Follow The Money: Is Your Portfolio Positioned for the New Growth Playbook?
By Roger Mortimer, Portfolio Manager
After a generation of falling interest rates, investors are grappling to come to terms with a new investing reality.
From a high of 20% in 1980, the Fed funds rate fell, with some variability, all the way to zero in 2008 (and again in 2020)1. In each of the three decades since the eighties, the average Fed funds rate was lower than the prior one. While the perception at the time was that the Federal Reserve had become an expert at managing growth, hindsight may suggest something different. By continuously lowering the discount rate, the Fed’s actions contributed to a world of inflated assets.
Long duration assets all appreciated dramatically during this period, including real estate, the stock market (especially high-terminal-value growth stocks), and ultimately, new speculative asset classes. To December 2022, the best-performing investment asset class over the past 30 years was US technology stocks, which returned 12.6% annually2. For context, US dollar cash returned 2.2% for the same period3. Fine art and wine, expensive watches, and classic cars all became viable collectible asset classes driven by low-cost capital. Some might also consider that the proliferation of crypto assets, certainly peripheral tokens and NFTs, was fueled by easy liquidity. By late 2019, when several European nations followed Japan’s earlier lead and introduced negative interest rate policies, it was clear that rates couldn’t go much lower. As we emerge from a post-COVID world, where we now face new scarcities in labor and commodities and the inflationary effect of deglobalization, we appear to be entering a new type of investing environment, one in which persistent cost pressures suggest an upward bias to interest rates.
It’s not always easy for us to accept and process fundamental changes in our environment. Many market observers are suggesting the Fed will buckle to the demands of the market to keep rates low. But as Mick Jagger reminded us more than fifty years ago, “you can’t always get what you want.” Higher interest rates increase the cost of borrowing and reduce disposable income, limiting consumption, and the market darling growth stocks are well off their highs. If interest rates remain elevated, this pressure will continue. According to Forbes, the world’s biggest tech companies have collectively laid off more than 150,000 workers in recent months4. Make no mistake, these businesses are not struggling, but their valuations may still be misaligned with their future growth prospects, now perhaps a little closer to earth than previously.
Amidst the downbeat economic headlines, there is another area where the boom is just beginning. Prompted by climate goals, the need for energy security and the desire to stimulate growth, governments are going all-in on the energy transition. Weaning ourselves off fossil fuels will drive one of the biggest capital investment cycles of all time, and for companies in the affected areas, it is a bonanza.
The US Inflation Reduction Act (IRA) and the European REPowerEU are government stimulus programs that target a specific group of industries with the objective of promoting the energy transition. The effect of these programs, which offer financial incentives across a range of energy and industrial sectors, will be the rapid adoption and deployment of electrification technologies and processes. Fearful of losing these large new industries to other regions, governments are in an ‘arms race’ to throw capital at the energy transition value chain.
The policy incentives, along with the carbon taxes imposed on legacy processes, level the playing field for new approaches, allowing them to scale more quickly. The history of solar and wind provides an indication of how effectively scale can drive down costs. According to the International Renewable Energy Agency (IRENA), the global weighted average levelized cost of electricity (LCOE) of newly commissioned utility scale solar PV projects fell 88% between 2010 and 20215, while onshore wind fell by 68%6. In 2021, the global weighted average cost of new utility scale solar was cheaper than the cheapest new fossil fuel-fired power generation option7. The US IRA, REPowerEU, and an expected further initiative in Europe will bring a whole range of energy transition technologies and processes into positive economic territory, enabling their rapid adoption. That the US program has the words ‘inflation reduction’ in its name tells you that governments believe that ultimately the energy transition will drive cost savings for consumers.
The IRA has a nameplate budget of $369 billion for energy security and climate change programs, but Credit Suisse estimates that because the incentives are uncapped and the economics of the activity are highly attractive, the ultimate public spending enabled by the IRA could exceed $800 billion8. Other estimates are even larger, with Goldman Sachs suggesting that the IRA could drive $1.5 trillion of capital mobilization to clean energy in the US by 20329.
Europe is threatened by the magnitude of the IRA’s incentives, and EU leaders are now iterating a “Green Deal Industrial Plan”10, an enhanced version of their prior initiative. The EU leaders see the IRA incentives as sufficiently great that they may result in capital flight and a potential loss of industrial development. For Europe, relying on an imported supply chain would perpetuate the strategic energy supply risk that the region is trying to remove, and local market incentives and expedited permitting are seen as critical. Early suggestions are that the European plan would mimic the IRA in its incentive offerings, and the two regions may work together to launch a form of ‘Atlantic IRA’11. Goldman Sachs suggests that a European IRA could mobilize €4 trillion of capital by 203212 and drive “an energy policy race to the top”13 as the two regions compete to attract clean energy investments.
This is where the KraneShares Global Carbon Transformation ETF (Ticker: KGHG) comes in.
Fossil fuels still account for close to 80% of global energy use: a number that has been largely unchanged for forty years14. In his landmark work for the Climate Accountability Institute, researcher Richard Heede identified that nearly two-thirds of carbon dioxide emissions since the 1750s can be traced to only 90 companies15. Our belief is that the greatest opportunity for both social and financial value creation will come from investing in the companies that are part of the problem but are actively managing the transition.
The companies in high-emitting industries targeted by energy transition policies have an unprecedented capital cycle ahead of them. Governments are showering them with money, tilting the economics of decarbonization in their favor, and facilitating capital allocation decisions. The effect is a long runway of opportunity: a chance to rebuild themselves entirely in a huge investment cycle that will drive earnings growth.
