewable sector
On paper, China's renewable energy story is one of the most compelling energy investment themes around. The country has pledged a significant portion of its future energy to renewable energy; Chinese component manufacturers hold considerable selling power in the domestic market; and high profile cases such as Suntech's IPO – which made its owner the richest man in China at the time – have generated an investment buzz which can be hard to resist.

But while there is no doubt renewable energy will provide an increasing slice of China's energy pie, investors wishing to participate should not get carried away by the short-term hype. According to at least one private equity investor, China's renewable sector is in trouble, while a closer look within the industry reveals deep systemic problems which, until solved, make Chinese renewable energy a far riskier proposition than at first appears.

Oversupply

Green sector faces a painful
correction says Lewis Wan
In his latest book, Winning at Private Equity in China, private equity investor Lewis Wan says the renewable sector is overheating. In fact, he foresees a painful correction in the near term.

According to Wan, Chairman and Chief Investment Officer of The Pride Group, the aggressive pursuit of "green tech" by provincial and local governments is causing a bubble in the component supply business. Wan says such overheating only becomes apparent with thorough company visits in China, and that analysts in New York, London and Hong Kong may be viewing a far rosier picture than actually exists on the ground.

As he says, Wan expects a "serious and painful consolidation in the short term" and will not be investing in any renewable projects for the time being.

Industry insiders in China’s energy market concur – former Ministry of Energy consultant Zhou Fengqi says there is no such thing as "overcapacity" in China’s wind power business, but agrees there is certainly short term oversupply. The distinction between oversupply and overcapacity should not be lost on investors. Long term industry growth will mop up overcapacity. But most investors do not invest in such broad generalities as long term prospects. Oversupply means failed short term earnings and real pain for investors choosing the wrong stocks.

Taking a more optimistic view than Wan, Zhou says that oversupply could be relieved through export markets – but as we will see, demand in international markets is drying up, and in many cases Chinese equipment manufacturers are a long way from meeting international supply chain quality standards. Export will not save the industry overnight.

Birth of the greerush

To give investors some idea of the true picture in China's renewable landscape, we can take a closer look at how the bubble in green tech has formed. In particular, we will look at the wind turbine industry – just what has prompted this wind turbine gold rush?

Blue Skies China tours the RMB1.5bn 150MW Longyuan
Wind Farm, Jiangsu Province, which uses GE's 1.5MW
turbine model and has generated 1.34bn kWh in its
first three years of operation.

According to Dr Bruce Yung, Managing Director of wind developer Hong Kong Energy, there are three key drivers for the renewable business in China. First, the country is aiming to reduce its dependence on foreign oil. Second, renewable power makes sound economic sense, in terms of creating new jobs, improving electricity supply in rural areas and growing the country’s domestic machinery sector and export potential. Third, of course, are China's environmental commitments, made sound in its 11th Five Year Plan and bolstered with its comprehensive Renewable Energy Law.

Among these factors supporting "green" energy, wind power emerges as the favourite supplier. China has ample wind resources, potentially up to 1,200GW. The government’s support of the wind industry is enthusiastic; it has pledged to raise installed capacity from 25GW to over 150GW; and finally wind energy is the most competitive renewable energy in China. According to Yung, the price gap between coal energy and wind energy is closing, Turbine prices have come down 25-30% in the last 12 months, he says, while incentives such as carbon pricing and disincentives such as coal fuel taxes mean price parity is within sight. Zhou agrees, although he says the costs are still high compared with traditional energies. "The industry is too reliant on subsidies," he says, while noting wind turbine efficiency is improving and costs are reducing.

Whether banks will lend on a 25 year project based on artificial policy tariffs remains to be seen – but even without such market manipulations, wind power is becoming a genuine price contender for some applications.

All the factors outlined by Yung above have contributed to the wind power goldrush and the problem of oversupply. The double whammy is that, oversupply is also being met with a global slowdown in wind turbine equipment demand.

In Europe, turbine makers are facing difficulties. In September, The Economist reported that, two years ago manufacturers' main worry was a shortage of components. It was only natural that component manufacturers would ramp up, new players would enter the market, and new supplies would flood the market.

But the story is very different now. Demand for these machines in Europe has slowed to a crawl. Electricity demand is weakening; renewable fever is waning; financing new wind projects is difficult. Indeed, a spokesman for the world's largest turbine maker Vestas, told The Economist the collapse of Lehman Brothers had a significant impact. "Lehman Brothers was a sort of a switchboard for the industry – and they didn’t pick up the phone anymore," he is reported as saying.

These are distinctly European problems – in fact, in China there is no shortage of capital for quality wind projects, and, as we have noted, longer-term demand for the machines is fundamentally there. But within the time horizons of many stock and private equity investors, there is a deeper rot threatening investments in Chinese wind energy companies. Long-term demand exists. Quality does not.

Shaky foundations

Quality control: a lego man inspects
a turbine blade for Danish firm Vestas
in this display promoting wind power
at Shanghai airport.
On the sidelines of a recent high level wind energy conference in Nanjing, one local quipped that the best way to invest in China’s growth story was to buy shares in German automakers. Audis, in particular, are the status symbol of successful local government officials and a quick straw count of the Nanjing Aqua City parking lot revealed every third car was German.

