With climate change concerns rising, the global economy has been making an increasing effort to turn away from greenhouse gas-emitting fossil fuels and toward clean, renewable energy sources. From 2012 through 2017, the global economy spent a staggering $1.5 trillion to add 1 million megawatts (MW) of new renewable power capacity. As a result of that investment, there was enough renewable electricity-generating capacity to meet 24% of the world's power demand in 2017.

That's just the tip of the proverbial renewable energy iceberg. Developed countries will need to spend $11 trillion in the coming decades to become 100% powered by renewables. That's a massive market opportunity for companies operating in the renewable power sector.

This guide aims to provide investors with a broad overview of the entire sector. That way, those investors can better understand the different ways to invest in renewable energy stocks.

A hand holding a plant with a bright lightbulb in it that's surrounded by icons for energy such as a solar panels and wind turbines.

Image source: Getty Images.

An overview of the renewable energy industry

The energy industry consists of three sectors: power, heat, and transport.

The power sector generates and transmits electricity to end-users, like homes and businesses. It produces this power from a variety of sources in two main categories:

  • Non-renewables such as coal, natural gas, nuclear, and oil.
  • Renewables like wind, solar, geothermal, biomass, energy from waste, and hydroelectric.

In 2017, those renewable sources met 24% of global power demand, though wind and solar contributed less than 10% of the world's electricity supply.

The heat sector transmits either the fuel or heated air to warm buildings. Several sources produce heat such as:

  • Non-renewables like natural gas, fuel oil, kerosene, and propane used to fire furnaces and boilers that heat homes
  • Renewable heat sources such as firewood or wood pellets burned in stoves and fireplaces, geothermal heating systems, and electric heat powered by solar panels

The transport sector, meanwhile, provides fuels needed to power vehicles. These fuels include:

  • Non-renewables such as gasoline, natural gas, diesel, and jet fuel
  • Renewables like biodiesel, ethanol, renewable natural gas, and all-electric vehicles 

The renewable energy industry aims to displace all non-renewable sources eventually. That's because most non-renewables emit greenhouse gases that are warming the atmosphere and contributing to climate change that is having an adverse effect on the planet. On top of that, there's only a finite amount of non-renewable resources available, which means that the world will eventually run out. The need to battle climate change as well as reduce the use of these finite resources is driving significant investment in renewable energy sources.

Key renewable industry metrics

Each sector of the market has specialized terms or industry-specific metrics that investors need to know. Here are five of the most important for understanding the renewable energy industry:

Megawatts (MW): A megawatt is one million watts of electricity. Renewable energy companies use this metric to demonstrate how much power they could generate if a plant were running at its full capacity. To put this metric into perspective, 1 MW of power can meet the electricity needs of 1,000 homes.

Megawatt-hours (MWh): While a renewable power plant might have the capacity to produce 1 MW of power, that doesn't mean it will generate that much energy. That's because renewable power sources like the wind and sun aren't always producing energy, which is an issue known as intermittency. So, renewable companies use MWh to show how much electricity they generated during a period.

Cost per watt: This metric measures how much it costs to produce a watt of electricity. While renewable fuel sources (wind, sun, and water) are free, solar panels and wind turbines cost money to build and maintain. Renewable energy companies normalize the cost with this metric, which makes for a better "apples-to-apples" comparison with fossil fuel sources like coal.

Efficiency: This term refers to how much of the sun's light a solar panel turns into electricity. In 2018, the average solar panel was about 16% efficient while the best ones had efficiency ratings of around 23%. The higher the efficiency rating, the better a solar panel is at generating electricity from the sun.

Cash available for distribution (CAFD): This metric measures how much cash a renewable energy company produced in a period that it could have distributed to investors. That makes it similar to free cash flow. Renewable energy companies focused on paying dividends will use this metric so that investors can measure the sustainability of their payout. 

Two people in hard hats and a laptop looking at a row of wind turbines.

Image source: Getty Images.

Headwinds facing the renewable energy industry

One of the biggest headwinds that renewables face is that the sun doesn't always shine, and the wind doesn't move at a steady speed. This issue, known as intermittency, puts renewables at a disadvantage to fossil fuels, which can produce consistent power. During the first six months of 2019, for example, wind resources where leading renewable power generator NextEra Energy (NYSE:NEE) operated were only at 92% of their historical average. This wind drought negatively impacted the cash flow of NextEra Energy and its wind power-producing peers. If intermittency issues worsen, it will reduce the return on investment that companies can expect to earn, which could slow the pace of growth.

