Stockholm (HedgeNordic) – The long-term case for the energy transition remains as compelling as ever (after all, climate change has not been reversed yet, has it?). However, amid higher inflation and more crucially, elevated interest rates, compounded by macroeconomic and geopolitical concerns, the valuations of energy transition shares have suffered, most recently in the past three months.
As Dan Lindström of Proxy P Management puts it, the current valuation level for the sector resembles that of October last year, a point considered as the “post-peak 2021” low. During this period, broader markets soared by approximately 20 percent from that October low, underscoring the extent of pessimism inherent in the sector. Lindström identifies several short-term challenges that have put a dent in investor confidence in the sector and market valuations, with higher interest rates being one of them. Vidar Kalvoy and Joel Etzler, the duo managing a long-biased long/short equity focused on renewables at Coeli, share Lindström’s perspective.
“Most of the energy transition companies are high growth companies with cash flows into the future. Their valuations suffer as higher risk-free rates increase discount rates.”
There are several reasons for the recent underperformance of energy transition-related sectors, but the main one is higher interest rates, argues Kalvoy. “Most of the energy transition companies are high growth companies with cash flows into the future. Their valuations suffer as higher risk-free rates increase discount rates,” explains the fund manager. Another reason is that cost inflation and higher capital costs have caused cancellations and delays of projects, particularly in offshore wind.
In some sub-segments, demand was pulled forward during the pandemic and last year’s energy crisis stemming from Russia’s invasion of Ukraine. “As demand expectations starting 2023 were too high, some industries are currently facing large inventory overhangs, with solar panels in Europe being just one example,” elaborates Kalvoy. Lindström agrees, saying that “while the sector has been preparing for future growth, a recent slowdown in a once-thriving sector has resulted in temporary excess supply in certain segments.”
Proxy P’s Lindström and the Coeli duo also acknowledge the subdued investor interest in the energy transition sector. “Sentiment is horrible after the renewable bubble of 2020/21 burst – a lot of investors were burned and will stay away until prices find a bottom,” argues Kalvoy.
“Pockets of lucrative investment opportunities have still existed and continue to exist.”
Despite the sector’s overall underperformance since 2021, Lindström and his team managing Proxy Renewable Long/Short Energy highlight that “pockets of lucrative investment opportunities have still existed and continue to exist.” Despite energy transition-related sectors with a long-duration growth character falling more than the broader markets in 2022, Proxy Renewable Long/Short Energy ended the year among the ten best-performing hedge funds in the Nordics with a net-of-fees return of 24 percent for the SEK A share class. The fund has delivered an annualized return of 22.3 percent since launching in late 2018 despite ending the first three quarters of 2023 down 10.6 percent.
Long-Term Case Unchanged
Despite recent downward market pressure on the renewable energy sector, the long-term case for the energy transition remains unchanged for both Proxy P Management and Coeli’s renewable energy specialists. “Our thesis is unchanged. The energy transition is the investment theme of the next decades,” says Joel Etzler. “It is no longer only about climate change, but also about energy security and security of supply chains.”
“Our thesis is unchanged. The energy transition is the investment theme of the next decades.”
According to Etzler, “the energy transition will create some great winners, which will generate fantastic returns for investors, but in many sub-sectors competition will be fierce and companies that lack any sustainable competitive advantage will likely fail.” The strategy pursued by Coeli Renewable Opportunities is to invest in the longer-term winners and create alpha by shorting the losers. “That is, of course, why we have had such a strong relative performance since our launch in February,” says Etzler. Coeli Renewable Opportunities, for instance, edged down 3.5 percent year-to-date since launching in February this year by outperforming the main renewable indices by about 25 percent with a hedged share class, meaning no benefit due to the weak Swedish krona.
Coeli Renewable Opportunities has a mandate to maintain a net exposure of between 40 percent to 80 percent. “We always want our portfolio to have a positive climate impact. However, since we were of the view that we are still in the process of deflating the bubble of 2020/2021, we have been conservatively exposed since we launched,” argues Etzler. Lindström anticipates the landscape of elevated cost inflation, high interest rates, and suboptimal policies to persist in the near term, which also led the team to adopt a strategy of hedging and downside protection, safeguarding their long positions while maintaining a conservative net exposure in the 50 ranges rather than the mid-80s.
“Even from a shorter-term perspective, value exists, though it appears that market sentiment dismisses this amid the sector’s ongoing headwinds.”
Lindström and his team identify compelling long-term value across all sub-sectors at present levels. “Even from a shorter-term perspective, value exists, though it appears that market sentiment dismisses this amid the sector’s ongoing headwinds,” says Lindström. “We recognize, however, that the sector’s resurgence – both in absolute and relative terms – often transpires before widespread optimism takes hold.” Although the Proxy P team does not yet call a sector bottom, they increasingly find value and alpha-generating opportunities, presenting investors with appealing entry points and attractive investment opportunities.
Barring a deep recession, Kalvoy expects next year to be better for the renewable space. “Save for a big recession, we expect renewables to outperform the general market when rates start to decline.” At the end of 2020, even professional investors stopped thinking and simply followed the crowd as the crowd was big and fundamentals did not matter, according to Kalvoy. “Today, the sentiment is the total opposite, the key renewable indices are more or less back to pre-Covid levels, and the thinking is that everything needs to be sold as nothing will work. We believe this will prove a good opportunity for long-term buyers.”