Why the going is about to get tougher for investing in climate change


2020 was an extraordinary year for climate change action. Public opinion, governments, businesses and financial markets all had major shifts in their appreciation of the urgent need to address the climate crisis. More investment, research and development, and international collaboration will now come together to enable a faster transition to a net zero economy.

While this is just a start, it is undeniably fantastic news for the planet and our chances of avoiding a climate disaster.

So far, the new political and business momentum has also been exceptionally supportive for investors in businesses working to mitigate climate change.

Valuations heating up

However, investing is rarely that straightforward. As financial markets woke up in 2020 to the scale of the transition ahead, company valuations started to reflect this.

There was a large upward re-rating in the valuations of companies with strong technology in areas such as renewable energy, electric vehicles (EVs), hydrogen, circular economy (an economic system that aims to eliminate waste and the continued use of resources) and sustainable foods.

This re-rating mainly reflects the improved growth prospects for those industries and the companies that have invested to create solutions as the transition gathers pace.

Competition is too

Higher market valuations for climate change assets not only represent a headwind to future investment returns, but broader awareness of the transition and growth opportunity ahead will now inevitably lead to stronger competition.

This competition will come from new entrants and from existing companies in adjacent industries that reorient their strategy.

Solar

There have already been several examples of competition driving down returns in climate-related industries, the best example of which is the solar industry. A wave of investment and capacity expansion by Chinese companies over the last decade has commoditised and fragmented the industry, putting almost all non-Chinese manufacturers out of business.

There is the odd exceptional survivor of this period of intense competition. For example, First Solar has managed to survive by pioneering a proprietary technology and manufacturing method for solar panels that has enabled it to continually cut costs and protect margins. However, overall, the solar industry has been a terrible long-term investment.

Another recent example is cathode materials, which are essential components in lithium ion batteries. As it has become clear that battery technology can enable a wholesale shift in the car market from internal combustion engines to EVs, there is an immense growth opportunity ahead as global EV penetration expands from 5% today to close to 100% eventually.

The suppliers to this industry, including cathode manufacturers, have dramatically scaled up their production, but there has also been a wave of new entrants building capacity, particularly in China. The industry structure has, therefore, fragmented and despite the strong growth the market has gone into oversupply with margins and returns on capital under pressure for all involved.

These are historical examples, but there are also other more current situations where we see signs of rising competitive intensity and fragmentation.

Electric vehicles 

Established pure play manufacturers such as Tesla and NIO are now being joined by a raft of new entrants. Numerous other start-ups have raised capital and listed via special-purpose acquisition companies (SPACs). And there has been an explosion of new model introductions by incumbent carmakers.

In fact, it seems not a week goes by now without an automaker declaring they will be 100% electric by 2030 or 2035. If that were not enough, Apple is also persistently rumoured to be entering the market in a few years time. This competition will be good for volume growth, and some suppliers will do very well, but it will likely be a lot more challenging for the automakers competing for market share with the consumer.

Renewable energy power generation assets

Here, the market is fragmenting amid a large increase in the number of companies seeking to build and own renewable assets. The new competitors include newly established developers funded by capital markets, incumbent utilities making the shift to cleaner generation, and most recently several traditional oil and gas companies which are reallocating their capital budgets from fossil fuels to renewable power.

In this environment of plentiful funding and an increase in competition, good stock investments must be much more carefully selected.

Successful companies will be those that have a clear and sustainable competitive edge. The better industries to remain invested in will be those where there remains a reasonable number of rational competitors because there are high barriers to entry and the potential for product differentiation.

The wind of change

One example where the competitive environment remains reasonable, in our view, is the wind equipment industry.

The wind turbine industry had a major shakeout over the last decade, and market share has consolidated naturally around the strongest companies. Furthermore, there have been no major new entrants in recent years, and the key players have different propositions, so the wind industry is one where we believe the prospects of achieving profitable growth at good returns look strong.

Any company references are for illustrative purposes only and are not a recommendation to buy and/or sell, or an opinion as to the value of that company’s shares.

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