“The transition to clean energy is happening worldwide and it’s unstoppable. It’s not a question of ‘if’, it’s just a matter of ‘how soon’ — and the sooner the better for all of us.” Those were the words of the International Energy Agency (IEA) executive director, Fatih Birol, earlier this year, when the World Energy Outlook 2023 was published*.

In its report, the IEA points to the fact that renewables are now the cheapest power source in the global economy and that demand for coal, oil, and gas is expected to peak this decade. The IEA’s Outlook also shows that governments now plan to deploy around two-thirds more renewable energy by 2030 than they did this time last year*.

The global clean energy industry has indeed experienced rapid growth over the past decade, driven by governmental and corporate commitments to environmental and sustainability initiatives. Over time, these ambitions have continued to expand. The Paris Agreement, adopted by 197 countries at the UN Climate Change Conference (COP 21) in 2015, brought in a legally binding international treaty with an overarching focus on limiting global temperature rises to no more than 2% above pre-industrialised levels. More recently, major economies have committed to achieving “net zero” greenhouse gas emissions, which is a crucial step in the process of limiting global climate change, underpinned by frameworks to support a global energy transition.

The energy transition refers to a move away from a global economy dependent on energy generated through burning fossil fuels and towards one that operates and relies more heavily on electricity produced by renewable and low-carbon forms of power generation. On the supply side, renewable energy generation has become a key component of the energy mix. According to the World Economic Forum, in 2022, renewable forms of energy accounted for 40% of the total electricity generation in the United Kingdom**, while the US Energy Information Administration says this figure is 23% in the US***.

Meanwhile, on the demand side, consumption of energy is slowly transitioning away from fossil fuels. The “electrification” of end users and the decarbonisation of energy-intensive industry both form key objectives. In this regard consumers are incentivised to switch to electric vehicles (EVs) and to install heat pumps, while the potential exists for greater use of green hydrogen and carbon capture technologies to help decarbonise large industrial users in future.

These incentives are working. The IEA says that electric heat pumps are expected to outsell fossil fuel boilers globally by the end of the decade and the adoption of EVs has already accelerated: they made up one in five cars sold this year compared to one in 25 in 2020*.

Despite this supportive backdrop for the clean energy industry, the sector has proved a challenging area for investors over the past few years. Indeed, the (predominantly US-focused) iShares Clean Energy index has lost approximately 60% in value between its peak in January 2021 and the end of October 2023. The high point certainly coincided with a peak frenzy for ESG investors attracted to the sector’s environmental credentials, but more recently the sector has suffered from the high inflationary backdrop and aggressive tightening of monetary policy in key jurisdictions like the US, UK, and Europe.

Inflationary pressures and higher interest rates have increased the costs for development projects that were struck at prices that no longer appear economically viable. Supply chain constraints pinching at key project delivery points in coming years serve to compound the problems. Developers and component manufacturers have faced margin pressures for some time in a highly competitive industry, while higher reference yields have proved a headwind to the perceived value of operational projects, where value is essentially driven by discounting expected future cash flows at an appropriate rate.

However, with influential central banks signalling that the rate hiking cycle is finished and key governmental initiatives in the US and Europe priming the clean energy sector with huge stimulus packages, we believe the sector is potentially reaching an inflection point following its material de-rating.

The most powerful example of stimulus is the combination of the Inflation Reduction Act (IRA) and Bipartisan Infrastructure Bill in the US, which allocate $260bn and $80bn****, respectively via tax credits and incentives for investment in the energy transition. The legislation – labelled as a “game changer” - provides a decade-long growth runway for projects including wind generation, solar generation, and energy storage solutions by introducing predictability over governmental support. There are incentives to drive greater adoption of electric transportation and biofuels among consumers, and hydrogen hubs and carbon capture within industry. There are also credits for domestic manufacturing supporting the clean energy power sector and allocations for grid enhancement and EV charging infrastructure. Some industry players have suggested the IRA could catalyse total investment approaching $3 trillion over the next decade.

The World Energy Outlook 2023 proposes a global strategy for getting the world on track by 2030 that consists of five key pillars, which the IEA believes could also provide the basis for a successful COP28 climate change conference. They are: tripling global renewable capacity; doubling the rate of energy efficiency improvements; slashing methane emissions from fossil fuel operations by 75%; innovative, large-scale financing mechanisms to triple clean energy investments in emerging and developing economies; and measures to ensure an orderly decline in the use of fossil fuels, including an end to new approvals of unabated coal-fired power plants.

We would contend that the energy transition is a multi-decade, structural trend that will provide many opportunities for investors at all levels of the value chain. After a period of reset for the industry, largely driven by macroeconomic factors, the prospects for recovery should not be overlooked.

*Source: IEA, World Energy Outlook 2023, October 2023

**Source: World Economic Forum, 6 January 2023

***Source: World Energy.org, 28 February 2023

****Source: EIA, EPA, Joint Committee on Taxation, IRA, November 2023

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