Equity investors set to benefit from progressing energy transition

Oskar Tijs

To meet Paris climate goals and mitigate the impact of global warming, all sectors must transition towards electrification and decarbonisation. With the economics of renewable energy sources rapidly improving, this transition is becoming more affordable and thus ever more inevitable. This presents challenges but also creates tremendous growth opportunities for companies within renewables, networks and storage. NN IP seeks out companies within the energy value chain that combine good growth prospects with the ability to earn attractive returns on capital, positioning them to become winners of the energy transition.

Many scenarios have already estimated the needed action to limit global warming to a 1.5°C or 2.0°C path. All point to acceleration of both decarbonisation and electrification as well as energy efficiency. Aurora Energy Research has calculated that to reach a net zero scenario, 80% of energy used must be renewable or nuclear by 2050. Renewables have taken the lead over the past decade, and today more than 50% of new generation capacity installed globally is renewable, with growth rates in renewable power averaging 8-9% per year over the past decade. If these trends continue, renewables will produce half of the world’s electricity by 2030. With the growing installed capacity, costs to generate power from these technologies have consistently dropped, to the extent that solar and wind are competitive with thermal and other forms of generation in an increasing number of regions, even without subsidies.

The renewable energy sector presents tremendous growth opportunities, but the challenge is to find companies with consistent strong returns. Solar has been a difficult segment for investors, as most of the supply chain is extremely competitive and very few companies have consistently covered their cost of capital. However, a few companies such as SolarEdge (a provider of solar inverters) have outperformed their peers.[1]

“SolarEdge launched a more cost-effective solution to the problem of energy loss in the case of shading,” said Oskar Tijs, senior investment analyst at NN IP. “This energy-efficient solution has resulted in leading market shares for the company in residential installations on a global scale. The technology is also scalable, with SolarEdge rapidly taking share in the commercial market and planning to enter the large-scale utility market this year.” NN IP’s Global Sustainable Equity strategy has been invested in SolarEdge since 2016. As NN IP’s conviction increased, NN IP’s European Sustainable Equity and Impact Equity strategies have also invested in the firm.

With regard to wind, the market is also competitive, with most original equipment manufacturers making low-single-digit or even negative margins on turbine sales in 2018 and 2019. NN IP expects margins to recover in 2020, as pricing has stabilized and several take-overs and mergers should lead to a favourable market structure. In addition, NN IP projects a 15% CAGR for offshore wind installations over the next decade, which will boost services segment revenues. This fast-growing segment looks attractive for market leaders such as Siemens Gamesa.

“Margins on Siemens Gamesa’s onshore turbines should improve in the next two years on the back of easing price pressure and cost savings,” said Tijs. “Conversely, the firm enjoys healthy margins for offshore wind turbines and services, which together make up around 90% of group EBIT.” NN IP’s Sustainable and Impact Equity strategies have been invested in Siemens Gamesa since 2018. In late 2018, NN IP increased its positions as the stock price weakened; this paid off as the stock rebounded in 2019.

Electrical equipment makers also stand to benefit from the energy transition, given the need to add power transmission capacity and make distribution grids smarter. Smart meter leaders such as Landis+Gyr are highly exposed to this, as government mandates push the installation of smart meters. Landis+Gyr’s cash flow returns on investment (CFROI) have exceeded those of competitors in recent years, as it receives better returns on capital from comparable activities.

“Landis+Gyr earns high margins in North America, where highly profitable software and networking services constitute an important part of its sales,” explained Tijs. “European margins have lagged in the past but improved strongly in 2019, boosting overall value creation.” This is reflected in the firm’s strong stock performance in 2019, which benefited NN IP’s Sustainable and Impact Equity strategies that are invested in the name.

Most of the traditional energy sector will lose our from the energy transition, as coal, oil and gas will ultimately be replaced by renewable energy. Since the oil price fell five years ago, the energy sector on average can no longer cover its cost of capital. However, NN IP sees opportunities in renewable fuels.

Hendrik-Jan Boer

“Neste Oil’s stock has strongly outperformed the energy sector as it focuses on renewable fuels, on which it earns superior returns on capital,” said Tijs. “Renewable diesel reduces life-cycle carbon emissions by 50-90% compared with traditional diesel. Its use of more sustainable feedstock (primarily waste and residues like animal fats and used cooking oil) also boosts margins as governments incentivise CO2 savings.”

In addition, Neste is investing in a new Singapore refinery, which will result in a 50% expansion of its global capacity to 4.5 million tons by 2023. NN Investment Partners has been invested in Neste Oil since 2016. It is the only oil company in which NN IP’s Sustainable and Impact Equity strategies are invested, owing to a positive view of Neste’s transition efforts.

From NN IP’s research and ongoing developments in the energy sector, it is clear that the transition to renewable and sustainable energy sources is only accelerating. “By remaining cognizant of sector-specific pitfalls while seeking out growth opportunities, equity investors can best position themselves to thrive as the energy transition progresses,” added Tijs. “Moreover, in doing so they can rest assured that their capital is being put to work to mitigate the impacts of climate change and create a more sustainable world.”