Oil Prices and the Renewable Energy Sector.

• Author: Kyritsis, Evangelos

1. INTRODUCTION

   The renewable energy sector has been experiencing remarkable growth over the past decade. Worldwide installations of renewable power capacity reached a new high record of 138.5 GW (1) in 2016 (New Energy Finance, 2017), and expectations for large-scale deployment of renewables have also been raised for years to come. Figure 1 depicts the contribution of each fuel source in electricity generation in OECD countries and highlights the rapid integration of renewables during the recent years. (2) This development, however, is not a result of a single factor or event, but rather a combination of economic and societal concerns associated with the reliability and security of energy supply, the depletion of natural resources, extreme weather events triggered by environmental degradation, and decoupling of economic growth from energy consumption. Moreover, the financial performance of renewable energy companies has a critical influence on the future development of the renewable energy sector, since companies' profitability is positively related to their success in acquiring private capital for infrastructure investments. Therefore, a better understanding of the underlying driving forces is of high interest, not only to investors who need to assess the risk exposure assumed by their firms, and construct hedge ratios and portfolio weights accordingly, but also to policymakers who must evaluate and adjust the renewable energy policy landscape, in order to facilitate the transition towards a sustainable energy system.

   This paper contributes to the literature on the relationship between the price of oil and the stock returns of clean energy and technology companies in several ways. First, we use monthly data over the period from May 1983 to December 2016, and estimate a bivariate GARCH-in-Mean structural VAR model by full information maximum likelihood, thus avoiding Pagan's (1984) generated regressor problems. By doing so, we directly investigate the effect of oil price uncertainty on the response of the renewable energy and technology stock returns. Second, we generate the impulse response functions to assess whether the response of stock returns is symmetric or asymmetric to positive and negative oil price shocks, after accounting for the effect of oil price uncertainty. As an additional contribution to the literature, the use of a test, recently introduced by Kilian and Vigfusson (2011), over the same data set allows us to investigate whether the renewable energy and technology stock returns respond symmetrically or asymmetrically to positive and negative oil price shocks of different magnitude.

   Financial performance of renewable energy companies is contingent upon numerous factors, and in fact prices of other energy products that are likely to substitute for renewable energy, for instance, through their positive cross-price elasticities, are considered to be among the most important determinants. Hence, with crude oil being the dominant energy source in the world, accounting for 36.9% of the global primary energy consumption in 2016 (Energy Information Administration, 2017), (3) it is essential to investigate the relationship between the oil price development and the financial performance of the renewable energy sector. Although the contribution of crude oil is decreasing over time in electricity generation, where the majority of renewable energy technologies are predominantly used, other fossil fuels such as coal and natural gas still dominate the electricity supply mix (see Figure 1). In fact, natural gas emerges as a considerable source of the electricity production mix, since it supports the flexible peak-load power generation that complements the intermittent nature of renewables (Kyritsis et al., 2017). Empirical studies, however, investigate the interactions between fuel prices and provide significant evidence of spillovers. In particular, Efmova and Serletis (2014), in a notable study, find unidirectional price spillovers from crude oil to natural gas and electricity markets, thus underlining the importance of crude oil in the U.S. economy. Hence, although crude oil and renewables seem to operate in different markets, they do interact with each other both directly and indirectly through other channels of influence.

   Apart from the vast majority of the literature that investigates the effects of oil prices on the economy, the aggregate stock market activity, or even other energy prices such as, for example, the natural gas price, only a few studies pay particular attention to the impact of oil prices on the financial performance of the renewable energy sector; the most noticeable being Henriques and Sadorsky (2008), Kumar et al. (2012), Broadstock et al. (2012), Sadorsky (2012a), Managi and Okimoto (2013), Wen et al. (2014), Inchauspe et al. (2015), and more recently Reboredo et al. (2017). All of these studies, however, ignore the potentially important effect of oil price uncertainty on renewable energy companies, and more particularly on their financial performance.

