As recent events at the COP26 climate conference have illustrated, investment in climate solutions has rapidly moved from the periphery into mainstream. To achieve climate goals, how we produce, distribute and consume energy will have to change significantly and will require monumental investment – as much as $120 trillion of over the next 30 years in order to get to net zero in 2050.
It is hoped the policies that emanate from the landmark Glasgow conference will lead to a more transparent and coherent framework for industry to accelerate investment in the energy transition to meet net zero goals. By investing in companies in areas such as batteries, electric vehicles and wind power, investors are helping support that transition, and businesses delivering products or services that are part of the solution should be well placed to deliver growth to shareholders.
Structural changes are necessary
To meet targets the energy system needs to undergo three structural changes, which are currently in their infancy.
Firstly, the decarbonisation of power generation. The share of electricity generated from renewables is expected to increase from 20% to almost 85% by 2050 in order to reduce carbon emissions, which should offer opportunity to utilities companies who specialise in renewables, electrical equipment companies, and energy storage companies who can help iron out the peaks and toughs of supply and demand.
Second, further electrification of energy use through the adoption of electric vehicles. The share of electricity in energy consumption is expected to increase from 20% to nearer 45% and most countries will require significant upgrades to their electricity grid and infrastructure.
Finally, increased efficiency is necessary to offset the growth in overall power consumption, which presents opportunities for businesses with intelligent or energy saving technology.
One option in the sector - Schroder Global Energy Transition Fund
There are broadening number of funds investing specifically in the transition towards lower carbon sources of energy and more sustainable forms of consumption. One is Schroder Global Energy Transition, which aims to outperform the MSCI Alternative Energy Index, the MSCI AC World Index and peers over a rolling 3-year period.
The fund was launched in December 2020 but adopts the same strategy as an offshore version that commenced in July 2019. It invests across the entire sustainable energy industry from production to end use, classifying investments into six activity groups:
- Renewable energy equipment
- Renewable energy generation
- Transmission and distribution
- Energy storage, batteries and other solutions
- Electrical equipment
- Clean mobility
Although investing across the sustainable energy industry spectrum provides some diversification, this is a higher risk and specialist investment. In addition, the portfolio comprises a relatively small number of constituents (30 to 50) which increases risk as each holding has a bigger impact on returns. In addition, some companies in the area may already be priced for high growth and any setbacks or inability to keep up with expectations could lead to significant share price falls.
List: Schroder Global Energy Transition top ten holdings
- Vestas Wind Systems (wind turbines) 4.4%
- Siemens Gamesa Renewable Energy (wind turbines) 3.7%
- Red Electrica (Spanish and South American grid operator) 3.4%
- Samsung SDI (batteries and electronic materials) 3.3%
- SolarEdge Technologies – (solar inverters and power optimisation) 3.1%
- Ormat Technologies (geothermal energy) 3.1%
- Johnson Matthey (speciality chemicals) 3.0%
- Volkswagen (vehicles) 3.0%
- Corp ACCIONA Energias Renovables (Spanish renewable energy utility) 2.7%
- Falck Renewables (European renewable energy generator) 2.6%
Source: Schroders – as at 30.09.21
Geographically, the opportunity set is global but there tends be a bias towards Europe, and away from the US.
Manager credentials and philosophy
The fund’s lead manager is Mark Lacey, Schroders Head of Global Resource Equities, who joined Schroders in 2013 initially to run their global energy strategy. He is the former manager of Investec’s global energy funds and the former Head of Global Energy at Goldman Sachs, among other roles.
Portfolio manager Alex Monk joined the team in September 2018 as a sustainable energy analyst, having started his career with Schroders in 2016. Felix Odey, also portfolio manager, joined the team as an energy equity analyst in June 2017. The team make use of Schroders’ global research platform and can interact with regional or sector specialists to enhance their own research. This is particularly important in regions such as China where corporate governance can be more variable.
The managers seek to capture the growth on offer in the energy transition space without paying too much in terms of valuation. Specifically, they focus on finding companies within the energy transition space that can generate sustainable, long-term growth and earnings and are resilient in terms of balance sheet strength. A differentiating feature is the manager’s willingness to run up some cash (up to 20%) when attractive opportunities are in short supply.
Managers’ current outlook
With significant investor interest in the sector finding reasonable value shares can be a challenge s. The manager avoids overpaying for exciting areas and currently sees an acceptable balance between risk and reward in larger industrial, electrical equipment and utility companies. In particular, the manager has been adding to Johnson Matthey (fuel cell membranes, cathode batteries) and Plastic Omnium (fuel cells). Positions in solar energy equipment were also added after a recent correction.
In smaller companies he suggests funding ‘gaps’ could occur and lead to some bankruptcies. However, he is less cautious than earlier this year, reflected by a cash level of 8%, down from March when it was at 18%. There is little exposure to areas perceived as ‘overexuberant’ such as hydrogen, and there is now negligible exposure to China which represented as much as 10% of the fund at the start of the year. The focus continues to be on attractively priced high-quality companies, strong balance sheets and sustainable business models.
Energy transition is a multi-decade theme where capital will be reallocated on an unprecedented scale, creating investment opportunities across a multitude of sectors and industries. However, there has been a surge in interest in renewable energy stocks recently and consequently valuations have become more expensive.
There have been some genuine drivers behind this: Fundamental resilience during Covid 19, a positive change in US leadership, loose monetary policy, enormous public fiscal support, and the shift in capital towards sustainability and environmentally themed investments. However, there is a danger that a large wave of money is seeking a relatively small number of opportunities in the area in a short time period, which could drive up prices in ‘hot’ areas.
We believe a selective, disciplined and active approach such as the one adopted by this fund is a sensible means to access the space. The combination of a well-resourced team and competitive charges for a fund of its type add to the attraction. However, even among the more established businesses in the energy supply chain there will likely be significant losers as well as winners. The combination of the strong recent track record of the area and the positive environmental outcomes should not distract from the high risk involved.
For patient, longer term investors it could be worth considering as a more adventurous, satellite holding in a broad portfolio. It is also worth noting that it excludes companies involved in fossil fuels and nuclear energy, as well as applying ESG screens, so it could be of interest for many responsible investors too.
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