Global Climate Change Fund Managers, Simon Webber, Matthew Franklin and Giles Money, look ahead into 2011 …
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Author: Simon Webber, Matthew Franklin e Giles Money di Schroders
For professional investors and advisers only
Many of the fundamental drivers of the climate change theme are turning up in 2011. Energy prices have begun to rise, public climate change concern has increased once more, and business confidence to invest in new solutions is increasing. In general, we therefore expect this to be a year of improving fundamentals for climate-related stocks, but it will be as important as ever to be selective on quality.
Here we give a brief overview of our outlook across five key investment themes for 2011:
1. Energy efficiency
The positive momentum behind energy efficiency technologies is likely to continue in 2011. Whether it is lighting, insulation, air conditioning, video conferencing, lightweight materials or power management systems, energy efficiency investments tend to have very fast pay-back periods. As a result, they generally have significantly higher return on investment than investments in, for instance, new energy generation technologies, and we expect energy efficiency to remain a spending priority for consumers, companies and governments alike.
A few examples below help to illustrate the powerful growth in many energy efficiency markets:
Lighting
LED lighting is set for explosive growth (chart 1), displacing other lighting technologies as a result of its superior energy efficiency characteristics. The general lighting (as opposed to consumer electronics lighting) market is just hitting the crucial point where payback periods on new investment have fallen to one to two years, making it a highly compelling switch for businesses.
Business Energy Savings Programmes
Ameresco undertakes energy efficiency programmes for public and private organisations in the US (new boiler, heating, insulation and air conditioning systems etc), participating in both the consultation and implementation phases. Through the use of Energy Savings Performance Contracts, or ESPCs, the company commits to the customer that a project will meet agreed savings targets. Ameresco then assists the customer in obtaining third-party financing for the cost of construction, limiting the upfront cost to the customer. The savings from the project are used to pay off the loan over time. Honeywell also has good exposure to this business, which is growing strongly.
2. Clean energy
In 2010, of the 113 groups in the Dow Jones Global Index, Renewable Energy Equipment came in 113th! This was despite oil prices being strong (the historical sector correlation with oil broke down as power prices left renewable energy less affordable relative to fossil fuels). For 2011, we expect to see three key developments for renewables:
–– Modest improvement in global power prices driven by higher economic growth and higher coal prices.
––Consolidation among European renewable equipment producers.
–– As domestic growth slows, Asian equipment companies and developers to come unstuck domestically and begin to attack foreign markets in their search for growth.
While valuations are attractive in many cases (charts 3 and 4), the industry will likely need regulatory drivers, and a further improvement in energy markets globally, for better performance.
On the regulatory front, China and Germany both have significant capacity issues with their electricity grids, while European politicians are increasingly bothered by the rising cumulative cost of solar subsidies. In the US, a Republican House of Representatives will not be favourable to new climate regulation, so 2011 could be a disappointing year for renewable energy sector public policy developments.
In 2010, China accounted for around 47% of the newly installed wind power (17GW) and Germany accounted for around 55% of the solar market (8GW). This concentration risk is not good for either industry, and we expect to see a healthy broadening out of the end markets in 2011, particularly in the solar sector.
In 2010, we observed subsidy cuts in Germany, Spain, France, Italy, and the Czech Republic. Going into 2011, we expect further subsidy cuts to be communicated in Germany and France, as well as natural declines in Italy. With the prospect for installation caps in a number of key end markets, there is a high likelihood of growth disappointment in solar.
Given these numerous headwinds, we have selective exposure to renewable energy sectors, with a focus on clear cost or technology leaders.
3. Low carbon fossil fuels
2010 was a bad year for natural gas markets, but particularly so in the US. Three key factors compounded the weakness:
1. International energy champions were financing investment in increased unconventional drilling to learn the technology.
2. Three-year land rights came with drilling requirements to keep the lease, leading to uneconomic drilling decisions.
3. Companies were well hedged in 2009 and 2010, at higher prices, and thus continued to produce.
All of this meant that natural gas inventories remained at very high levels despite strong growth of gas usage in industry and power generation. This has kept power prices suppressed and thus continues to burden renewable energy. While US gas prices have been severely impacted, the European gas markets have recovered and did not dip to the same levels – given much more oligopolistic behaviour from producers. Recent M&A activity in the gas exploration and production group highlights the value that private markets and insiders see in North American gas assets, and we should see modest improvements in gas prices as inventories slowly correct from their all time highs in 2011.
Longer term, the outlook for natural gas industries is strong for several key reasons:
1. It is becoming a preferred fossil fuel (over coal and oil) in practically every major economy.
2. Higher prices are needed to justify new investment.
3. Rising European Union carbon prices will support the price of gas relative to coal and other substitutes.
4. New regulations from the US Environmental Protection Agency threaten up to 30% of the US coal fleet with accelerated closure because of the economics of retrofitting older plants with new technology. These plants are likely to be replaced with natural gas plants, leading to significant new gas demand in the next several years (chart 6).
There has been little change in our exposure to this theme, as we have retained or added to positions in companies with low cost of production and good growth in volumes.
4. Sustainable transport
This continues to be a very attractive theme, given the revolutionary shift in vehicle technology ahead. With fuel efficiency and emission regulations tightening fast, auto companies are working flat out to put new technology into the car. Borgwarner are seeing a step change in demand for their dual clutch transmission and turbo-charging technology – both relatively simple ways to make improvements in gasoline engine fuel efficiency.
At the same time, 2011 will see Electric Vehicles (EV) such as the Nissan Leaf and Plug-in Hybrid Electric Vehicles (e.g. GM Chevy Volt, Toyota Plug-in Prius) hit the dealerships from major global auto brands, driving fast growth in battery volumes for the auto market and supporting growth for battery suppliers such as LG Chem and JCI Saft. Chart 7 highlights the explosive EV battery market growth ahead, with the wide range of estimates for 2020 between $15 billion and $70 billion. This all represents major increases on the 2010 market, which was $2-3 billion.
5. Environmental resources
The environment in 2011 remains supportive of high and rising agriculture prices (see Chart 8 below). Supply disruption is a serious issue in many parts of the world, and consumer inflationary expectations are rising. We believe the only solution to rising pressure on agriculture, water and forestry prices lies in careful management of land, and investments in a range of productivity improvements. While we have made some changes to individual holdings, exposure to this theme remains a major component of our strategy.
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Source: ETFWorld – Schroders