   Since the outset of the global financial crisis in 2008-2009, the crude oil market has experienced dramatic oil price fuctuations, for instance from $140/barrel in the summer of 2008 to $60/barrel by the end of 2008, which were followed, after the sharp downturn in the mid-2014, by low and remarkably volatile oil prices (see Figure 2a). Increased oil price volatility translates into significant uncertainty in the crude oil market, and its overall impact should accelerate future transition towards renewable energy. The main argument behind this statement is that with renewable energy considered as a substitute for crude oil, increases in oil price uncertainty should encourage a substitution effect away from crude oil towards renewable energy sources, thus improving the financial performance of renewable energy companies. We read in a press article: "But perhaps the biggest factor is one of the least tangible: uncertainty... people working in renewables say that the volatility in oil is precisely the reason to go green--prices are more stable, with fewer ups and downs" (BBC news, 2015). However, despite some anecdotal evidence that rising oil price uncertainty strengthens the dominance of the renewable energy industry in the global energy scene, and therefore its financial performance, an up-to-date empirical evidence is imperative to confirm or invalidate the hypothesis.

   The rest of the paper is structured as follows. In section 2, we review and discuss the empirical literature related to the effects of oil price on the aggregate and industry-specific stock returns, while paying special attention to the relationship between oil prices and stock returns of clean energy and technology companies. Section 3 presents the bivariate GARCH-in-Mean structural VA R model, which is employed to investigate the direct effects of oil price uncertainty on the employed stock returns, as well as the impulse response functions that are employed to evaluate the effect of oil price uncertainty on the response of stock returns to an oil price shock. In Section 4 we present the data and discuss the empirical findings, while in Section 5 we investigate whether the stock returns respond symmetrically or asymmetrically to oil price shocks of different signs and magnitudes, by using a formal symmetry test based on a nonlinear structural VA R model recently proposed by Kilian and Vigfusson (2011). The last section discusses the findings and concludes the paper.

2. REVIEW OF THE LITERATURE

   2.1 Oil Prices and Stock Market Activity

   Given the indispensable role of crude oil as an energy commodity in the world economy, but also as a financial asset since the early 2000s, there is a substantial and growing body of literature investigating the relationship between oil price shocks and stock market returns. On theoretical grounds, stock prices reflect the value of expected future earnings of companies that contingent on several factors, such as relative sensitivity to changes in oil prices or dissimilar dependence on the oil industry, might be driven by oil price shocks. In regard to this, Chen et al. (1986) and Hamao (1988) study the effects of oil price changes on the U.S. and Japanese stock markets, respectively, and find no compelling evidence that supports such a relationship. Kling (1985) and Jones and Kaul (1996), in contrast, argue that changes in oil prices have a detrimental effect on stock market returns, while Sadorsky (1999) confirms that oil price fuctuations are imperative for understanding stock market development. Huang et al. (1996), however, find no negative relationship between changes in the price of oil futures and the returns of various stock indices; while Wei (2003) reports that the decline in the U.S. stock market in 1974 cannot be attributed to the 1973-1974 oil price increase. In fact, he suggests other possible factors, including the tightening of monetary policy. This view also receives strong support from Bjornland (2009), who examines the small and open oil-exporting country of Norway, and argues that oil prices affect stock market returns indirectly, through monetary policy.

   A possible explanation for all the aforementioned studies not reaching a general consensus is that none of them, apart from Bjornland (2009), differentiates oil-exporting from oil-importing countries. Wang et al. (2013) compare the relationship of oil price shocks and stock returns in several countries with different oil-dependence, and find that the explanatory power of oil prices shocks to stock return variations is stronger in oil-exporting than oil-importing countries, as well as the evidence of different magnitudes, durations, and directions of stock response. Arouri and Rault (2012) support this view through their study, with particular reference in the Gulf Corporation Countries, finding a positive relationship between oil price shocks and stock...