Another problem that renewables face is that they can be more expensive than fossil fuels like natural gas when it comes to producing power. In 2019, a highly efficient natural gas plant could generate electricity for as low as $41 per megawatt-hour (MWh) to as much as $70 an MWh, according to an estimate by financial advisory firm Lazard. The unsubsidized cost for wind, meanwhile, ranged between $29 and $56 per MWh while solar was $40 to $46 per MWh. Those costs, however, don't include the additional expense of battery storage -- which added $4 to $7 per MWh -- to help offset the intermittency issue. While wind and solar can be cheaper than natural gas, that's not always the case, which can hinder renewable development.

Governments have played a significant role in helping narrow the gap between fossil fuels and renewables by providing subsidies that incentivize investment in wind and solar projects. Those subsidies aren't as crucial to the industry's growth as they once were due to the significant decline in the cost of installing renewables. However, they're still necessary in many cases, such as installing rooftop solar panels on residential homes. If governments cut those incentives too deeply, it could reduce the growth rate of this part of the industry.

Another way that governments can negatively impact the solar industry is through burdensome regulations and policies. In 2019, for example, the U.S. imposed tariffs on solar panel imports to put domestic producers on a level playing field with their foreign counterparts. The tariffs ended up increasing the cost of all solar panels, which made them less competitive against other sources of energy such as fossil fuels. If governments implement more policies that are harmful to the renewable energy industry, it could slow its growth rate.

Lower energy prices can also impact renewables. If natural gas prices tumble, it can make gas-fired plants cheaper to operate than renewables. Meanwhile, if the economy slows down, it can impact electricity rates, which would hurt renewable development since it needs higher prices to thrive. Finally, slumping oil prices can affect the demand for higher-cost biofuels.

The tailwinds driving the renewable industry

Climate change concerns are playing a significant role in driving growth in the renewables sector. According to a Reuters poll in June 2019, nearly 70% of Americans wanted the country to take "aggressive" action to combat climate change. That strong support is leading governments to propose solutions that will rapidly transition the economy away from fossil fuels. If climate change concerns continue growing, it could drive more aggressive government incentives to invest in the renewable energy sector.

One of the most significant impediments to the development of renewables had been their higher costs compared to fossil fuels. In the early 2000s, for example, the unsubsidized costs to generate wind and solar power were around $70 and $120 per MWh, respectively. Those costs, however, have declined significantly. By 2019, renewables were cheaper than coal and natural gas, in many cases, before adding in the extra costs for battery storage. Storage costs are also declining. Because of that, renewables are on track to be cheaper than all but the most efficient natural gas plants by 2023 even after adding in enough battery storage to overcome intermittency. With renewables closing in on that inflection point, the industry's growth rate could accelerate.

Solar panels in the field with a bright sun in the background.

Image source: Getty Images.

Opportunities in the renewable energy industry

Investors considering renewable energy stocks have five ways to potentially benefit from its expansion:

1. Component manufacturers and installers: These companies build and install the mechanical equipment needed to generate renewable energy. They include:

  • Solar cell and panel manufacturers such as First Solar and SunPower
  • Component and accessory producers like SolarEdge and Enphase
  • Solar power system installers such as Sunrun and Vivint Solar
  • Wind turbine and blade manufacturers such as General Electric, Siemens, Vestas Wind Systems, and Arcosa 

These companies make money by selling a product or service to customers. As such, their revenue has some variability. It can grow as demand expands or contracts due to competition or increased industry headwinds. That makes them a higher risk, but it also could make them a higher reward opportunity.

2. Utilities: These companies generate power and sell it to end-users. While most utilities still produce a large portion of their electricity from fossil fuels, some are investing heavily in renewables. NextEra Energy, for example, generated more power from the wind and sun than any other company in the world in 2018. Meanwhile, Xcel Energy (NASDAQ:XEL) was the first utility that pledged to generate 100% of its electricity from carbon-free sources. Though Xcel Energy doesn't expect to reach that bold goal until 2050.

3. Independent power producers or renewable yieldcos: Utilities operate an integrated business as most generate power and also distribute it directly to customers. Some companies, on the other hand, focus solely on operating renewable power assets. They typically sell the electricity these facilities generate under long-term, fixed-rate power purchase agreements (PPAs) to utilities and other end users like industrial plants and data centers. Those contracts supply these companies with predictable cash flow, the bulk of which they pay out to their investors via high-yielding dividends. Some of the largest yieldcos are Brookfield Renewable Partners (NYSE:BEP), TerraForm Power (NASDAQ:TERP), and Pattern Energy (NASDAQ:PEGI). These companies are ideal options for income-focused investors to consider.

