KGHG Q3 Update: Inflation Reduction Act and Energy Independence Drive the Energy Transition
By Roger Mortimer, Portfolio Manager
2022's third quarter (and the fund's second full quarter of operation) was marked by substantial and impactful policy developments in both the United States and Europe. For the period, the KraneShares Global Carbon Transformation ETF (Ticker: KGHG) portfolio generated a gross return of -4.2%, which compared favorably to the MSCI World Index's total return of -6.1%. The fund’s investment strategy is not executed with a specific benchmark in mind; however, the global equity reference provides context. The S&P 500 total return was -4.9% for the period.
For KGHG standard performance, top 10 holdings, risks, and other fund information, please click here.
In what was an exceptionally difficult operating environment, the fund performed favorably when compared with major indices. US dollar strength (caused by Fed tightening), implied weakness in most non-USD currencies, and the fund's heavy allocation to Europe resulted in a negative FX impact on returns. The Euro fell 7.8% against the dollar during the quarter. The fund's 32.5% allocation to this region alone resulted in a negative currency impact of 284 bps and 68% of the fund's negative return for the period. The fund had 36% exposure to the US at quarter end, a substantial difference from the MSCI World Index's 69% exposure. Broadly speaking, the fund does not hedge either equities or currencies. Policy uncertainty, particularly in Europe, has resulted in significant short-term volatility, but our thesis remains high-conviction.
To reiterate our mission, KGHG seeks to invest in companies that are transitioning to lower-emission business models, and we believe that this strategy has the potential to create both social and financial value. Low emitting (‘green’) companies offer the potential for lower cost of capital, higher profitability, and higher valuations than companies with high emission profiles. As investor demand for green investments grows, we believe that this trend will intensify. The geographic distribution of the portfolio’s investments is a function of a number of factors, including national climate policies, affected high-emitting industries, and the domicile of the leading energy transition candidates.
In August, the Biden administration executed the Inflation Reduction Act of 2022 (‘IRA’) in the United States. This landmark climate bill is highly significant and reinforces the critical role that government policy has in catalyzing climate mitigation activity and the resulting investment opportunity.
A Credit Suisse report on the IRA noted that "the IRA's programs and incentives will keep flowing no matter the macro environment, which makes betting on clean energy one of the most certain economic trends of the next few years. Clean energy is now the safe, smart, government-backed bet for conservative investors."**
A key tenet of our investment thesis is that climate mitigation will be a structural growth theme driven by government policy - with a key implication that it will have a higher certainty of occurring than the continuing discretionary spending that has driven much of economic growth over the past decade. With interest rates rising, growth may become more scarce. We believe that these policy drivers will deliver structural growth in climate mitigation at a time when growth is harder to find.
The IRA passage vaulted the United States into a leading role in the energy transition. In previous writings, we have noted that governments broadly have three reasons to advance the energy transition: delivery on sovereign climate targets, enhanced energy independence, and as a major driver of economic activity. Countries around the world have differing priorities among these three drivers, but in combination, they are tremendously powerful. While in Europe, energy security is the critical driver in the wake of the Russian invasion of Ukraine, in the United States, which is energy-independent, climate mitigation represents a major economic opportunity. Already the world's largest producer of both oil and natural gas, the United States, supercharged by the IRA, could emerge as the leader in a number of clean energy areas also.
From our perspective, the IRA is particularly supportive of the development of green hydrogen infrastructure. Green hydrogen is essentially 'green natural' gas: a clean-burning gaseous fuel made with renewable electricity. The IRA incentives, to be in place for a ten-year period, place this new approach at near-parity economics to legacy approaches, even before it has scaled. We expect that this will unleash a torrent of capital expenditure, which will, in turn, drive costs lower and create a flywheel of adoption. From our perspective, the concept of modest (15%) blending of green hydrogen into existing natural gas uses and infrastructure represents a huge initial market and does not require modification of either existing infrastructure or the end-use applications.
