Portfolio manager at Schroders Alexander Monk explains how the energy transition universe has been challenged in 2022 and looks ahead to its prospects for 2023.
2022 has proven to be a very challenging year for financial markets, with most asset classes down materially from their prior year-end highs. Unfortunately, energy transition equities have not been immune to this pressure. Despite benefiting from the growing interest in energy security following the Russian invasion of Ukraine, and later the passing of the Inflation Reduction Act in the US, the MSCI Alternative Energy Index was still down -11% YTD as of the end of October.
We have been highlighting three key headwinds impacting the global energy transition universe:
The first headwind, which emerged in 2021 but has continued into this year, has been the severe disruptions to global supply chains, and the logistics issues and inflationary pressures these disruptions have caused. These supply chain challenges have caused a material fall in company earnings across the sustainable energy value chain given the reliance many businesses have on key materials, critical components, and smooth freight and logistics to deliver the goods and services they sell.
The second key headwind impacting the space has been growing concern around future earnings as the wider economy starts to materially slow.
Finally, while these first two headwinds have impacted the earnings part of valuation equation, the final headwind for energy transition equities has been the broader macroeconomic environment, and specifically the tightening of monetary conditions and rapid rise in interest rates. It has been unsurprising, especially given where valuations started, that in such an environment, prices across the many parts of the energy transition space have had to materially fall.
How’s 2023 shaping up for the energy transition universe?
Looking forward, we are not convinced these three headwinds are fully behind us just yet. However, all three of these headwinds, as damaging as they have been this year, will eventually ease, and indeed in some cases are already showing signs of just that.
And even with these headwinds, it is important to understand that the three fundamental forces driving the global energy transition – economics, consumer demand and policy support - have never been stronger and should continue to accelerate demand for clean technologies.
In addition to our long-term decarbonisation goals, the current energy crisis globally creates additional demand for cheap, clean energy to enhance and build-up our energy security too.
Crucially, for the first time in eighteen months, valuations across the space have finally reset to very attractive levels when taking a long-term view. Not only have headline multiples now retraced almost their entire post-pandemic gains in both absolute and relative terms, but the long-term upside from our discounted cash flow models is now as high as it has been since the end of 2019.
It is hard to know exactly when the current market headwinds impacting the energy transition space will subside. But for the first time in some time, the fundamental outlook for energy transition equities looks compelling. We are still positioned cautiously to provide some protection from potential near-term risks, but are focused more than ever on layering in to the long-term potential winners with strong potential upside given the valuation picture we now see.
2023 is gearing up to be an exciting year for energy transition equities.
