The world is wisely transitioning from reliance on fossil fuels for energy to more renewable sources. Transitions often present investment opportunity. And we believe the energy transition will prove no exception.
Initial commitments from governments around the globe to hit 2050 climate goals are encouraging. Demand estimates for renewable energy sources are staggering. BloombergNEF, a provider of financial data, estimated late in 2020 that green energy will require around $11 trillion of investment through 2050.
When investors see macro numbers like these, and we are in a bullish market environment supported by record stimulus and low interest rates, it is easy to see how the hype around any company tied to the energy transition can explode. It is human nature to have the desire to help the environment, but when that desire mixes with investing, danger of losing money arises. Investing in companies tied to the energy transition should undergo the same fundamental, balance sheet, and valuation analysis as any other investment. Although many companies in this space will never achieve their growth targets, and many will not even exist years from now, many investors blindly buy them for their “story”.
As history showed us in past decades, every new industry and transition from craft brewing to the internet to alternative energy to cannabis to crypto has left the world in a better place, but many investors in a worse place. When investors buy at obscene valuations before actual fundamentals materialize, they are pulling forward future returns. So even if companies execute, the risk is that the valuation will decline, offsetting core business growth, leading to potentially disappointing returns for these investors.
Let us quickly provide just a couple examples of this dynamic –
- A major clean energy company recently reported financial results for the fourth quarter 2020. In that report it produced negative revenue, but the stock rose over 10% as the focus was on future deliverable billings years in the future. The stock is up over 6 times from levels seen last June and trades at 20x 2023 revenue. For broad context, the S&P 500 trades at 2x 2023 revenue and a basket of clean energy companies heavily weighted towards utilities trades at just over 3x.
- A major utility that is not expected to grow revenue between now and 2023 saw its enterprise value-to-EBITDA valuation multiple expand from 12x median pre-2020 to 33x in early 2021.
Often ignored during these indiscriminate buying sprees fueled in part by large, very long term demand forecasts is the supply risk. This is especially the case in a world where the cost of capital is extremely low and the zeal to participate in a green revolution is fueled by good intentions that can ignore risks in the name of a creating a greener future. Entrenched incumbents in the power and energy supply chains have major incentives to find solutions to participate in the green energy future. Plus, still readily available liquidity and investor passion for clean energy is leading to significant investment that will create more competition than some investors may realize.
Consider these cases –
- A special purpose acquisition company (SPAC) acquired an electric vehicle charging station company, and saw its price go from around $10 to $60 in 3 months. Even after selling off from the highs, the company trades at 26x 2023 revenue versus 6x for a major clean-energy-focused utility. This despite the possibility that a coalition of U.S. electric utilities could explore rolling out a charging network of their own. The utilities can raise funding at lower costs than the recently acquired charging company, due to having a stable core business, plus have built-in customer relationships creating lower customer acquisition costs.
- A company that provides financing for clean energy projects saw its stock go from $30 last summer to $70 early in 2021. A growing number of financial institutions are looking to try to provide similar financing offerings to the market, potentially putting pressure on the yields this company could earn in the future.
- A major global traditional energy company recently lowered the required rate of return on clean energy projects. As a diversified business it can afford to do this. Focused clean energy companies may not be able to continually lower return rates over the long term and deliver acceptable financial results to investors.
As these examples demonstrate, hype can lead to prices that make investment irresponsible. And as a fiduciary, we cannot participate.
Instead, we embrace the energy transition while responsibly investing in it with more of a margin of safety –
- We vet broad baskets of clean energy for the most attractive mix from a valuation and fundamental growth perspective since the quality of the indices vary, while also prioritizing due diligence on individual opportunities that could benefit from the transition but whose valuation does not adequately reflect it.
- We continue to align with companies supporting the energy transition, even if they are traditional energy companies, as long as they are making material strides to improve their environmental impact. Examples include 1) an oil service company that is investing in new energy services that help implement the energy transition; 2) an energy producer who has cut their greenhouse gas emissions intensity by over 50% in the past year and provides a fuel that helps utilities have a stable energy source while they grow their renewable energy mix; 3) an energy infrastructure company that supports the displacement of dirty fossil fuels like coal; 4) an energy infrastructure company that is positioned to benefit from the growing use of renewable diesel; and 5) an energy infrastructure company that could benefit from the use of hydrogen and the company’s abilities in carbon capture.
We strongly endorse the energy transition. We also take seriously our role as a fiduciary to attempt to protect and grow client’s wealth in order to meet their long term goals. We do not believe these are at odds. And we look forward to responsibly participating in the investment opportunities created by this exciting transition.