Rystad Energy - Energy Knowledge House
Rystad Energy - Energy Knowledge House

Commentary

A klondike in the making – will inflation history repeat itself in renewables?

As the pandemic is about to loosen its grip on global energy demand, another major investment cycle is brewing. This time it is not about fossil fuels, as in 2008/2009, but renewables as the world recovers and transitions to low-carbon energy. With a 22% growth in added capacity for solar and wind generation, and the doubling of added production capacity in the battery sector, unit prices have shown a massive upward trend in 2021, challenging continuous cost improvements for developers and expanding margins for suppliers.

As the pandemic is about to loosen its grip on global energy demand, another major investment cycle is brewing. This time it is not about fossil fuels, as in 2008/2009, but renewables as the world recovers and transitions to low-carbon energy. With a 22% growth in added capacity for solar and wind generation, and the doubling of added production capacity in the battery sector, unit prices have shown a massive upward trend in 2021, challenging continuous cost improvements for developers and expanding margins for suppliers.

The cost of developing fossil and renewable energy has been coming down steadily since 2014 as unit price deflation, coupled with efficiency and productivity gains, resulted in higher output for the same dollar invested. The oil and gas space has seen a steady improvement since commodity prices fell in 2014 and E&Ps initiated major cost cutting programs, while for renewables we have seen that economics of scale, learning curves and technology advancements have lowered the cost-per-megawatt for capacity. However, we could now be seeing a shift in the direction costs are going. Isolating the pure input factors for developing energy, like materials, services, and labor, reveals that the unit prices have been climbing since the second half 2020 and further strengthened in 2021. O&G unit prices are up 1%, wind is up 6% and solar 12%, and it is likely this trend will continue for the next years.

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Solar projects have seen massive improvements in cost deflation over recent years and the cost per energy output – a reduction of up to 43% for dollar per watt – driven by lower unit prices for equipment and services, improved efficiencies and productivity in the supply chain, and also economies of scale. Recently, solar cost reductions have started to taper off and move closer to a floor, currently defined by the prices of the input factors required such as labor, polysilicon, silver, copper, aluminum and steel. These input factors have seen a clear rise in prices in 2020 and 2021. Mono polysilicon, the key ingredient in photovoltaic panels, rose from $7.6 per kg in 2019 to $9 per kg in 2020, and it is likely to average at $18 per kg in 2021. Further, silver, which is important for the connections from the silicon cell to copper wires, increased from $550 per kg in 2019 to $850 per kg (on average) in 2021. With the fact that the PV market absorbs now around 10% of the global consumption of silver, the combined effect of all input factors is that global panel prices have gone up 16% so far in 2021 versus 2020. The weighted price inflation for solar projects, including labor – from installation and other equipment to construction work, which account for an increasing share of overall costs – means total costs are up 12%. The wind industry has also seen a significant hike in prices in 2021. Prices for wind turbines, which account for 70% of the cost for an onshore wind farm and 30% for an offshore one, have increased 6% so far in 2021 compared to 2020.  Within offshore wind, where the installation of foundations, turbines and cables can make up around 20% of overall costs, vessel day rates have climbed up to 25%. Other construction and equipment costs, like foundations and sub-stations, have gone up 9% in 2021 compared to 2020 as steel prices are up 10%-30% so far this year for various grades and pipes due to the doubling of iron ore prices.

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Much of the price growth in 2020 and 2021 is down to the pandemic and the activity recovery across most sectors. The recent steel price surge is due to a couple of key factors. First, Chinese demand for iron ore soared as the country quickly recovered from Covid-19, boosting steel demand on the back of massive government investment programs. This coincided with disappointing iron ore exports from Brazil, where Covid-19 has impacted operations and maintenance activity, limiting output so far in 2021 and squeezing prices from the supply side. Iron ore prices were pushed to even higher levels by the geopolitical clash between China and Australia, which saw the former place high duties on nearly all Australian exports to China. In addition, shipping cost have rose substantially due to more than a doubling of day rates for bulk and container vessels, causing goods transportation to be a larger cost element than in 2019.

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Labor costs have been highly resilient, in large part led by rising wages. Wages for major construction trades such as welders, construction equipment, electricians, construction managers, drivers, and helpers have not dropped across many energy sectors despite a Covid-19-induced downturn, but instead seem to have grown 1%-3% in 2021.

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Meanwhile, as the solar and wind market grows, the need for power storage has increased. Topped with the rising EV demand, the need for lithium-ion batteries sky-rocketed. Battery cell manufacturers have announced several gigafactories to increase production capacity, but demand is likely to outgrow supply by the second part of this decade, despite annual capacity additions anticipated to grow from 200 GWh to 800 GWh by 2025.  This, with potential challenges around mining enough ESG-friendly lithium and cobalt, means prices have jumped up 20%-50% for these important ingredients. As such, battery makers are focusing on securing feedstock supply through long-term contracts and the acquisition of stakes in mining operations around the globe.

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With the rise in prices for input factors across the energy space, project economics might need to brace for impact going forward. While the world shakes off the pandemic in 2022, challenges will persist due to the fundamental accelerating growth of renewable energy investments in light of the energy transition. In fact, comparing the input factors’ inflation for O&G with renewables reveals that the petroleum sector is likely to see only 1% growth in inflation in 2021 compared to 2020, much lower than renewables. The oil sector has been hit worse by the pandemic due to the lower demand from passenger vehicles and aviation. However, the renewable industry, such as offshore wind, has barely been impacted by Covid-19 in 2020. Annual new renewables capacity is expected to grow from 105 TW in 2019 to about 200 TW by 2023, meaning the capacity within the renewable supply chain, like wind turbine and solar panel manufacturers, will start to see utilization maximized creating a potential price surge. This is especially a worry for semi-conductors, lithium, polysilicon, high-end materials and alloys.

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The fundamental trend of seeing energy investments move from molecules to electrons, coupled with a post-pandemic industry-wide recovery, could mark the beginning of an inflammatory environment within renewables, which can only be compensated by further improvements to project designs and productivity. This will be a challenge that energy developers will have to manage carefully to ensure that projects turn profitable. But that risk will be an opportunity for suppliers – this could turn out to be another klondike, where the massive and rapid shift can create many years of value generation for the supply chain. Investors seems to be valuing renewables suppliers the most in this shift and have already taken their bets. We have seen this happen before in oil and gas, like in 2004-2008 and 2009-2014, and now history is likely to repeat itself, just not in oil and gas but in renewables.