Value investing: myth and reality

Value investing: myth and reality

Recently, I came across an interview of Berkshire Hathway’s vice-chairman Charles Munger (A Fireside Chat with Charlie Munger, Wall Street Journal, 12 September 2014) where he states the peril of value investing as espoused by Benjamin Graham—“picking up cheap, cigar-butt stocks”. On Graham, whom Warren Buffett revered, Munger said, “I don’t love Ben Graham and his ideas the way Warren does. You have to understand, to Warren—who discovered him at such a young age and then went to work for him—Ben Graham’s insights changed his whole life, and he spent much of his early years worshiping the master at close range. But I have to say, Graham had a lot to learn as an investor. His ideas of how to value companies were all shaped by how the Great Crash and the Depression almost destroyed him, and he was always a little afraid of what the market can do. It left him with an aftermath of fear for the rest of his life, and all his methods were designed to keep that at bay.

“I think Ben Graham wasn’t nearly as good an investor as Warren Buffett is or even as good as I am. Buying those cheap, cigar-butt stocks (companies with limited potential growth selling at a fraction of what they would be worth in a takeover or liquidation) was a snare and a delusion, and it would never work with the kind of sums of money we have. You can’t do it with billions of dollars or even many millions of dollars. But he was a very good writer and a very good teacher and a brilliant man, one of the only intellectuals—probably the only intellectual—in the investing business at the time.”

Among various investment styles, value investing has emerged as the most famous (also probably the most misused and abused). Given the scale, longevity and consistency of the track record of Berkshire Hathway, value investing has emerged as the most successful investment strategy. So, it’s no wonder that most professional investors would want to ascribe their investment success to it. In India, with its limited investment history (Nifty 50 index was created only in 1995, as against S&P 500 in 1957), value investing has always been regarded as the pure form of investing. Myriads of local practitioners of this style have emerged over the years. But so exclusive is this club that the media feted mutual fund industry fund managers are usually excluded from such groupings, a rare display of disdain to another ‘super’ tribe of investors. But that is another story for another day.

What is value investing?

Given the strong words used by Munger, value investing is not just clearly buying “cigar butts”. 

While his personal track record is not as public as that of Buffett, his positioning, even as a long standing associate (or in his own words, a “side-kick”) to the original legend makes his comments on Graham and value investing worthwhile to reconsider the original hypothesis of this style. In the Indian context, value investing has been used mainly as a tactical tool of buying cheap, beaten down stocks.

Emerging markets, like India, have always been identified for their superior growth. In such a market, would value investing work? Would it be the classical “cigar butt” style or the one ascribed by Munger and followed by Berkshire Hathway? To figure this out, we used the BSE 200 index. We used three different classifications to find out whether value investing works.

The classification test

We made a few assumptions. We excluded financial stocks from this study. Why? Because the performance of the low price-to-book (P-B) based financials, especially of public sector banks, has been so secular in its underperformance that any grouping of growth versus value would be one sided, with the higher priced P-B “growth” stocks outperforming for most years, except 2009 and 2010. Second, we used P-B value (and not price-to-earnings) as the valuation measure for classifying companies into growth and value. Third, portfolios were re-jigged each year on 30 June and then held without any turnover till the next year ending 30 June.

In the first test, stocks were stacked from highest P-B to lowest. A gap of 20% between the lowest valuation in the growth index and the highest valuation in the value index was maintained to separate companies into either growth or value index. As a result, the number of companies in each category was in a range of 70-85 out of the BSE 200 on market cap basis. The range of coverage was within 67-82% of the market cap of the index.

The results showed no pattern. Neither growth nor value had any predictable pattern of outperformance.The value index outperformed five out of 13 years on an annual basis. As per this methodology, growth index delivered a compounded annual growth rate (CAGR) of 19% from 2003 to 2015, while the value index registered growth of 15%. When the portfolio strategy was extended to a buy and hold for three years, as against one year, the return profile did not change much. clearly, buying “cheap” companies on a random or absolute basis as a strategy did not work.

