Apr 14 - Business Week

For most of its nearly four-decade history, Earth Day has been a call to safeguard such precious resources as clean air and water for future generations, resources put at increasing risk by pollution. Lately, though, the annual April observance has also become a time for investors to take stock of the clean-technology opportunities in energy that have arisen in recent years.

One thing to keep in mind is that, despite virtually assured growth of these industries, bets on individual stocks require more patience than investments in sectors where companies are already serving fully developed markets. In some cases, what makes a company a really compelling bet is the fact that it hasn't yet turned a profit -- and is priced accordingly.

Much of what's driving the push toward cleaner energy sources and greater energy efficiency is the prospect of legislation within the next few years that will effectively impose a carbon surcharge on companies that are producing carbon emissions beyond certain defined limits.

Tariffs Are a Risk

Such legislation will likely be in place by 2012 in order to enable U.S.-based companies to keep up with global emissions standards expected to be enforced in 2013, when the Kyoto protocol gives way to the next phase of global environmental compliance, says Kevin Book, senior energy policy analyst at Friedman Billings Ramsey (FBR).

Any country that hasn't taken steps to regulate carbon emissions from its own industries by then will probably be hit by tariffs from trading partners, predicts Book. "If the U.S. is not up to global standards, it could be disruptive from a trade and economic perspective," he says. "Any economy that wants to play in that game is going to want at least one year of lead time."

Another factor that's ushered in demand for clean technology is the much greater cost of adding electric generation capacity in the traditional way -- by building new power plants, which would also soon face the uncertainty of carbon caps. The failure to build new power plants has caused spare capacity on the electric grid across the U.S. to fall off to the point where it's below comfortable safety margins in certain regions. That makes local communities more susceptible to brownouts and blackouts during peak-usage periods.

A Challenge for U.S. Investors

Also, 25 states have adopted renewable portfolio standards that mandate that utilities garner a certain portion of their generation capacity from renewable sources such as solar and wind. Some states are far ahead of the curve on this, such as Connecticut, which extended its standards to all utilities across the state in 2003.

Where can investors interested in clean technology start? Some of the most promising renewable energy stocks -- including Vestas Wind Systems (VWSYF), SolarWorld (SRWRF), and Q-Cells (QCLSF) -- trade only in Europe or over the counter in the U.S., making it hard for U.S. investors to get a piece of the action. But in each subcategory, there are stocks that are available on American exchanges.

Although solar power still has a way to go until it is priced comparably to coal- or gas-fired electricity, it's becoming more compelling to utilities that aren't able to build more power plants and want to meet renewable standards, and to consumers who like the idea of doing their part in reducing greenhouse gas emissions.

Silicon Solar Cells Will Be Edged Out

The dominant solar technology is currently based on silicon, a nonmetallic substance that is packed into wafers that fit into panels, which absorb sunlight and convert it into electricity and heat. Eventually, however, silicon solar cells are likely to be edged out by thin-film cells, which at the moment aren't nearly as efficient as silicon-based cells.

While most solar panel manufacturers understand that they will eventually need to make the transition to thin-film, only two -- SolarWorld and SunTech Power Holdings (STP) -- have made public statements about their intention to do so, says Jack Uldrich, who heads a nanotechnology consulting firm and writes about investing in emerging technology for The Motley Fool Web site.

"The manufacturing economics tell me the future is in thin-film, as well as flexible polymers, and not silicon," says Uldrich. "Both [SolarWorld and SunTech] are positioning themselves to take advantage of that," he says. At the same time, they maintain strong positions in silicon.

Wind Generation May Have Reached Maturity

The long-term supply contracts that both SolarWorld and SunTech have secured at fair prices will enable them to ride out any fluctuations in silicon prices. The contracts also include the flexibility to renegotiate rates if silicon prices fall, Uldrich says.

Unlike solar power, which still has a lot of room to run, wind generation has reached its maturity, he believes. Major players such as Siemens (SI), Vestas, and Spain's Gamesa (GCTAF) will keep building generation capacity, but he argues that the potential for high growth is no longer there. Part of that is due to the huge land requirements that wind turbines necessitate, he says.

FPL Energy, an unregulated division of FPL Group (FPL) has adopted a new strategy that takes advantage of the fact that wind power has matured to where it can now compete with natural gas-fired capacity, says Angie Storozynski, a utilities analyst at Macquarie Research in New York, who has an outperform rating on the stock. [Macquarie Capital USA or an affiliate expects to receive or intends to seek compensation for investment banking services from FPL Group in the next three months.]

FPL Goes for a Merchant Strategy

Until recently, FPL Energy has sold its wind power, most of which it produces outside of its regulated territory in Florida, to other utilities under long-term, fixed-price contracts. But a sustained surge in natural gas prices has spurred the company to shift to a merchant wind growth strategy for the next few years. FPL believes it will be able to get bigger margins from higher gas prices, since gas determines the marginal price of power in most U.S. markets.

