Equities | ESG & Climate Change | Global | US
- Clean energy has been the worst-performing sector in our model portfolio in 2022. But over the past seven years, it has outperformed the broader market.
- The 2022 underperformance is due to various factors, including deflating a post-election bubble, the slowdown in China, and higher rates, which weigh on loss-making companies.
- The clean energy sector has enormous investment potential. But it is unlikely to achieve that potential until countries take well-funded action on their commitments. It will happen – it is just a question of when.
- We expect the clean energy sector will perform in line with, or modestly worse than, the broader market for now.
- We will hold our present positions and look to add if there is a further significant selloff. Otherwise, we will wait for evidence governments are preparing to commit far more serious resources to reduce carbon emissions.
- For the full overview of our equity insights, please see the latest Equity Trades report.
COP27 – More Commitments, Short on Action
The annual climate Conference of the Parties (COP) is occasion to celebrate new commitments to limit carbon emissions. It is also a time to lament missed targets and the challenges of implementing cleaner energy policies. The latest COP27 in Egypt was no exception.
After much debate, rich countries agreed to establish a fund to help emerging market countries. These countries contributed little to global warming to date but are disproportionately subjected to the environmental hazards, inadequately equipped to recover from disasters, and less able to adjust to future changes. That, of course, was the easy part.
COP meetings also renew attention on the whiz-bang technology that could lead to a carbon-free future. Think green hydrogen, longer-lasting battery technology, carbon capture machines, and ocean desalination methods. Yet naturally, they bring little new money to develop these ideas.
Clean Energy – Good Investment or Feel-Good Investment?
Clean energy technology has been under development for much of this century. Exchange-traded funds (ETFs) focusing on companies in the clean energy sector have been around for over a decade (Table 1). TAN, focusing on solar energy, debuted in April 2005.
The clean energy sector has gained momentum in the past few years as awareness about the consequences of global warming rises. We summarise 24 clean energy ETFs in Appendix A-1. Most were created in the past couple of years.
Having various clean energy investment vehicles is one thing – the key question for investors is whether they are good investments or just ‘feel-good’ investments.
We have been long seven clean energy ETFs in our model portfolio since August 2021, in a burst of enthusiasm following the COP26 meetings in Glasgow. As we have discussed elsewhere, the clean energy sector has been the worst performer in 2022. Between that and the more pessimistic tone as COP27 closes, it is reasonable to ask: is clean energy a good investment? Quick answer – probably not for investors looking for year-ahead performance. Longer term? The potential is there.
We focus on ETFs that have been in our model portfolio and a few other similar ETFs (Table 2, model portfolio holdings highlighted in bold). We plan to return to other subsectors, such as electric vehicles, soon.
How Have Clean Energy ETFs Performed?
Chart 1 shows the performance of several clean energy ETFs available since at least 2016.
- Most trailed the S&P 500 in the years before 2020.
- The serious rally started after the 2020 presidential election in hopes of new investment in infrastructure and clean energy.
- Clean energy ETFs rallied again in autumn 2021. This was on hopes that clean energy would be included in the infrastructure bill that became law in November 2021 and then sold off.
- They rallied again briefly when the Inflation Reduction Act passed and provided $369 billion for climate-related investment.
The most robust ETFs are LIT (which focuses on lithium mining, processing, and related technology) and QCLN (which focuses on US companies involved in clean energy). Since 2016, all these ETFs have outperformed SPX except FAN, which focuses on wind power.
Why Is Clean Energy Underperforming in 2022?
Overall, clean energy ETFs have been an investment success story, albeit a volatile one. We clearly cannot write the sector off as a hopeless cause. Yet we can reasonably ask, does it make sense to commit more capital to the sector?
Let us review why clean energy has underperformed in 2022.
- The post-election rally was a bubble, and the selloff is a return to more reasonable valuations.
- Some of these ETFs have 10–15% exposure to China. The MSCI China Index is down about 25% versus the SPX in 2022. At one point, it was down about 50% due to Covid-related lockdowns and stalled economic growth.
- Many companies in the clean energy sector are small and loss-making. They have been hurt in a rising rate environment due to a higher discount rate on future profits.
The loss-making issue is apparent in Table 4. We can obtain financial performance data for most indices that underlie clean energy ETFs, including earnings per share (EPS) data. Several posted negative trailing EPS. The difference between the trailing EPS and the trailing EPS for companies with positive earnings is particularly striking. For example, TAN (one of the best performers in 2022) posted trailing EPS of $3.24 and positive trailing EPS of $28.07. Forward earnings are $19.75, implying that the loss-making problem will remain for the foreseeable future.
The only ETFs where the gap between EPS and positive EPS are GRID and LIT. GRID’s holdings are largely established utilities that have invested in clean energy infrastructure. LIT has benefited from the extraordinary eightfold surge in lithium prices over the past year (Chart 2).
What Next for Clean Energy?
We expect clean energy will perform roughly in line with or modestly worse than the underlying market for now. Clean energy has enormous potential, as the gap between trailing and positive trailing EPS makes clear. But we just do not see the sector achieving the kind of scale required to move to the next level in the foreseeable future.
Most people accept that climate change is a reality we must address. That is different from implementing change. Most countries are far behind their commitments to reduce greenhouse gases. The incoming Republican House of Representatives in the US wants to cut funding for clean energy investments. While any attempt will likely die in the Democratic Senate and will fail before a presidential veto, the foreseeable future holds no new clean energy initiatives or funding.
As an aside, the US has cut carbon emissions from 5.7 kilotons in 2007 to 4.8 kilotons in 2019. But this was mostly due to the oil and gas fracking phenomenon that caused gas prices to collapse and pushed utilities to switch from coal to gas. Absent that fortuitous occurrence, US carbon emissions would likely be little changed or have risen even higher over the past decade.
Aside from the inaction of many countries, the immensity of the technical and logistical challenges involved in reducing greenhouse gases is now becoming apparent. To be blunt, countries will have to commit far more resources to limit carbon emissions.
It will happen, if only because it must. The only question is, when?
We will hold our clean energy positions for now. If there is a further significant selloff, we will add to positions. Otherwise, we suggest waiting until we see evidence that all those commitments are turning into well-funded actions.
Index refers to the underlying index that the ETF tracks. More information is available on Bloomberg by appending “Index” to the index name and hitting <ENTER>.
The sponsors of FAN and PBW do not provide data on their underlying indices, including the members and financial performance. Going forward, we will not recommend or endorse any ETF that does not provide full disclosure about the underlying index.