This methodology also clearly has a key lacuna as the outperforming sectors, especially since 2009—domestic consumption, healthcare and IT services—all have high P-B and would consistently feature in the growth index. To remove this lacuna, we aggregated companies on a sectoral basis. Companies were classified from highest to lowest on P-B within a sector and then assigned to either growth or value grouping. This gave both the indices representation from every sector.

The results based on a sector focused approach were dramatic. The value index now outperformed growth index eight out of 13 times. The CAGR of the value index increased from 15% to 18%, while that of the growth index declined from 19% to 17% over the previous classification. On a 3-year basis, however, the results were patchy—value outperforming growth five out of 11 times during this period. This was, compared with the previous approach, a more consistent way of outperforming growth index.

Next, we applied certain “quality” parameters to filter BSE 200 companies. These were graded based on the number of years they met the criteria and then classified into four quartiles, with those in the top three quartiles forming the universe from which companies were classified on growth or value index, based on their P-B.

The quality parameters were:

1. Debt to Ebitda (earnings before interest, taxes, depreciation and amortisation) less than 3

2.Operational cash flow (profit after tax plus depreciation less increase in working capital) divided by Ebitda being greater than 33%

3.Return on net worth (RoNW) greater than 15% or Ebitda/net operating assets greater than 30%

The above filters were run from the period starting 2003 on an annual basis for 13 years. Companies were graded into three quartiles based on number of occurrences over this time period. Those that qualified nine out of 10 trailing years were in quartile1; those that qualified for four out of last five years were in quartile2; and seven out of trailing 10 years or three out of last five years constituted quartile3. All these companies became the universe from which they were then stacked based on their trailing 12 months’ valuation metric, P-B.

As earlier, we first classified into growth and value on an absolute basis without any sector basis. The value index outperformed growth eight out of 13 years. The CAGR of both indices improved. The value index generated 22% CAGR against 19% for growth. Clearly, focusing on quality resulted in returns improving dramatically by 400 basis points per year over a 13-year time frame. Importantly, such a selection also outperformed on 3-year holding. (One basis point is one-hundredth of a percentage point.) The value index outperformed seven out of 11 years, as against five out of 11 years in the previous two classifications.

Finally, we classified the P-B of “quality” companies on a sector basis, assigning the highest within a sector to growth and the lowest to value indices. Such a classification appeared to have hit the bullseye—value index outperformed in 11 out of 13 years. Its CAGR over this time frame further expanded to 24%, while growth index gave a return of 18%. Such consistent outperformance also led to 3-year returns of the value index outperforming growth 10 out of 11 years.

The other question that arises is whether there is a characteristic for the year in which value underperforms growth? One clear pattern that emerges is the importance of annual profit growth. Across all classifications, a key correlation was underperformance of value whenever profit after tax (PAT) growth of the index was significantly lower than that of the growth index. As this occurred in all four classifications, we could denote that the critical factor for outperformance of any grouping was driven more by PAT growth than valuation parameters. This reinforces the belief of India being a growth-oriented market.

Conclusion

The results of the test clearly highlight Munger’s views. Buying cheap or value companies for the sake of cheapness is not a winning strategy. Results improve, if valuation classification is sector based rather than on absolute basis. The best results emerged from filtering companies on “quality” parameters and then favouring companies that were cheaper on a sector basis. However, no strategy has worked across all time periods, either on an annual basis or a 3-year buy and hold basis. The consistency of returns, though, improves following a focus on buying companies with strong operating parameters, and within such a universe, buying the relatively cheaper companies. This gives added returns and a more consistent performance. 

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Jaisalmer villager's letter: lessons on how to survive water scarcity.

Before the drought, caused by the shortage of rainfall, comes a drought of ideas."

These wise words were written by Chatarsingh Jaam, a villager from Ramgarh in Jaisalmer, the desert heart of Rajasthan.

At the National Consultation on Drought held by Swaraj Abhiyan in the Capital on Sunday, people came from drought-hit Latur, Bundelkhand, Rajasthan, Maharashtra and Telangana to share their anguish and experiences of suffering the third consecutive drought to hit India.

