The energy transition opportunity

The energy transition investment theme covers the value chain of renewable energy equipment manufacturing through to power production, as well as looking at how to decarbonise transportation. In recent years the theme of energy transition has evolved beyond the need to address climate change and now has the additional structural underpinning of the need for energy security in a more polarised and unstable world.

Since Russia’s invasion of Ukraine, the EU has focused on the goal of energy independence. In 2022, the EU announced the REPowerEU plan focusing on energy efficiency and renewable energy generation targets. This, coupled with Biden’s US Inflation Reduction Act (IRA) provided unprecedented support for climate and energy security.

2023 saw these plans start to take hold. In the US, the IRA is credited with creating 170,000 jobs in the first twelve months of being passed into law and it is projected to create 1.5 million jobs by 2030. The level of investment seen to date, some $270 billion, is adding to hopes for the US to reduce emissions at the pace needed to meet climate targets. In Europe, the European Investment Bank (EIB) announced €88bn in funding for 900 green and innovative initiatives which are expected to lead to €320bn of investment and support over 5 million jobs in the coming years.

On a global level, the climate change agenda remains one of the key drivers for the energy transition theme. This was shown by the commitment of 130 countries at COP 28 in signing the Global Renewables and Energy Pledge. COP, or Conference of Parties, is the United Nations Climate Conference, where global leaders came together in December 2023 and agreed to ‘transition away from fossil fuels’.

Can upcoming elections impact renewable energy policies?

If the trend continues of more right-leaning representation following the EU parliamentary elections this summer, it could mean less of a focus on the climate agenda for sure. However, lots of policy has been agreed upon in recent years, and it is now up to the member states to implement them. Regardless of party policies, all sides agree that energy independence, and controlling the costs of energy and in turn inflation for consumers is of the utmost importance.

In the United States, now that the IRA is enshrined in the tax code, it is very difficult to undo. We do acknowledge that a Trump presidency can be unpredictable, so there are no certainties. However, it would take Republicans to control the House, the Senate and the White House to make meaningful change here. Even if Republicans gain full control, it is hard to see Republican senators voting against jobs in their states as red states have seen more jobs and investment than blue states. According to the American Clean Power 2023 report, Texas had the greatest number of clean power installations in 2023, almost double that of the next state which was California.

It's not all about policy support - the economics make sense

While there have been many false dawns with the clean energy revolution in the past, we are now at a stage when the cost of renewable energy is cheaper than fossil fuels. The cost structure for renewables is different than fossil fuels with 70-80% of the cost upfront. In comparison, a natural gas project would have less than 20% upfront cost. The concept of Levelized Cost of Electricity (LCOE) is used to compare the full lifetime cost of power generation. In 2023, the International Renewable Energy Agency reported the cost of wind and solar ranged from $0.05-0.07 per kilowatt hour (a measure of energy) while the cost of fossil fuels $0.10-$0.20 per kilowatt hour. In the case of solar, this is almost a 90% reduction on 2010 costs despite the rise in rates making projects more expensive in recent years.

Macro environment

While the structural tailwinds from policy remain supportive, there have been macro headwinds. 2023 was an example of that, stubborn inflation forced global central banks to react with interest rate increases throughout the year. This was a challenging environment for energy transition companies. Renewable energy projects are sensitive to interest rates as they require a lot of upfront capital compared to non-renewable alternatives such as gas and coal. Most energy transition companies are high-growth companies with a large emphasis on future earnings, their valuations decreased as higher interest rates meant that future cash flows were now discounted at higher rates.

The outlook is a lot different for 2024. Central banks have made progress in fighting inflation and investors have turned their attention to interest rate cuts. The charts below show the progress made on inflation so far and the lower interest rates now expected by the market. Lower rates would make power generation projects more commercially viable and will boost the debt-intensive energy transition sector.

Earnings and valuations

The sell-off in the Energy Transition sector in 2023 has made the sector more attractive from a valuation perspective. The S&P Global Clean Energy Index started 2023 with a P/E (price to earnings) ratio of 73x1, the index now trades at a multiple of 22x1. For context, the MSCI All Country World Index (ACWI) currently trades at a multiple of 19x1. The valuation premium to the ACWI (All Country World Index) is reflective of the relatively stronger earnings growth expected in the clean energy sector due to some of the catalysts mentioned earlier.

Problems encountered so far

Commercial viability: Many energy companies agree on long-term contracts before projects are developed, fixing the price at which they sell energy. This became a problem in 2023 as inflation caused massive increases in costs while interest rate increases raised the cost of debt. In offshore wind, for example, some companies signed lossmaking contracts that were only partially offset by government subsidies. Easing inflation and the prospect of interest rate cuts make the outlook brighter for 2024.

Policy: On the government policy side, the Inflation Reduction Act in the US pledged huge financial support to renewable energy companies. Many firms, however, have had to postpone investment decisions until further clarity is obtained on tax credits. Firms expect to receive this in the coming months.

Global competition: In the solar sector, competition from China has been a huge problem for solar manufacturers in Europe & the US. This has led companies in the sector to put pressure on lawmakers to limit Chinese solar imports, hoping to prevent a dependency being built on Chinese solar power. More recently, the sector has staged a rally on the hopes of a demand recovery in Europe.

In summary, a large proportion of the problems holding back the energy transition sector are short-term in nature. The outlook for the sector remains promising with a more constructive macro environment, further policy support and ever-growing demand for alternative energy solutions. The projected growth of renewables as shown in the chart below is a massive tailwind and will be an important driver of returns for investors in the space.

¹ Bloomberg, March 2024