Energy transition generates potential investment opportunities

Structural changes in the world’s energy systems represent significant investment potential across an array of sectors. Analysts on our equity research team offer insights on the impact and opportunities.

Ryan Kauppila | Analyst | Global natural resources

The decarbonization of the global energy system, also known as the energy transition, likely entails the largest infrastructure investment in human history, with hundreds of trillions in U.S. dollars at stake. The change won’t happen overnight, but past energy transitions highlight the magnitude of potential disruption ahead. It’s hard to overstate the implications. Consider the shifts from raw to cooked food, from nomadic to agrarian lifestyles, and the more recent transition from wood to hydrocarbons, which enabled urbanization and our modern lifestyle.

We believe such a monumental undertaking requires an open-minded, flexible approach to investing. The energy sources most typically associated with clean energy — such as solar and wind — will likely play a hugely critical role and will likely continue to see rapid technological progress. However, what’s underappreciated is the same can be said for legacy forms of energy like nuclear and oil and gas hydrocarbons. Over the next decade, we’ll likely see higher energy price volatility. This will be due to the interplay of inelastic energy supply, less predictable demand, the scaling of new technologies, and the implementation of policy instruments aimed at reducing the amount of carbon in energy. This expected volatility is an important lens for evaluating both legacy energy producers and next-generation energy technologies. In our view, the energy companies that best adapt to a more volatile price environment are likely to see the greatest multiple expansion over the coming decade.

The price volatility is likely to create equity price inefficiencies when sentiment ebbs decidedly toward one solution over another, or if a company-specific aspect is poorly understood. For an acute example, both cutting-edge hydrogen fuel cell manufacturers and legacy coal miners will have roles in the energy transition, but we expect the assumptions embedded into their valuations will vary significantly over time.

Peabody Energy, the largest U.S.-listed coal producer, has outperformed the largest hydrogen fuel cell manufacturer, Plug Power, by approximately 70% since January 1, 2020. However, this masks the year between February 1, 2020, and February 1, 2021, in which Plug outperformed by 1,500%! It’s an extreme example of the dynamic and highly volatile investing environment we expect to accommodate decarbonization.

Given that energy use is central to every human activity, the magnitude of the task at hand is immense. The decarbonization of the global energy system is incredibly complex, with a wide range of potential solutions. When investing in the energy space, we believe it is critical to stay focused on the overarching goal of transitioning the system while remaining unbiased about how that is achieved. We are excited about the dynamic investment landscape that lies ahead.

William Rives | Portfolio Manager, Analyst | Utilities

The energy transition is one of the biggest themes in the utilities sector today. Moving from coal and gas power plants to solar, wind, and nuclear power creates a wide range of potential opportunities for businesses in the sector. This includes not only building solar and wind plants, but also building transmission lines to connect these new generation resources to demand centers. The transition also involves modernizing the distribution grid to handle these intermittent resources. We aim to project which utilities have the latent opportunity to transition and improve their overall environmental profiles, because that often leads to more investment. This is key for regulated utilities, as more investment drives more earnings growth, and earnings growth powers stocks.

Also, as the economy increasingly electrifies, utilities will be key enablers. Every 2–3 electric cars on the road represent an entire house’s worth of electricity consumption. Utilities will need to invest more into the grid to meet this demand. This means improving existing infrastructure as well as building new transmission and distribution systems — the wires and poles. Further down the road, utilities could play a key role in clean hydrogen production. Overall, the energy transition means more investment in this country’s electrical grid, which will likely help drive earnings growth for the sector over time.

Key enablers — and potential beneficiaries — of the energy transition are businesses like NextEra Energy, one of the largest electric utility holding companies, and Ameren Corporation, which has large, depreciated, high-cash-flowing coal fleets and is transitioning to wind energy.

Carly Schulz | Analyst | Electric mobility and green technology

The energy transition is creating potential investment opportunities in the “clean-tech” realm, specifically electric vehicle (EV) batteries and solar power.

Manufacturers of EV batteries

We are at the start of a once-in-a-generation secular growth opportunity for EVs and the batteries that power them. Of all cars sold globally in 2022, EVs represented less than 10%. Looking forward, as EVs become cheaper and more reliable, EV penetration is estimated to reach 25% to 30% by 2030, suggesting 25 million to 30 million EVs sold annually. As EV adoption accelerates and zero-emissions mobility becomes commonplace, demand for EV batteries will inflect higher. We expect global battery shipments to grow at a compound annual growth rate of 20% to 30% or more through 2030.

Additionally, the Inflation Reduction Act (IRA) should meaningfully subsidize U.S.-based production of EV batteries. As IRA-related tax credits for U.S.-made batteries could represent more than 30% of the typical battery price, battery manufacturers with outsized U.S. production capacity could see margins shoot higher if they qualify for and receive these tax credits.

Potential winners include larger Korean battery manufacturers, such as LG Energy Solution and Samsung SDI. These companies benefit from substantial existing U.S. production capacity, with plans to add even more, and long-standing relationships with major auto equipment manufacturers. Additionally, unlike their Chinese competitors, LG Energy Solution and Samsung SDI are relatively unencumbered by geopolitical tensions.

Manufacturers of utility-scale solar panels

Growth in shipments of U.S. utility-scale solar panels is expected to accelerate from already strong levels as utilities and businesses seek to lower their emissions/carbon footprints, and as the IRA incentivizes significantly more demand via subsidies and tax credits.

Historically, U.S. panel makers have struggled to gain share versus their Chinese and Southeast Asian counterparts, which have consistently offered the lowest-priced panels on the market. We believe this will change under the IRA. The legislation should drive demand for U.S.-built solar panels materially higher, as the IRA directly subsidizes solar developers’ purchase of U.S.-made solar equipment. As demand accelerates, U.S. panel manufacturers could also benefit from a large production tax credit that would drive their profits substantially higher.

We view First Solar, the largest U.S.-based panel manufacturer, as uniquely positioned to benefit from these tailwinds for U.S. utility-scale solar. First Solar has three times the U.S.-based production capacity of its next-largest peer and a backlog spanning the better part of this decade. And, in contrast to foreign competitors, First Solar has many more years of experience manufacturing panels in the higher-cost U.S. market.

Manufacturers of residential solar equipment

Residential solar power demand has surged globally as more consumers seek clean energy to lower both their bills and their impact on the planet. A favorable backdrop of declining solar energy system costs and rising utility rates has driven six-fold growth in annual residential installations over the past decade.

In our view, the most attractive way to take advantage of the growth in residential solar adoption is through equipment makers that offer differentiated, mission-critical technologies. Inverter manufacturers SolarEdge Technologies and Enphase Energy strike us as beneficiaries given their entrenched competitive positions and profit margins that are well above the industry average. Together, they hold 85% of the U.S. market as well as improving share in the fast-growing European solar market.