Under huge strategic pressure to secure domestic energy supply in Europe, the EU accelerated its renewable energy directive (RED) under its 'Fit for 55' climate plan. The revised RED II set a new EU target of a minimum 40% share of renewables in final energy consumption by 2030 (up from 32%), accompanied by new sectoral targets. This acceleration of its renewable plans will bring forward spending, and value, for those companies engaged in the activity.
The passage of the IRA created a fertile environment overnight for climate mitigation investment in the United States, something that was not as obvious previously. While the fund owns a number of US-domiciled companies and many foreign entities that have large US operations, we felt that the opportunities created by the IRA passage merited increasing our US weight. We achieved this in part by selectively adding exposure to companies involved in the climate mitigation value chain through names including energy storage group Fluence*, fuel cell and electrolyzer maker Bloom Energy*, and hydrogen value chain player Plug Power*. While these enabling companies will remain a small part of the fund's portfolio, we feel that the IRA is transformative to their prospects, and we expect them to benefit from significantly increased spending in these areas.
We also added Swedish energy company Orron Energy* to the portfolio. Formerly Lundin Oil and Gas, the company met our criteria of engagement in transformational change. It had divested its oil and gas assets and announced plans to invest heavily in renewables. To our pleasant surprise, the market recognized this quickly, and the stock was bid up substantially from our purchase cost. This confirmed to us that there is a cohort of investors (that we believe to be growing) seeking this type of green energy company. The idea that there will be a shrinking number of investors in the future for high-carbon-emitting companies and a growing number seeking low-carbon-emitting companies is a key value driver in our strategy.
On a security basis, the fund generated significant positive attribution (+265 bps) from Orron, discussed above, which at its peak more than tripled during the period, causing us to reduce the position twice to manage risk; from LNG and energy infrastructure developer New Fortress Energy* (+48 bps); and from hydrogen value-chain company Plug Power* (+44 bps). These two stocks rallied after the passage of the Inflation Reduction Act, of which they are major beneficiaries. Both have considerable exposure to potential green hydrogen development. The IRA provides particularly attractive incentives in this area with a 10-year window. We believe it will catalyze substantial green hydrogen development.
The three most significant negative contributors during the quarter were Korean refiner, industrial chemical and battery company SK Innovation* (-107 bps), which fell 32% in the quarter, heavily influenced by falling oil prices (the price of oil fell 25% during the quarter); US oil service company Baker Hughes* (falling 82 bps on oil and global growth concerns); and German steel and industrial company ThyssenKrupp* (-47 bps), which postponed the IPO of its electrolysis unit Nucera shortly before the quarter began, removing a positive catalyst in the short term.
We believe our thesis of owning ‘greening’ companies is extremely well positioned in this slowing environment. Decarbonization activity is driven and supported by government policy and addresses climate goals, the need for energy security, and economic development objectives. We are appreciative of your confidence.
*KGHG holdings mentioned:
- Fluence (FLNC: NASDAQ) is held in KGHG as of 9/30/2022 at a weight of 1.46%
- Bloom Energy (BE: NYSE) is held in KGHG as of 9/30/2022 at a weight of 1.43%
- Plug Power (PLUG: NASDAQ) is held in KGHG as of 9/30/2022 at a weight of 2.33%
- Orron Energy (ORRON: STO) is held in KGHG as of 9/30/2022 at a weight of 0.99%
- New Fortress Energy (NFE: NASDAQ) is held in KGHG as of 9/30/2022 at a weight of 3.10%
- SK Innovation (096770: KRX) is held in KGHG as of 9/30/2022 at a weight of 2.61%
- Baker Hughes (BKR: NASDAQ) is held in KGHG as of 9/30/2022 at a weight of 2.72%
- ThyssenKrupp (TKA: DE) is held in KGHG as of 9/30/2022 at a weight of 1.18%
Holdings are subject to change. Current and future holdings are subject to risk.
**Any mention of a safe, smart, government bet applies to the underlying theme of the fund and not the fund itself. There are risks associated with investing in the fund.