FPL is also betting that the merchant energy strategy will enable it to capture more upside from utilities if carbon costs are imposed by legislation, something regulators wouldn't permit under contracts, says Storozynski. Down the road, once FPL feels that gas prices have stabilized, it plans to switch back to long-term contracts for wind power, but at higher prices. "The longer they wait to fix their prices, as utilities get closer to deadlines for renewable portfolio standards, they will be willing to pay up for wind," she says.

The strategy also exposes FPL to risk from volatility in gas prices. The company can hedge that risk in the short and medium term to smooth its earnings but is likely to see more ups and downs in profitability over the long term, she warns.

Reducing Consumption During Peak Usage

While wind has reached maturity, there are research efforts in Denmark aimed at developing smaller wind turbines that can operate at lower wind speeds and cooler temperatures. That could lead to equipment that can derive two to three times as much energy per acre of land as larger turbines. "That could kick the wind sector back into high growth, but I don't see that coming on line any time in the next two to five years," Storozynski says.

There's also a nascent industry taking shape around a concept called demand response, under which residential and business customers agree to be connected to equipment that reduces their energy consumption at times of peak usage or because of market prices. Companies such as EnerNOC (ENOC) and Comverge (COMV) provide electricity monitoring systems. "The cleanest, most affordable type of energy efficiency is never using energy in the first place, and that's exactly what these companies help utilities to achieve, and consumers," says Uldrich.

"As sensors get more effective and drop in price as a result of advances in the semiconductor business, they will find more opportunities and be able to go into more people's homes with these smart networks," he says. "There's a lot of efficiency still to be squeezed out of the system and both those companies are close to figuring out how to do it."

Multiyear Contracts Make Revenue Predictable

Rob Stone, an analyst at Cowen (COWN) in Boston, advises investors to look at companies such as Comverge as bets that will pay off over the long term, once they have put the up-front expenses of building out an intelligent network for reducing usage in homes and businesses behind them. [Cowen and/or its affiliates received compensation for investment banking services from Comverge in the past 12 months and makes a market in its securities.]

"What [they're] doing is building up a base of assets that will produce long-term recurring revenue and very good cash flow, particularly in the case where they can sign a new contract on an existing fully depreciated network," Stone says.

Even though he doesn't expect Comverge to be profitable until 2009, Stone has an outperform rating on the stock. As the company continues to sign up new customers, it will add on layers of recurring revenue from utilities, which pay according to the number of megawatts under management, he says. And the multiyear contracts it has with utilities ensures that revenue will be fairly predictable year by year.

Congress Expected to Cap Carbon Emissions

Geothermal energy, which is produced by pumping water into volcanic rock, also has a lot of potential for growth, says Uldrich. One big advantage that geothermal power has over solar and wind is that it's considered base load generation that can be relied upon all the time, no matter the weather conditions or time of day. It's also sustainable because the hot water used in the energy-generation process can be reinjected into the ground to produce more steam.

It's highly likely the next Congress will enact some kind of legislation that puts a cap on carbon emissions, which would make geothermal power that much more attractive, as it's a genuinely clean energy source, Uldrich says.

He particularly likes Ormat Technologies (ORA), which develops and operates geothermal and recovered energy-based power plants, and also makes and sells power units and other power-generating equipment. The Nevada-based company has good opportunities, having already leased a great deal of land in Nevada and parts of California, "so they have the right to begin developing geothermal plants on that space."

Calpine (CPN), which emerged from bankruptcy in January, owns the world's largest geothermal power facility, known as the Geysers, in Northern California.

A Large-Scale Update of Old-Tech

Book at FBR predicts that opportunities in environmental retrofitting of old technology to make it more climate-compliant will "be the biggest part of green." He believes it will turn out to be a three-decade, multitrillion-dollar effort that will dwarf the amount of clean technology that gets rolled out.

To keep older power plants firing under a carbon-cap regime will require sequestering carbon, or injecting it into the ground, which is not yet viable or without risk, says Book. That will mean a lot of carbon pipelines and sequestering plants will have to be built.

Ironically, it may turn out that the most lucrative bets for those who want to hitch a ride on the green bandwagon will be in companies with inextricable ties to the fossil fuels industry: pipelines. "The first movers [in building the new facilities] are pipeline companies," says Book. "They're in that business now and they want to be in that business in the future." Besides having already built carbon pipelines for enhanced oil recovery in the Gulf Coast and parts of Alberta, Canada, pipeline master limited partnerships have the added advantage of a favorable tax structure, Book says.

With a little homework, green-focused investors may be able to find some plays that are Earth- and wallet-friendly.