Jaam's letter was read out at the consultation to a spellbound audience. He wrote about how a 500-year-old technique of community farming is helping him and his village to cope in an area which has always seen low rainfall. Jaisalmer saw 4 mm of rainfall in July 2014 and 33 mm of rainfall last July. To understand how low that is, here are two figures to compare:

Latur received a low rainfall of 28 mm last July. And the national average rainfall in July 2015 was 192.7 mm.

In both years Jaisalmer survived with dignity, not needing a single water tanker from the state.

Jaam's letter is a lesson in how to survive arid climes year after year. And why this year's drought is a purely man made crisis.

The letter

We have been watching the horrific news of the drought situation in several states on TV.

My native district of Jaisalmer is among the most arid zones of the country. It receives scanty rainfall, sometimes none whatsoever.

The region may be sparsely populated, and people may be more dependent on animal husbandry than farming, but we still need our share of water. Livestock, consisting of lakhs of sheep, goats, cows and camels, also require a constant water supply.

How we do it

Our region received a rainfall of only 4 mm in July 2014. The figure for the month of August was just 7 mm. It amounted to a total rainfall of 11 mm in those months.

Yet, Ramgarh, where I live, did not hit the headlines for a famine-like situation. Our efforts prevented the situation from deteriorating to such a level.

The rain gods were as cruel the next year. On 23 July 2015, a rainfall of 35 mm was recorded. The month of August that year saw a total of merely 7 mm of rain, coming down further to 6 mm in September. However, we still managed to fill the 500-year-old Viprasar pond.

The Viprasar pond holds special significance for this region. The layers of Khadia soil and Gypsum accumulated on the bed of this pond over millions of years prevents fresh water from mixing with the brackish water flowing beneath. These layers precipitate the moisture of the sand.

The surface water of the pond is available only for a few months. The trapped water lying below is preserved through beautiful structures called beri.

The result is that the Viprasar pond is filled to the brim even in the third week of April, enabling us to remain self-sufficient in water supplies till the next rainy season.

This special technique is also applied to many fields across Jaisalmer.

Cooperation is the key

We have never allowed the monopoly of one single person or clan on these special fields. These are traditionally considered as the collective assets of the entire society.

The ideals, often restricted only to slogans elsewhere, have been implemented on the ground by our sagacious forefathers. These special pieces of land are used for community farming, even in this era of cutthroat competition and mutual jealousy. Such tillages never lose their greenery, even in severe droughts.

We have plenty of water, foodgrains, and fodder for our cattle, even in the heart of the desert. We are not only self-dependent in foodgrain production, but also provide employment to people from other regions. Labourers from Bihar, Punjab and Madhya Pradesh have come to Ramgarh to harvest crops for the first time during this season. These people belong to areas that receive much more rains than our native place. Yet, they have found a source of livelihood here.

Appalled at Marathwada situation

We are pained to see the news of farmer distress in regions like Marathwada and Latur. There are riots over water, and the administration has even imposed Section-144 in some of these areas. In contrast, the water scarcity has not affected the amiable relations in our society.

The mindless focus on sugarcane farming has plundered Marathwada's low existing ground water resources. It has now come to a situation where hundreds of buckets are seen in an already dried-up well. There is complete mayhem there.

The new methods of cultivation, rapid industrialisation and overgrowing cities have ended the age-old tolerance for others' right to water. This is why we are facing extreme conditions like the Chennai floods and famine-like situation in Latur.

The distribution of rainwater has always been decided by nature. Regions like Konkan and Cherrapunji get excessive rainfall, whereas our villages receive almost none.

Only those societies which have adapted to the availability of natural resources without greed have managed to survive. They have remained immune to the water crisis.

Spreading the message

Conditions had worsened in some of our villages, but the trend has been reversed during the last 10-15 years. It was made possible by the construction of hundreds of various traditional reservoirs for water harvesting through collective efforts. You will not find any boards or inauguration stones of government or NGOs near these water sources. We have made them for ourselves. This is why they have never dried up.

