How has coronavirus impacted the energy transition?
The spread of Covid-19 is affecting all walks of life and the energy transition sector is no exception, but we believe the long-term opportunity remains intact.
The spread of Covid-19 around the world has brought about dramatic changes to economies and to everyday life. The full scale and duration of the impact from the virus remains unclear and will depend on both its future spread as well as the global policy response.
What is clear is that economic growth will see a sharp downturn, at least in the short term. (Read the latest forecasts from the Schroders Economics Team here).
With respect to the energy transition, we believe there are three main risks to companies: an impact on consumer demand, supply chain difficulties, and the effects of uncertainty and travel restrictions. We would highlight though that the sharp stock market sell-off in February and March opened up opportunities in stocks that were previously trading on lofty valuations.
Above all, we remain convinced of the long-term opportunity in the energy transition. If the world is to limit temperature rises to less than 2 degrees, as per the 2015 Paris Agreement, then the energy transition is essential. This is a long-term investment opportunity that will transform the entire energy system over the next 30 years and beyond.
What are the three main Covid-19 risks to energy transition stocks?
- Economic slowdown to hit consumer demand.
First and foremost, the economic slowdown will likely impact consumer demand in key end markets such as electrical goods, electric vehicles and residential energy applications. This would undoubtedly have a short-term negative impact on companies in the electrical equipment and battery markets.
- Supply chain and logistical risks
The second major risk concerns the supply chain and the logistical risks to companies across the different energy transition sub-sectors.
China dominates global supply chains, and particularly the production of solar equipment and lithium-ion batteries. With the Chinese government restricting movement across the country, the ability for Chinese factories to ramp up production following the Chinese New Year was limited. Production shutdowns are now occurring in many other countries too.
At the same time, global transportation networks have been restricted. As well as slowing production in factories, logistical challenges created by the lockdowns mean many facilities are unable to receive raw materials and components.
We believe the most material impact of any supply chain disruption could be to the renewable energy developers, with disruption in equipment deliveries potentially delaying project construction schedules across the world. It could also have the effect of increasing component pricing, which is an important assumption when considering project returns.
This risk has already started to play out. The full extent of any impact, however, will depend on the manufacturing time lost to the virus and whether this continues into the coming months. Many project developers, especially those in the US, will have already received equipment for 2020 projects.
- Impact of uncertainty and travel restrictions
The final risk comes from heightened global uncertainty and restrictions on travel. Together, these two forces may have the effect of seeing new renewable energy projects delayed or postponed.
2020 was meant to be a record year for both wind and solar installations globally, with new China additions central to this scenario. However, with restrictions on travel and challenges in securing investment for projects to be built, projects are likely to be delayed.
Again the full extent of any impact will depend on the policy response worldwide.
How have valuations been affected?
While we cannot predict how the virus will evolve from here, we remain conscious of the risks and are engaging with companies closely to understand the potential effects.
It is important to recognise, however, that despite the uncertainty, valuations in the market changed following the market fall.
Heading into February, valuations across parts of the energy transition landscape were starting to look stretched, at least in the short term. The chart below shows how valuations for the energy transition universe of companies declined sharply as the Covid-19 outbreak intensified around the world in March.
With valuations no longer looking so stretched, this opened up opportunities in high quality companies that we had previously viewed as too expensive on a risk-reward basis.
Energy transition remains a long-term theme
We acknowledge that the risks around the coronavirus in the short term are high, particularly with respect to 2020 earnings disruption. However, we believe the long-term value and potential of companies exposed to the energy transition has not materially changed.
While the coronavirus is dominating the world’s agenda, the imperative to reduce greenhouse gas emissions and slow the pace of climate change has not disappeared. Indeed, the single positive side-effect of coronavirus has been signs of improved air quality, as reduced economic activity has led to lower pollution in many areas. If we want to see lasting improvements in air quality, while returning to normal levels of economic activity, then investment in the energy transition is crucial.
The EV/EBITDA ratio is a valuation measure. It compares a company’s enterprise value to its earnings before interest, tax, depreciation and amortisation. Enterprise value is a company’s market capitalisation plus its net outstanding debt. EBITDA is a measure of a company’s cash generation, before interest payments on debt have been made.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.