2023-04-23 07:07:51 ET
Summary
- Positive drivers for ESG investments are not enough to outweigh the current risks.
- EU and US investments have already been priced, reducing potential capital appreciation.
- Energy transition is proving to be slower and more difficult than anticipated, which will test the survival of many companies.
Investing with a focus on ESG thematic has become increasingly common for both retail and institutional investors, and iShares Global Clean Energy ETF ( ICLN ) could potentially be a good way in for the former class of investors. However, I will argue that for now it’s better to stay on the sidelines for ETFs such as ICLN due to some significant risks and an overall market overvaluation that would hinder future gains. The outperformance that many claim to be a benefit of ESG investments is not as certain as publicized.
It's not a secret that major economies are investing heavily, or at least they're beginning to, in the energy transition, and the market has likely already priced in this reality. However, I believe that investors are underestimating the magnitude of the issues governments and companies are facing and will continue to in the future, which will create slowdowns and losses. With most of the upside being so oversold in the public eye and a lot of the risks not being discussed enough, I think it's better to avoid large spectrum energy transition ETFs. On the other side, investors with particular interest and knowledge might find single stocks to invest in.
The Upside
Between the covid pandemic and its related supply chain problems and the conflict in Ukraine, countries worldwide, particularly the US and Europe, have been forced to face the issue of energy independence. In particular, the EU has been suffering greatly the consequences with historically high energy prices that have crippled the industries of many countries, production of goods and services and consumer spending .
Two major policies have been promoted, the Inflation Reduction Act (IRA) and the REPowerEU, in the US and the EU respectively. Both measures have the objective of incentivizing local investments in manufacturing for a variety of clean energy technologies. With an IRA budget of roughly $500 billion and an REPowerEU budget of about €300 billion, both policies have a lot of potential and can clearly change the market drastically .
Forecasts are also very promising on the pace this transition is expected to have. As seen in the graphs below, both demand and production capacity are expected to rise significantly in the next decade in both EU and US.
S&P Global Commodity Insights
Furthermore, EU countries, as seen below, have set quite ambitious targets to achieve by 2030. This is a very good sign for the companies in the ICLN portfolio that have operations in the EU.
S&P Global Commodity Insights
According to a Deloitte report while has not been the best year for renewable energy growth (more of that later), there are still very strong positive drivers for the years ahead.
- Although costs have risen significantly in the past year due to inflation and supply chain disruption, solar and wind energy are still the cheapest source in many areas since the costs for traditional fuels have risen even more drastically than those for renewable.
- As mentioned above, most major economies are implementing significant policies to incentivize energy transition.
- Investors are increasingly aware of the importance of clean energy in the long-term; one demonstration is that 43 of the 45 largest US investor-owned utilities have committed to significantly reduce their carbon emission.
- More than 380 global businesses have committed to 100% clean electricity by joining the RE100 renewable electricity initiative, up from about 200 in 2019.
- Together with the above mentioned IRA and REPowerEU, other forms of incentives such as tax credits have spurred private investments in renewable energy, which have reached a record $10 billion in the past year.
The path ahead for companies involved in renewable energy and manufacturing of related components appears to be promising, however, as we’ll see below there several hurdles ahead that might suggest waiting on the sidelines for now as an investor.
All that glitters is not gold
There are many obstacles that the energy transition efforts need to overcome to achieve all of the ambitious goals that are being set, and while it’s likely that in time they will be reached, timing is quite relevant for an investment to take place.
The main hurdles I see in the development of renewable capacity are:
- Regulations : while several countries have been pushing for adding capacity of renewable energy production and energy storage, implementation of the policies is much more susceptible to local government actions. For instance, in the EU there have been several administrative delays due to the issuance of permits. Furthermore, the labor shortage has been affecting also the public sector, which in turn only exacerbates the delays.
- Grid capacity : building large and functioning grid systems is fundamental for achieving all the above-mentioned objectives, and countries are facing new challenges that are idiosyncratic of the renewable energy generation. In fact, while it is often ideal to build solar and wind plants in rural areas, these are also the places in which there is less consumption and less grid infrastructure. Traditionally, power plants have been built relatively close to the place of consumption, however, this is not the case for renewable energy. Building power grids to reliably transport energy from the place of production to the place of consumption is a further hurdle that companies and governments need to face.