Nobody can understand the pain of water scarcity better than us. Our anguish will not end until we spread the message of water conservation to other parts of the country as well.

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Billions Are Being Invested in a Robot That Americans Don't Want.

Brian Lesko and Dan Sherman hate the idea of driverless cars, but for very different reasons.

Lesko, 46, a business-development executive in Atlanta, doesn’t trust a robot to keep him out of harm’s way. “It scares the bejeebers out of me,” he says.

Sherman, 21, a mechanical-engineering student at the University of Minnesota, Twin Cities, trusts the technology and sees these vehicles eventually taking over the road. But he dreads the change because his passion is working on cars to make them faster.

“It’s something I’ve loved to do my entire life and it’s kind of on its way out,” he says. “That’s the sad truth.”

The driverless revolution is racing forward, as inventors overcome technical challenges such as navigating at night and regulators craft new rules. Yet the rush to robot cars faces a big roadblock: People aren’t ready to give up the wheel. Recent surveys by J.D. Power, consulting company EY, the Texas A&M Transportation Institute, Canadian Automobile Association, researcher Kelley Blue Book and auto supplier Robert Bosch LLC all show that half to three-quarters of respondents don’t want anything to do with these models.

“Technologically, we will be ready for automated driving within this decade,” said Kay Stepper, a vice president and head of the automated driving unit at Bosch, which supplies components to the world’s leading manufacturers. “But it will take well into the next decade to convince consumers.”

Automakers and tech giants including Alphabet Inc.’s Google unit have high hopes for a rapid rollout of autonomous vehicles, which they say will radically reduce traffic deaths and cure congestion in big cities. Google, which announced plans on Tuesday to expand its test fleet with 100 Chrysler Pacifica minivans, predicts people will be tooling around in robot models by 2020. Boston Consulting Group says the market for autonomous technology will grow to $42 billion by 2025, and self-driving cars may account for a quarter of global sales by 2035.

All of this depends on people buying something they don’t currently want. In the Kelley Blue Book study, 75 percent of the 2,076 people surveyed said they don’t think they’ll ever own a self-driving car. In the EY study, just 40 percent could imagine engaging the autopilot, a feature already available on Tesla’s sport utility vehicle and sedan and coming soon on models from Audi, Volvo, Mercedes and Cadillac.

Not Overwhelming

In a survey released last week, J.D. Power found that just 23 percent of Baby Boomers would trust self-driving technology. Acceptance improves with younger cohorts, but it’s not overwhelming. Less than half of Gen Xers (41 percent) would trust robot cars, while 56 percent of Gen Y and 55 percent of Gen Z are comfortable with the concept.

“It’s a little overwhelming for most people,” said Kristin Schondorf, executive director of automotive and transportation mobility at EY and a former engineer at Ford Motor Co. and Fiat Chrysler Automobiles NV. “For certain generations who like to drive, that is going to be difficult to give up.”

The biggest obstacle is fear. Consumers who’ve endured computer crashes as part of their everyday existence are wary of trusting software to keep them safe.

“We’re putting a machine -- a robot on four wheels -- in control of driving us down the road,” Stepper said. “Their main concern is that the technology could fail at any point in time. And then what is going to happen? It’s this big unknown.”

No Human Input

Experience will assuage those apprehensions. But experience is hard to come by right now: Only engineers are testing cars that require no input from humans.

Consumers are getting their first exposure through semi-autonomous features such as automatic brakes, systems that steer a drifting car back into its lane and adaptive cruise control that operates the brake and accelerator to stay a set distance from vehicles ahead. Luxury makers such as Mercedes and Audi soon will introduce traffic-jam assist that takes over in stop-and-go situations.

Relinquishing complete control is a much greater leap. Drivers’ willingness to allow an autopilot to steer their car improves to 66 percent from 40 percent if they have the option of taking over the wheel in an emergency, based on the EY study. But safety regulators blame human error for more than 90 percent of crashes, so it’s actually not best to override the robot in a stressful situation, according to Schondorf.

