Amid the intensifying global trend toward decarbonization, Japanese capital goods companies have seen a significant increase in new orders for gas-fired power generation equipment in the last couple of years.

Why it matters:  The Asian region needs to balance decarbonization targets with growing electricity needs. For now, the latter is prioritized and demand for new gas-fired power plants remains high, compared with other regions. There are significant implications for earnings and credit quality of such issuers.

What we think and why:  Japanese capital goods companies will likely continue to benefit from growing demand for gas-fired power assets in the next three to five years. But decarbonization brings new challenges for the industry. Renewable power projects are more complex and face more severe competition, and future development of greener technologies for gas-fired power generation may shift the competitive landscape in the long term.

Strong demand means new orders for gas-fired power generation equipment are growing significantly at Japanese capital goods manufacturers.   Three companies have leading global positions in manufacturing large-capacity, high-efficiency gas turbines: Mitsubishi Heavy Industries Ltd., GE Vernova Inc. of the US, and Siemens Energy AG of Germany. Mitsubishi Heavy Industries' orders for combined cycle gas turbine power plants grew by more than 30% in fiscal 2022 (ended March 2023), and by more than 50% in fiscal 2023. This was considerably greater than the figures of the two peers.

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We believe that the increase in orders shows that gas will remain an essential source of stable power in Asia and the rest of the world over the next few years.   There is a strong push by governments to expand renewable energy and private sector investment is increasing, even in Asian countries that rely heavily on gas and coal. However, it is becoming increasingly difficult to quickly and affordably meet the growing demand for electricity. The spread of generative AI as well as economic growth have raised power demand for data centers and other facilities. Simply building new renewable energy installations cannot meet growing needs at an affordable cost. We believe that demand for new gas-fired power generation capacity and upgrades will remain firm at least until around 2030, amid decarbonization.

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Gas Power To Support Profitability

Gas-fired power generation equipment will remain an important and stable source of earnings for Japanese capital goods makers over the next three to five years. In our view, earnings of gas power equipment are more stable than the rapidly expanding renewable energy business due to its technological maturity and cost efficiency, as well as long-term after-sales service revenues. We expect that robust demand for gas power will continue to help Japanese capital goods companies maintain stable earnings.

We expect Mitsubishi Heavy Industries to be a particular beneficiary of continued demand for thermal power equipment. The company has the world's top share in new orders for large-scale gas-fired turbines for power generation (on an output basis). Its energy segment, which includes the gas power business, accounts for about 40% of its consolidated EBITDA. We believe that demand for new installation, higher efficiency and conversion from coal to gas, as well as earnings from related after services, will support earnings over the next few years based on its strong business base in Asia. The company's profits are highly stable compared with GE Vernova and Siemens Energy, which handle wind power generation facilities in addition to gas-fired power generation equipment.

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Expanding Wind Power To Hurt Short-Term Results

The rapid expansion of wind power installation projects in Asia, including China, could destabilize performance at some Chinese capital goods companies in the short term. Construction of offshore wind power is growing rapidly in the region. In particular, the amount of offshore wind power generation installed in China is world-leading. However, we believe that building these installations is more technically challenging and involves higher risks than thermal power facilities. Such challenges include cost control under inflation and project management in harsh natural environments. These risks are becoming apparent for some of China's major players. As demand for new construction surges in the coming years, companies like Shanghai Electric are likely to face severe pressure on prices given intense competition in the domestic market. Earnings from wind power will likely remain unstable.

We view investment in the wind power segment by Chinese capital goods issuers as consistent with Beijing's decarbonization policy. The Chinese government's 14th five-year plan contains a target of reaching a wind power generation capacity of about 580GW by 2025. There is 140GW left to fulfill in 2024 and 2025. Chinese wind power equipment providers have also invested in developing offshore capacity as an area with major growth opportunities, especially deep-sea equipment.

In contrast, we foresee the impact of development risk remaining limited for Japanese capital goods issuers. They have already withdrawn from in-house development and manufacturing of wind power generation equipment in recent years. Mitsubishi Heavy Industries dissolved its offshore wind power business and capital alliance with Denmark's Vestas in 2020. The Japanese company has since focused on sales and technological support of Vestas products in Japan. Hitachi retired its own production of wind turbine generators in 2019, and now specializes in operation and maintenance services.

Innovation Crucial For Credit Strength

In the long term, gas power equipment businesses could have a more negative impact on the creditworthiness of capital goods companies. Gas-fired power generation (LNG combined cycle) produces less than half the carbon dioxide emissions of coal-fired power generation. However, it lags renewable energy generation, which does not emit carbon dioxide. Therefore, there is greater uncertainty about the future of gas-fired power demand beyond the 2030s in our view.

We believe that the mid-to-long-term negative impact on the credit quality of capital goods companies could be mitigated, depending on how well they adapt to the energy transition. Development underway to further reduce carbon dioxide emissions. These include hydrogen/ammonia co-firing, dedicated combustion technologies, and carbon capture, conversion, utilization, and storage (CCUS). It will likely be many years before these technologies are fully commercialized. We see Mitsubishi Heavy Industries as more or less on par with major overseas peers in this area. The company recently announced plans to invest heavily in new technologies over the next three years. In terms of credit quality, we believe we need to closely examine whether:

• Cash flow can cover increased investment; and,
• Investments are large enough to ensure it does not fall behind in terms of new technology.

While greener technologies will be crucial in the long-term, Asia's need for power ensures capital goods companies can rely on thermal power assets for at least the next three to five years.

China: Different Policies And Demand

Orders for equipment for coal-fired power plants are increasing rapidly at Shanghai Electric Group Co. Ltd., rising 14% in fiscal 2022 (ended December 2022) and 84% in fiscal 2023. Project approvals are accelerating as the Chinese government seeks to enhance energy security and the stability of peak energy supply.

We expect Shanghai Electric to benefit from solid demand for thermal power generation facilities including coal plants for the time being, given its market share of 40%-50% in China. However, the company's business is widely diversified beyond power generation equipment, and the business' contribution to earnings is unlikely to be as large as that for Mitsubishi Heavy Industries.

We consider that coal-fired power generation equipment businesses have a greater negative impact on the creditworthiness of capital goods companies. These businesses emit significantly higher levels of carbon dioxide than other types of power generation. We expect demand for coal power to decline by around 2030, even in Asia. Mitsubishi Heavy Industries has almost completed structural reforms in the coal-fired power generation equipment business in anticipation of falling demand, and profits are improving. We believe that the negative impact of the decline of the coal-fired business on the company's creditworthiness will be small.

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