The policy incentives to transform their operations are coming at a time when companies in high emitting industries are facing growing pressure to change the way they do business. As regulation and carbon taxes shrink their traditional markets and squeeze their margins, the status quo is no longer an acceptable strategy. The universe of ‘green’ seeking investors is growing, driving down the cost of capital for companies taking this route and enabling equity valuations to expand.
The KGHG investment thesis is that high-emitting companies can create shareholder value by decarbonizing. For the incumbent emitters, the idea of getting greener has multiple benefits: faster growth, possible market share gain from slower moving competitors, the potential for margin expansion as growing scale drives down new technology costs, lower-cost access to capital, and a growing shareholder universe, implying potentially higher valuation. Investor perception of these companies will change: previously perceived as environmentally-offensive low growers, they will increasingly be seen as green growth leaders, and will be revalued as a result.
In identifying companies that can create value through the energy transition, we look for four key qualities: intention, adjacency, investment, and shareholder engagement. We focus on companies with clear decarbonization strategies, natural advantages in entering new growth areas, clear evidence of capital commitment, and responsiveness to shareholders in maximizing value creation. Three examples of KGHG portfolio holdings are:
- Canadian miner Teck Corporation recently announced that it would spin off its steel making coal business, which accounts for 55% of its gross profits, into a separate company called Elk Valley Resources. The continuing company, to be renamed Teck Metals Corp., is a copper and zinc powerhouse; both are key electrification metals. By removing the high-emitting coal assets from the business, changing a previously restrictive share structure, and showcasing its copper assets, we believe Teck will appeal to a growing group of green shareholders who would not previously have considered investing in the company.
- German utility RWE is undergoing a similar transformation from carbon-heavy to green. A key strategic supplier of German electric power, the company plans to triple its net generating capacity by 2030, and everything it is building is renewable. An activist shareholder has already engaged management on the disposal of its coal-related assets, and at such time as market conditions are appropriate, we would expect this to occur. The effect of these two steps is that a low-growth, high carbon utility will transform itself into a high growth green utility. This could result in a substantial re-rating as it appeals to a growing group of green-seeking shareholders.
- Indian conglomerate Reliance Industries is also transforming itself to meet India's rapidly growing demand for renewable energy. The energy-importing nation has the objective of 50% cumulative installed electric power from renewables by 2030, and has one of the world's largest renewable growth programs, supported by policies that both protect and incent local industry. Reliance is investing heavily across the green energy value chain, spending 68% of its energy investment capital on transition-related businesses, the highest among major oil companies. The returns it generates from this new business are also higher than those earned in the dirtier legacy businesses. The energy transition is fueling growth and increasing profitability, which, in our view, will drive share value creation.
The KGHG portfolio companies are capturing the growth and, in many instances, the expanded margin opportunity of the carbon transformation. This high certainty of growth, enabled by the red carpet rolled out by governments around the world, may look like a rarity at a time when persistent high interest rates are pinching the profitability of former market leaders.
Are you following the money in your portfolio?
For KGHG top 10 holdings, please click here. Holdings are subject to change. This material contains the author’s/speaker’s opinion, and it should not be regarded as investment advice or a recommendation of specific securities. Holdings are subject to change. Securities mentioned do not make up the entire portfolio and, in the aggregate, may represent a small percentage of the fund.
- Data from Bloomberg. “US Federal Funds Effective Rate”, retrieved February 9, 2023.
- Asset Class Historical Returns, last updated December 2022. Lazy Portfolio ETF. Retrieved January 31, 2023.
- Bernard Marr, “The Real Reasons for Big Tech Layoffs at Google, Microsoft, Meta And Amazon”, Forbes.com, January 30, 2023.
- International Renewable Energy Agency, “Renewable Power Generation Costs in 2021”, IRENA, 2022.
- Ibid. “global weighted average cost” refers to the levelized cost of electricity. “new utility scale solar” refers to photovoltaic solar.
- Betty Jiang et al, “US Inflation Reduction Act, A Tipping Point in Climate Action”, Credit Suisse Equity Research, September 28, 2022.
- Alberto Gandolfi, Brian Lee, Brian Singer, Ajay Patel, Mafalda Pombeiro, Simon Bergmann, Jojo. Kwofie, Michael Hao Wu, “Electrify Europe: The Need for a Europe IRA”, Goldman Sachs, January 9, 2023.
- Philip Blenkinsop, “EU recovers appetite for trade in green industry push”, Reuters, January 30, 2023.
- Alberto Gandolfi, Mafalda Pombeiro, Simon Bergmann, Ajay Patel, Jojo Kwofie, “The Europe IRA: clean energy re-industrialization and a golden age for the Green Energy majors”, Goldman Sachs, February 1, 2023.
- Alberto Gandolfi, Mafalda Pombeiro, Simon Bergmann, “Energias de Portugal: IRA tailwinds, energy prices and simplification”, Goldman Sachs, January 9, 2023.
- Gandolfi et al, “The Europe IRA”, Op. Cit.
- Fossil fuel energy consumption (% of total), The World Bank.
- Richard Heede, “Carbon Majors: Accounting for carbon and methane emissions 1854-2010, Methods & results Report”, Climate Accountability Institute, 2019.
- Bernard Looney, CEO BP PLC, speaking at investor session, February 7, 2023.