Robots Rule

“There might be a reason the driverless car is doing something that you don’t even understand because you can’t see what the cameras and sensors see,” Schondorf said. “If you take control, that could be the thing that harms you.”

Still, humans will need to feel they’re part of the process. Bosch’s Stepper recommends outfitting autonomous autos with multiple screens that tell drivers in advance which decisions the master computer is making and what route the car is taking. These could be supplemented with audible explanations of actions, akin to station announcements a commuter might hear on a train.

First, though, consumers will need to try out robot cars in a safe environment. And that will require the government and companies to provide test drives.  Government authorities also could create autonomous highway lanes, protected from other traffic, to help inspire confidence. In Europe, tests already are under way, including automated vans that take passengers around a fixed course in urban areas and tourist destinations.

Trust Issues

Trust “is a big issue that will go away as people become more experienced with the technology,” said Johanna Zmud, senior research scientist with the Texas A&M institute.

Engineering student Sherman, who has studied autonomous sensors and software, understands better than most how driverless cars will make roads safer. But he laments that soulless machines won’t make them more fun.

“I’m going to have to find some way to cope,” Sherman said. “I hope there will still be communities of people like me who like to control the vehicle. But we might not be able to drive that car on the street.”

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How Billionaire Carl Icahn Became “The Greatest Investor Of All Time.

How Billionaire Carl Icahn Became “The Greatest Investor Of All Time” And Amassed A Fortune Of Rs. 136,500 Crore From Stocks Despite Mediocre Stock Picking Ability

​​Carl Icahn has taken over the mantle of “World’s Greatest Investor” from Warren Buffett. Icahn has made a mind-boggling fortune from stocks despite having a win rate equal to the toss of a coin. How he achieved this remarkable feat is revealed by Bryan Rich of Forbes

​​First, we must compliment Carl Icahn for recently netting a profit of Rs. 13,000 crore ($2 Billion) from the sale of his entire holding of Apple stock. He bought the stock three years ago and had then called it an “undervalued” “no-brainer” with “great barriers to entrance”. Carl has now revealed that he sold Apple because he anticipates that the Company will have serious problems with China’s policies.

Second, we must compliment Carl Icahn for an incredible investing track record which surpasses that of Warren Buffett.

​​Bryan Rich of Forbes has revealed in his article “Billionaire Carl Icahn’s Winning Traits” that Carl Icahn has compounded his wealth at an incredible CAGR of 31% since the year 1968. Carl’s return since the year 2000 is an impressive 20%. He beat the S&P 500 by 4 to 1 over the period.

In contrast, Warren Buffett has compounded his wealth at a relatively modest CAGR of 19.5% in the same period from 1968 onwards.

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In practical terms, if we had invested $1,000 with Warren Buffett, it would be worth about $5 million today. The same sum invested with Carl Icahn would be worth an eye-popping $400 million today.

This makes it clear that Carl Icahn has “superior skill” as compared to Warren Buffett and is “THE greatest investor of all-time” Bryan Rich says.

Bryan Rich adds that though Carl Icahn has amassed a net worth of $21 billion (Rs. 136,500 Crore) from his investing prowess, investors will find an analysis of his stock picks “very surprising”.

(Image Credit: Forbes)

Rich has analyzed Carl Icahn’s investments from the year 1994 onwards and deduced that

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the Billionaire’s “Win Rate” is merely 58%, which is almost equal to the result one would get from the toss of a coin. Out of the almost 100 stocks that Icahn purchased over the past 20 years, only a little more than half have been profitable.

However, what has made the difference to the ultimate result is that Icahn has put himself in the position where a winning stock has delivered disproportionate result.

​​The winners are almost twice that of his losers. While the average winner is +87%, the average loser is -49%.

This reminds me of Mohnish Pabrai’s investment doctrine of “Heads I Win, Tails I Don’t Lose Much”.

The same doctrine is followed by Rahul Saraogi of Atyant Capital that a stock is worthy of investment only where the risk of loss is low and the prospects of gains are “asymmetrical”.

