China's Greenhouse Gas Cap Could Spark Solar

China’s subsidies to domestic solar companies have been the backbone of that sector’s growth – even as longer-term investors have been subject to continuous whipsaws in the country’s solar stocks.

However, a recent development has helped spark another near-term rally while also providing a possible backdrop for longer-term optimism.
As part of his visit to the US late last month, China President Xi Jinping committed to the start of a national program in 2017 that will limit and put a price on greenhouse gas emissions in China.

The move to create a so-called cap-and-trade system would be a substantial step by the world’s largest polluter to reduce emissions from major industries, including steel, cement, paper and electric power, according to a New York Times article announcing the plan.

Domestic and external pressures have driven China’s government to firmer action to curb emissions from fossil fuels, especially coal. Growing public anger about the omnipresent noxious air that envelops Beijing and many other Chinese cities has prompted the government to introduce restrictions on coal and other sources of smog, with the side benefit of reducing carbon dioxide pollution. The authorities also see economic benefits in reducing fossil fuel use, the Times said.

More on point for Chinese solar stock investors, however, was Xi’s pledge to put in place a “green dispatch” program to create a price incentive for generating power from low-carbon sources, officials said.

China also will help provide financing to poorer countries to help them pay for projects that reduce harmful emissions. In addition, the country agreed to “strictly limit” the amount of public financing that goes toward high-carbon projects, in line with a 2013 commitment by the US Treasury Department to cease public financing for new coal-fired power plants.

Many Chinese solar stocks have rallied since news broke of China’s intentions on Sept. 24. Trina Solar Limited TSL, which has a 20.9% weighting in the Chinese Solar motif, has gained 17% in that time.

The Chinese Solar motif has gained 14.6% in the past month alone. The S&P 500 has increased 2.9% in that same period.

Over the last 12 months, the motif has fallen 16.2%; the S&P 500 is up 5.8%.

It’s worth mentioning, however, that the start of the latest rally in Chinese solar stocks pre-dated Xi’s visit to the US – indeed, the Chinese solar motif has gained about 20% since late August, after falling nearly 50% in the previous four months.

In fact, just days before China’s cap-and-trade plan was announced, Goldman Sachs analyst Frank He upgraded Trina Solar to buy, citing both the bullish seasonality dynamic of Chinese solar stocks as well as their dropping valuations.

According to Barrons.com, the Goldman analyst noted that “most tier-one module makers indicate a full order backlog in 2H15, with some order inflows in 1Q16….Historically, solar companies’ 2H earnings are higher than 1H in general, due to higher product sales and margin.”

Second, valuations had plunged. The large solar stocks were on average trading at 6.7 times forward earnings, well below the historical average of 12 times and one standard deviation below the mid-cycle of 9.5 times. In addition, most solar companies still generate reasonable cash returns, with 2015 cash return on invested capital averaging 15.2%, according to He. “The current valuation has largely priced in the headwinds,” He wrote.

On top of that, China’s National Energy Agency is reviewing the 13th five-year plan right now and is likely to revise up the government’s planned installed capacity to 150GW from 100GW by 2020.

Goldman’s upgrade of Trina projects the company accomplishing “market share gain, cost reduction in the module business and ramp-up of downstream projects.” The analyst slapped a $12 price target on the stock, implying upside of another 17% — even after a 12% run-up over the last month.

Chinese solar stock forecasts may need to be taken with a grain of salt. But investors with a higher-risk profile may be intrigued in the possibility for continuing outperformance by the entire sector.