4. Biofuel and biomass producers: These companies make renewable fuel products that they sell to customers as a replacement for fossil fuels. For example, Clean Energy Fuels (NASDAQ:CLNE) manufactures Redeem, which is a renewable natural gas made from organic waste that comes from landfills and farms. This fuel is as much as 70% cleaner to burn than diesel and gasoline. Enviva Partners (NYSE:EVA), in the meantime, is a master limited partnership (MLP) that manufactures utility-grade wood pellets. Utilities can burn these pellets instead of coal, which can help them reduce their carbon footprint by about 80%. Because biofuel and biomass companies make replacements to fossil fuels, they can highly sensitive to changes in commodity prices. That makes them riskier options for investors.

5. Electric-vehicle manufacturers and component makers: Companies like Tesla (NASDAQ:TSLA) are developing and manufacturing all-electric vehicles to replace those powered by gasoline. So, they're taking a different approach from biofuel makers in disrupting the transport-focused segment of the energy market. Tesla offers a potentially fully renewable-powered electric vehicle since it also sells an integrated rooftop solar system that includes the panels and battery storage.

Risks facing the renewable energy industry

Despite the renewable energy industry's fast-paced growth over the years, the sector has struggled to generate above-average returns for investors. One issue that has caused this underperformance is intense competition. While this competition has helped drive down the price of components like solar panels, it has also squeezed the profit margins of companies operating in the sector. Because of that, many companies have struggled to make money in the industry. Several have even filed for bankruptcy, which wiped out their investors in the process.

The investment needed to support the growth of the renewable energy industry far outstrips the sector's ability to internally finance its expansion with free cash flow. Because of that, the industry needs to issue equity and debt to fund growth. However, given the sector's past financial struggles, investors aren't pouring as much money into it as they had in the past. That's forcing many companies to shift their funding strategies. Yieldcos like Pattern Energy, for example, used to be able to issue new stock and debt with ease. However, Pattern Energy had to stop increasing its 2017 dividend. That enabled it to retain more of its CAFD to finance growth after it got too expensive to sell more stock. The company aims to get to a more sustainable funding model by 2020 so that it can resume dividend growth.

The energy industry is continuously investing in research and development. It's doing so in hopes of finding new forms of energy that will help speed up the world energy producers' ability to reach its goal of one day being carbon-free. These investments have included pursuing advancements that will reduce the cost of existing wind, solar, and battery technologies as well as in developing new commercially viable sources. Some of the more promising renewable energy technologies under development are:

  • Tidal energy and wave energy that generate electricity through underwater turbines.
  • Algae-based fuel that use the chemicals in seaweed to create a clean and renewable biofuel.
  • Nuclear fusion, which creates energy by fusing two atoms. In a sense, it's the opposite of current nuclear fission technology, which splits one atom into two to create energy.

If technologies like these advance to the point where they can produce low-cost energy on a commercial scale, they could disrupt companies focused on more traditional renewable resources.

Ways to invest in renewable energy stocks

Investors can take many different paths to finding potential stocks in the renewable energy sector.

One is to focus on companies that build or install renewable energy components or make renewable fuels. These companies offer a higher reward potential since they could grow as fast or faster than the overall sector. The downside, however, is that they're more sensitive to the sector's headwinds and risk factors, which will likely make their stocks much more volatile. As such, they're better options for investors who are seeking high-upside growth opportunities.

Another way to invest in renewables is to focus on companies that operate renewable energy-producing assets and sell the electricity they generate under long-term, fixed-rate contracts. This business model helps reduce risk since it enables these companies to produce relatively predictable cash flow. Because of that, most of these renewable energy companies typically pay out a large portion of that money in dividends. That approach makes them ideal options for retirees or other income-seeking investors.

Investors can also consider using exchange-traded funds (ETFs) that focus on owning renewable energy stocks. ETFs are an ideal way to gain broad exposure to a sector since they typically hold several stocks in an industry. The Invesco WilderHill Clean Energy ETF (NYSEMKT:PBW), for example, held nearly 40 renewable energy stocks as of the middle of 2019. Among its largest holdings at that time were solar component makers SolarEdge and Enphase, solar panel manufacturer SunPower, and renewable energy yieldco TerraForm Power. In addition to that, other ETFs enable investors to target one aspect of the renewable energy sector such as on solar or wind stocks.  

Given the enormous growth potential of the renewable energy industry, any of these paths could prove to be highly profitable over the long term. Investors, however, can increase the probability of making money on renewable energy stocks by focusing on companies that have excellent financial profiles. Companies with strong balance sheets will have greater flexibility to navigate the industry's headwinds and risks. That will give them a competitive advantage over weaker rivals in capturing the sector's growth opportunities.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.