Bryan Rich has formulated four takeaways of Carl Icahn’s investment philosophy:

Takeaway 1 – An investor need not have a high win rate. What he requires to ensure is that he does not lose much on his losing stocks and wins more on his winning stocks:

This is best exemplified by George Soros’ immortal quote: “it’s not whether you’re right or wrong, but how much money you make when you’re right and how much money you lose when you’re wrong.”

Takeaway 2 – Make concentrated bets where you are certain of winning big:

This principle is exemplified by Warren Buffett’s classic advice that we should not swing at every ball that is thrown to us but should wait for the “right pitch”. When the “right pitch” comes, we must swing at it with all our might.

Warren also advised that we should invest as if we are limited by a punch card with 20 slots in it. Every investment decision must be thoroughly thought of before being implemented.

Takeaway 3 – Be patient:

There is no better way to explain this than to see Carl Icahn’s interview where he revealed the “real secret” behind his success is the fact that he has

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held on to stocks for as long as 31 years.

“The real money that I made over the years is holding companies for 7, 8, 9 years and keeping them ….. You got to buy them when nobody wants them really …. That’s the real secret …. It sounds very simple but it is very hard to do … when everybody hates it, you buy them … and then when everybody wants it, you sell it to them … And that’s what we do” Icahn said.

Takeaway 4 – Don’t be afraid to take risks or to suffer losses:

Rich emphasizes that Icahn has multiple stocks over the past 20 years that have gone to zero and become full losers. However, this has not been an impediment to Icahn’s progress because he has had a portfolio of big winners which have more than made up for the losers.

We can implement Carl Icahn’s technique by adopting a “portfolio approach” and not obsessing over the losses of individual stocks.

We should also bear in mind the revolutionary advice offered by Prof Sanjay Bakshi that “Loss aversion turns us into reckless gamblers“.

Takeaway 5: Stay alert to changing circumstances and churn the portfolio.

One more takeaway that can be added to the four takeaways listed above is that one must keep one’s eyes and ears alert to changing circumstances.

This is exemplified by Carl Icahn’s action towards Apple. Though he described Apple as a “no-brainer” and an undervalued stock with great potential, he did not hesitate to dump his large holding over concerns that the political hostility in China towards the Company does not auger well for its prospects.

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Dubai Shatters all Records for Cost of Solar with Earth’s Largest Solar Power Plant - $3 / kWh

The Emirate of Dubai set a new world record for the cost of solar power on May 1, 2016 with the Dubai Electricity and Water Authority (DEWA) receiving bids for the 800 MW Sheikh Maktoum Solar Park Phase III as low as 3.00 U.S. cents per kilowatt-hour (kWh). This not only marks the lowest cost ever for solar power, but also easily beats all available fossil-fuel options in Dubai on cost.

At the bid opening, DEWA read out the bids for a base variant of 200 MW (AC) only, but with further optional stages the project has the potential to become the largest solar power plant in the world at 800 MW. The project will be implemented on an independent power producer (IPP) basis, with bidders proposing a technical and financial solution to build, own and operate the plant for 25 years.

The lowest bid was submitted by a consortium of Abu Dhabi’s Masdar and Spanish developer FRV, which was acquired by Saudi Arabia’s Abdul Latif Jameel (ALJ) group in 2015. Second, according to industry insiders, came Chinese module maker and developer JinkoSolar at 3.69 cents/kWh, soundly beating Saudi Arabian Acwa Power in a consortium with the U.S. solar thin-film module pioneer and developer First Solar at 3.96 cents/kWh. Two French-led consortia submitted somewhat distant but close bids – Engie, the former GDF Suez, together with Japanese Marubeni at 4.44 cents/kWh and utility EDF with Qatar’s Nebras Power at 4.48 cents/kWh.