But government officials do not yet apply the same quality standards to local power equipment as they do to their own automobiles. When it comes to wind power equipment, price, not quality, is the deal-maker, and the issue is beginning to rear its head. Zhou spoke of cracked gearboxes, and literally shaky foundations for wind turbines made in China. "Many accidents happen," he said. "We need to reduce the accidents – and if there is an accident, we need to pay compensation."

In fact, the price competition is such that even western manufacturers are aiming to bring down the quality of their products to compete. According to one insider, Siemens is stripping out standard refinements such as elevators from its wind turbines to bring the cost closer to its domestic Chinese competitors. It is a frustrating situation for the foreign suppliers, and it is peculiar to this industry. Could we imagine Audi stripping out electric windows to compete on price?

Zhou says this is the new barrier for wind turbine growth in the country. "The biggest bottleneck previously was electrical, gears, bearings," he said. "Now we have all these components – but people don’t trust the quality. People need to pay more attention to certification," he said.

The quality problem runs deep – or rather, it runs too shallow. While European turbine makers instil quality management systems before the engineer first picks up a pencil, in China quality management applies, if at all, to the finished product assembly. An executive from certification firm DNV told the Nanjing conference that, for Chinese wind turbines to go abroad, the companies need to start from scratch.

"Certification in Europe is involved from the beginning of the design and considers all elements, from strategy, planning, design, manufacture – this makes a complete certification procedure," said Yuan Feng, Business Development Leader, DNV Cleaner Energy & Natural Gas. "But in China, there are gaps."

According to one Finnish consultant, working on a China outreach programme, there are literally hundreds of wind turbines sitting in warehouses across the country, unusable. "They simply don’t work," he says.

Although it seems against their best long-term interests, Chinese wind farm developers continue to compete on price, but the pressure is on. For investors, the quality problem is a time-bomb waiting to go off. According to a consultant with one of the certification companies, the industry will receive an ugly wakeup call this Year of the Rabbit. Most manufacturers guarantee their equipment for two years – and in early 2011, a rash of equipment built during the last wind rush of 2008 will fall out of manufacturers' guarantee. The certification companies are doing their best to find problems, for example TUV is offering a complete wind farm inspection service, but it is likely serious problems will surface across the country. Cracked gearboxes, with a telltale bloom of black oil spreading across the nacelle, are commonplace already.

While wind farm operators continue to order based solely on price, the landscape is changing, and quality is gaining more attention. Indeed, at a lunch given by a local government official to celebrate a visit by a western delegation, nearly three quarters of the guests at the official's table were from quality assurance or certification companies. You don't need to be a weatherman to know which way this particular wind is blowing.

But for investors without direct experience in renewable energy, how to pick the company which is supplying these time bombs? How to invest in the right component manufacturer rather than a lemon? Companies are, according to one certification expert, telling blatant lies to their customers – we should not expect such companies are being entirely truthful with investors either.

Positive signs

The answer is, first of all, to look for a commitment to quality. Commercial lending is a positive sign. While banks have traditionally spurned risky wind farm investments of loans, there are signs that this could be about to change.

HSBC's Jonathan Drew: good
projects will find money
Indeed, Jonathan Drew, a Hong Kong based Managing Director, Global Banking with HSBC says commercial banks are now ready to bet on wind farms.

Traditionally, wind farms are risky investments, with sketchy tariff structures and unreliable power output, together with relatively new technology. An LNG plant, for example, will enjoy a fixed price fuel contract over the 125 year life of the project. Nobody knows what the price of wind energy or carbon subsidies will be in three years, let alone 25. But HSBC's joint US$60 million loan, with Bank of Communications (BOCOM), to build the 49.5MW AEI/NBT Jilin wind farm in Baicheng is a signal of change. Drew outlined the reasons why this project was the first project to attract commercial lending in China, and his checklist makes a good benchmark for investing in any renewable project and for investigating investments in underlying equipment and component suppliers.

Success story: seven factors contributing to HSBC’s commercial support of the Baicheng wind farm

  1. The wind resource assessment was carried out by respected international consultants Mott Macdonald
  2. The project underwent a thorough technical analysis.
  3. Grid connections and tariffs were already in place – a key factor in wind projects, which grid companies traditionally find troublesome.

  4. Construction risk was mitigated with fixed price contracts.

  5. The project featured a cashflow buffer mechanism to protect the company in case of delays in central government tariff payments.

  6. Carbon credits were all set in place and approved.

  7. The clients had strong experience, skills and track record internationally and in China.

These are the projects which will boom in China. For capturing this opportunity, stock-picking investors can seek quality component firms and overseas firms building an established China presence. From the operator side, the big state-owned companies dominate - there are few private operators, although Hong Kong Energy is one fast growing player, with the benefit of being listed in Hong Kong. Meanwhile, a diluted exposure may be obtained with investments in the commercial banks which are opening their doors to wind power for the first time – such as HSBC and BOCOM.

In the meantime, we would advise investors to take great care when looking at individual component companies. The winners will be those working with quality certification companies, those who have successfully joined the international supply chain.

As a benchmark, Siemens has 50 people in Shanghai qualifying its wind turbine component supply chain, and as yet has covered just 70% of the components for its new domestic 3MW machine. "Keeping this quality is a huge effort," says an engineer with the company, "and if we didn’t make this effort, [our suppliers] would not stick to the quality requirements, I am sure." According to the engineer, local suppliers do not have the same quality management, allowing them to compete hard on price.

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