ETF Update: Follow the Money in Clean Energy Picks

Summary

• The clean/renewable energy sector has rallied strongly since the Russian invasion of Ukraine and soaring energy prices highlight the need to improve energy security.
• But any further rally will require significantly more funding from governments – particularly the US. That will not happen until Congress passes at least the climate-related section of the Build Back Better legislation.

Investment Outlook

• In the near-term, we go from ‘overweight’ to ‘market weight’ in the clean energy sector. But we continue to believe the clean energy sector will outperform the broader market over the medium term.

Clean energy is one of the key secular investment themes we have been advocating. Indeed, since August 2021, we have been overweight nine clean energy ETFs (see table above). These funds outperformed into and immediately after the Glasgow UN Climate Change Conference in November 2021.   However, the funds underperformed for much of the period after – some by as much as 15-30% versus the S&P500.

What Explains Earlier Underperformance of Clean Energy

The three main reasons for that period of underperformance were:

1. Lack of profits. Many of the companies in the clean energy sector are early-stage growth companies that are unprofitable. One – if not the primary – theme of 2022 so far has been a wholesale shift away from speculative growth companies to value companies.
2. Lack of progress. Second, many countries are clearly yet to start reducing carbon emissions or meet the targets they committed to in Glasgow. China, prioritizing growth, gave its steel industry five additional years (to 2030) to meet emissions goals. The US has done little. And with the collapse of the Build Back Better legislation, it will likely do little for the foreseeable future. Only meagre progress is likely until at least the climate change provisions of the Build Back Better legislation are enacted.
3. Lack of investment.  A stark example of the power of government investment is the performance of two infrastructure ETFs, IFRA and NFRA. Both invest in the kind of infrastructure covered in the $1 trillion bipartisan infrastructure bill that became law last November (Chart 1).  The difference between IFRA and NFRA is that IFRA holds US infrastructure companies, which will benefit directly from government-funded infrastructure investment. Meanwhile, NFRA invests in infrastructure companies globally and only has 40% exposure to the US.

We expect the clean energy sector will benefit enormously once federal money starts to flow into the sector.

Russia/Ukraine Conflict Makes Renewables Fashionable Again

The Russian invasion of Ukraine has brought renewed and intense focus on the West’s exposure to fossil fuels and the autocratic countries that produce much of the world’s supply. Politicians have turned again to renewables as a means of achieving energy security – with the additional benefit of cutting emissions.

Another impetus was the latest assessment from the IPCC, warning that time has all but run out to limit global warming to 1.5 C. But the juxtaposition of these events only underscored the relative importance of security versus emissions.

Most clean energy ETFs, in turn, have rallied sharply since the invasion. Notably, TAN (solar power) is up 25%, HDRO (hydrogen power) is up 24% and FAN (wind power) is up 10%.

One notable laggard is the battery sector (BATT and LIT), which declined. An obvious reason is the skyrocketing price of essential metals to manufacture batteries (Chart 2). But these ETFs invest in both mining of battery-related minerals and battery technology/manufacturing. They should rally once metal prices start to decline.

While we believe the future is bright for renewables and clean energy over a multi-year horizon, we are more cautious in  the near-term for several reasons:

• Much renewable technology relies on metals and minerals such as copper, nickel and lithium. No one can say when prices of essential raw materials will return to normal. It could be days, weeks, or months. A lot of the clean energy sector will be on hold until prices fall, and that will surely feed into equity prices near term.
• There is no visibility on when the US might enact the clean energy component of the Build Back Better legislation. Republicans have opposed every aspect of it so far, and in any case, legislative priorities have shifted to geopolitical concerns. Without that influx of money, clean energy is unlikely to rally much more.

• Another key question is how long hostilities last in Ukraine. As long as the war persists, clean energy equities may have a modest tailwind. If it ends soon and energy and metals prices return to more normal levels, the current talk of investing in renewables to achieve energy security will fade and momentum will likely slow.

Bottom Line

We do not expect the clean energy sector to significantly outperform the broader market until governments (particularly the US) commit more resources and investment. However, given geopolitical and climate realities, downside is also limited. For now, we see clean energy as a hold, although investors may want to gradually add to positions.

Appendix

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)