The results are remarkable in that they end the winning streak of Acwa Power, which won the two previous DEWA IPP tenders, the Sheikh Maktoum Solar Park Phase II and the recent Hassyan coal power plant tender. This time, Acwa was beaten by JinkoSolar, which is not only the global cost leader in silicon solar modules, but with this bid also demonstrates its capability to successfully develop extremely competitive projects. JinkoSolar apparently surpassed Acwa in the craft of meticulously optimizing all moving parts in a project. However, the lowest bid was submitted by the Masdar/FRV/ALJ consortium. FRV/ALJ, which came a close second to Acwa Power in the previous phase II tender, was clearly determined to win in phase III and seems to have found the winning formula in partnering with Masdar, also known as the Abu Dhabi Future Energy Company, a subsidiary of Abu Dhabi’s sovereign wealth fund Mubadala.

Three cents – a repeatable precedent?

The price bid by Masdar/FRV is 19% lower than the second-lowest bid submitted by JinkoSolar. It can be expected that both JinkoSolar and the third-lowest Acwa Power pushed their proposals very close to what can be considered commercially feasible today. One may speculate how Masdar and FRV seemingly manage to play in a universe of their own. Because the majority of the expenses for a solar power plant lie in the upfront cost of construction, which gets recovered over numerous years, the cost of financing is a key overall cost driver. One can suspect that Masdar had access to long-term financing through the wealthy emirate of Abu Dhabi that no commercial banks, the primary source of capital for the other bidders, could match in cost.

It should be noted, however, that what we are seeing now is only part of the picture. DEWA invited developers to submit bids for configurations made up of three sub-phases: a mandatory 200 MW to be commissioned in April 2018, and another two optional 300 MW tranches in 2019 and 2020, respectively. Results of the two requested variant bids for total project sizes of 500 or 800 MW were not made public at the bid opening. However, insiders suggest that Masdar/ALJ essentially provided a peek behind the façade of the 200 MW bid by submitting the same price of 3 cents/kWh for all three bid variants, speculating that DEWA would find the 800 MW variant most attractive anyway. At the same time, other bidders can be expected to have achieved lower tariffs through further economies of scale with the larger variants, which means that the gap between Masdar/FRV and the second-ranked bidder would potentially be much smaller when looking at the largest 800 MW variant.

Still, with this somewhat unique bid, 50% lower than Acwa Power’s winning bid in the previous phase II submitted just 18 months ago, the danger arises that Dubai’s tender raises global expectations of the cost of solar to a level that cannot be quite matched elsewhere, making the industry get somewhat ahead of itself.

World-record solar now beats fossil fuels on cost

Yet, even the second and third-lowest bid at 3.69 and 3.96 cents/kWh, which appear bold yet commercially viable, are unprecedented and mark another breakthrough milestone for the progress of renewable energy. All three lowest bids by themselves clearly set a new world record for the unsubsidized cost of solar electricity. A recent bid of 3.6 cents/kWh by Enel Green Power in Mexico did not include the value of additional green energy certificates. Solar tariffs in the USA now regularly dip below 3 cents/kWh, but these include a 30% tax incentive and other subsidies.

Besides setting world records for solar power, the results unequivocally demonstrate that large-scale solar power can now regularly beat fossil-fuel power plants on cost. Solar (when delivered in 2018–2020) has now become by far the lowest-cost option for generating electricity in the Gulf region, effortlessly beating even coal-fired power plants. As recently as October 2015, Dubai Electricity and Water Authority (DEWA) awarded the new Hassyan coal power station at a much higher tariff of 4.501 US cents/kWh. Gas-fired power plants in Dubai have an even higher generation cost.

Dubai sets the standards for renewable-energy deployment in the region

Dubai has now firmly established itself as the forerunner of solar energy in the Gulf region. As part of its program to reach energy diversification goals by 2030, Dubai launched the Mohammed bin Rashid Al Maktoum Solar Park in 2012. The park is located on 40 square kilometers of land south of Dubai city and is planned to eventually host 5 GW of solar projects. In 2013, a 13 MW PV power plant was commissioned as phase I of the project. In 2014, DEWA tendered a 100 MW PV power plant on an IPP basis as phase II, with stunning results at the time. Saudi Arabia’s Acwa Power bid a low tariff of 5.98 cents/kWh, already lower than DEWA’s cost of gas-fired power plants.

