Kondi Nkosi, Country Head for South Africa at Schroders

As focus shifts toward nearer term macro and geopolitical headwinds, energy transition efforts lose pace. But climate change will not solve itself, and Schroders believe there continue to be energy transition opportunities for investors.

As politicians, consumers and market participants battle with near term issues such as stickier-than-hoped inflation and broader economic burdens – focus has shifted off longer-term issues such as climate change and energy transition. Coupled with this, benign weather in certain locations and a decline in global energy prices have undoubtedly relaxed the efforts to address both pressing problems. These long-term issues often take a back seat when the economic environment weakens or the direct stresses they create start to ease (e.g. energy crisis, extreme weather), but they are still problems that need to be solved eventually, creating potential financial risks if ignored.

This is according to Kondi Nkosi, Country Head for South Africa at global investment manager Schroders, who says that recent energy transition returns as well as continued outflows from global sustainable energy exchange-traded funds (ETFs) have mirrored this shift in focus (below graphs).

“Entering 2024, we were cautious about the potential for continued short-term volatility across energy transition equities given the risks we saw with respect to both persistent inflation and higher rates, as well as the timing of earnings inflections across energy transition equities. The uncertain political landscape was front of mind too. Given this perspective, the challenging sector returns seen in the first quarter are not hugely surprising, especially given the very strong performance observed to close out 2023.”

Nkosi explains that after a strong close to an otherwise challenging 2023, energy transition equities have once again been under pressure from adverse cyclical forces at the start of 2024. “Sticky inflation, resilient economic data, and continued fiscal largesse (particularly in the US) saw developed market bond yields turn higher again after their sharp decline towards the end of last year, putting renewed strain on valuations across more interest-rate sensitive parts of the space – such as energy transition equities.

But Schroders believes a brighter outlook is tentatively shining through. “From an earnings perspective, we have started to see some signs of demand in consumer-focused markets troughing, and the high inventories built by distributors during the post-pandemic disruptions starting to clear. Although different markets remain at different stages, electric vehicle battery, electric vehicle charging, and residential solar companies have suggested that the weakest quarters of shipments are currently being seen, with demand to then pick-up throughout the rest of the year, says Nkosi. “Although still relatively limited in number, both the early signs of improving earnings momentum and the positive reaction to such news gives us confidence in our future earnings outlook,” says Nkosi.

So, although volatility could remain in the short-term with headwinds still in place, Nkosi believes focus will reshift again. “The long-term potential for many global transition companies has not changed at all and that demand for energy transition products and services will flourish again as structural drivers continue to build and as the macro headwinds ease.”

Nkosi explains that the three core structural forces driving the energy transition – competitive economics, growing consumer demand, and policy support – remain largely as aligned as ever, and investment into the sector has stayed remarkably strong in absolute terms.

“As we continue further into 2024, Nkosi says he believes that the direction of travel for energy transition and energy transition equities will still largely be determined by three key dynamics:

• The direction of travel for global monetary and financial conditions. “Interest rates and financial liquidity dominated 2023 and have already influenced returns in 2024. This situation is unlikely to change short-term, meaning both the absolute level of nominal and real interest rates and the volatility of rates will likely matter going forward too.”

• The extent to which fundamental company earnings improve. “2023 was highlighted by large downward earnings revisions in key sub-sectors across the energy transition universe, a dynamic that has so far continued entering 2024. The speed and extent to which earnings in under-pressure sub-sectors can stabilise and return to growth will be vital moving forward. Likewise, the resiliency of earnings in those sub-sectors that continue to outperform will be important for sentiment too.”

• Changes to policy and politics. 2024 could be strongly influenced by politics, says Nkosi. “Most important here will be the US election in November given the risks to Inflation Reduction Act (IRA) support in a strong Republican win, but European elections will be critically important too.”

Nkosi concludes that under almost all energy transition scenarios, and even in instances where we do not transition away from fossil fuels at all, the world is going to use a lot more electricity. “We need to electrify our economy not only to decarbonise it, but also to digitalise it too through things like artificial intelligence and data centres. When adding on population growth and other potential structural shifts like industrial reshoring, higher electricity demand is unquestionably one of the surest structural themes associated with our future global energy mix,” he says.

ENDS