- Supply chain : disruptions in the supply chain have been slowing the rate of onshore and offshore projects, threatening the energy transition goals. In Q3 of 2022 the production has fallen quite significantly due to these challenges, which might be a warning to future difficulties, and companies are often suffering the consequences. For instance, Siemens Energy has declared that their adjusted earnings have fallen from the €661 million in 2021 to €379 million in 2022, while GE expects a loss of roughly $2 billion for its renewable energy department for the 2022 year. Finally, supply chain issues exacerbate the delays in production capacity expansion; for instance, 14.2 GW of clean energy power have been delayed in the US in Q3 2022.
- Labor Shortage : as for many sectors of the economy, also renewable energy companies are experiencing a tightening of the labor market and are working with governments to incentivize labor participation in roles such as installers, electricians and grid specialists.
Finally, while investments in ESG ETFs has been increasing rapidly in the past 5 years, pushed by both retail and institutional investors as the graph below shows, the same funds have been suffering and underperforming.
However, in 2022 ESG equity funds have seen their first net outflow since 2011 according to Refinitiv data , with roughly $13.2 billion withdrawn. This is due partly because of the general unfavorable macroeconomic environment with a threat of global recession and to a historical underperformance of ESG funds compared to their non-ESG counterparts, as shown below.
Fund composition and key data
Some information on the iShares Global Clean Energy ETF before addressing the allocation:
- Created on June 24, 2008;
- Expense ratio of 0.40%;
- Semi-annual distribution frequency;
- Total NAV as of April 17, 2023: $4.8 billion.
Although in the past 5 years ICLN has been outperforming the S&P 500 by a quite significant margin, I believe that this only indicated that the market has already priced in most of the potential benefits. In fact, I view this past performance as an indicator of a potential overvaluation of the ETF and the underlying holdings, for which investors might not have incorporated fully the potential risks and slowdowns.
Top 10 holdings
As we can see below, ICLN’s top 10 holdings are for the large part in the information technology and utilities sectors, with 23.34% and 23.48% respectively. However, the top three companies aren’t actually traditional information technology firms as they are all involved - each one to different a different extent - in the manufacturing of batteries, solar panels, charging stations and power plants, in addition to providing related services and products. I see this as generally positive as these companies are involved along the entire vertical of the energy transition. Furthermore, having a good allocation to utilities can also be beneficial for the fund as this sector is considered key to the energy transition and, therefore, will likely benefit from several government investments.
Geographical and Industry diversification
The picture that we got from the top 10 holdings is consistent with what we see in the industry exposure breakdown below - although there seems to be some differences in the classifications the message is the same: utilities, component manufacturing such as semiconductors, and renewable electricity are the main investments of the fund. Finally, considering that this ETF holds investments in 97 companies, not much compared to more broad-focus ETFs, it is quite well diversified sector-wise.
However, geographically the fund is less diversified than what an investor would like to see in my opinion, with too much concentration in the US compared to the EU or China.
Conclusion
There are several advantages to investing in an ESG-focused ETF such as ICLN, however, I believe that the moment is not ripe for a retail investor to join. Although there are positive drivers that are hard to ignore, I think that the uncertainty that comes attached to this investment is too high to justify entering the industry now. Furthermore, with a P/E of 21.27 as of the 17 of April 2023, I think the market is pricing in many of the potential upsides and not enough of the downsides.
Therefore, even if the promises and objectives were to be met, there is the very concrete risk that an investor might not experience any capital appreciation, or not enough anyways. The market has already incorporated all of the massive investments happening in the US and the EU, and therefore I see a relatively low performance for ICLN in the future. Investors that are considering an investment in ICLN should be very careful in assessing the potential upside of the underlying companies and the market sentiment around ESG investment funds; I would personally stay on the sidelines for the moment.
For further details see:
ICLN: Be Cautious About ESG Promises