At the same time, Acwa Power proposed alternative variants of up to 1,000 MW. DEWA ultimately settled at 200 MW at a tariff of 5.85 cents/kWh. The successful results of the tender sparked an even greater appetite for solar power. In late 2015, Dubai announced an aggressive target of 25% share of solar power in the grid by 2030 and 75% by 2050. As the first step toward reaching these goals, DEWA launched the public tender for phase III of the Sheikh Maktoum Solar Park project, with the intent to award a 25-year power purchase agreement (PPA) to the lowest bidder.

Compared to phase II, the prequalification criteria were made even more stringent, with the goal of allowing only very strong and experienced players to participate in this tender of unprecedented size. DEWA required the consortia to present rigorous, fully detailed technical and financial proposals.

In a multi-stage process, 97 parties submitted an expression of interest (EOI) to participate in the tender. Around 40 parties were invited to submit a request to prequalify, of which 24 international consortia responded. Finally, 14 consortia were prequalified and invited to submit bids on May 1, 2016. As a testament to the stringent requirements (and also high costs) of submitting a bid, eventually only five consortia handed in proposals on May 1. It is expected that DEWA will negotiate with the frontrunners among bidders over the coming weeks and then settle on a sub-phase configuration that maximizes value for DEWA, in all likelihood, the largest 800 MW variant.

Compared to phase II, when twice as many bids were submitted with a much larger spread between lowest and most expensive bid (2.5x vs. 1.5x), we are now seeing a much more mature solar downstream industry. Effectively, the “mega project” model similar in financial volume to conventional power plants has set the standard for the procurement of renewable energy in the region.

Leaving no stone unturned to optimize tariffs

One may ask – how could bidders submit such low tariffs? The substantially lower price level of all bidders, compared to the already low price point in phase II, was the result of intensive optimization across the entire gamut of project parameters. After phase II had given an indication of the level of competitiveness required to win, developers left no stone unturned to reduce project costs.

The strongest contributor to the lower tariff is a lower capital expense for the project, driven by lower component costs and more efficient system designs. Compared to the previous tender rounds, component costs have fallen further across all parts of a solar power plant, and engineering, procurement and construction (EPC) companies have further firmed up their cost estimates for the region. Still, a key challenge was the identification of a construction company that can provide EPC services for a project of this magnitude, with only a few suitable providers available globally.

A key technical contributor to the low tariffs was likely the widespread consideration of single-axis tracker technology, which leads to a gain of approximately 15% in energy production over fixed-tilt systems, at a lower relative increase in system cost.

Financing a project of this size, requiring around a billion dollars in funds for the largest variant, also represented formidable challenges. The project’s equity will be held jointly by the developer (40%) and DEWA (60%). The project will be financed in a highly leveraged non-recourse project finance structure, with the majority of the funds typically coming from commercial debt. For Sheikh Maktoum Phase II, financed in 2014, regional banks including Emirati and Saudi institutions demonstrated a great appetite to provide debt at aggressive terms, crowding out all other international financial institutions. However, with the severe drop in oil prices, the regional credit environment has taken a turn for the worse and the market has essentially dried up, with most regional banks pulling out of new project finance deals. This sent developers searching for debt from international banks, including French and Chinese institutions.

Although not unexpected by industry insiders, the results of this tender will send further shock waves through the global power markets. Fossil power plants are not only coming under pressure through a renewed drive to reduce global carbon emissions marked by the Paris climate accord, but also by the sheer economic competitiveness of solar (and wind, for that matter) power. Just a few years ago, nobody would have imagined that solar power would be able to beat all fossil fuel sources including coal already in 2016.

Boosting the deployment of solar energy in the region and beyond

This result will further increase the development of solar power globally, particularly in sun-rich countries with growing energy needs. Dubai and neighboring emirates and Gulf countries will build on the now proven approach to procure solar power plants on a similar scale to conventional power plants. As a case in point, Abu Dhabi’s utility company ADWEA has just released a tender for a 350 MW solar power plant.