Growing political and business momentum has been increasingly supportive over the past 12 months or so for investors in businesses working to mitigate climate change. Yet, as financial markets look to seize the scale of the transition ahead, company valuations are reflecting the competition.
“There was a large upward re-rating [in 2020] in the valuations of companies with strong technology in areas such as renewable energy, electric vehicles (EVs), hydrogen, circular economy and sustainable foods,” explained Simon Webber, lead portfolio manager at Schroders.
This trend mainly reflects the improved growth prospects for those industries and the companies that have invested to create solutions as the transition gathers pace.
As a result, amid the headwind to future investment returns from higher market valuations in climate-related industries, investors need to be more discerning when looking for exposure to key sectors.
Knowing the competition
The solar industry has seen numerous examples of competition driving down returns. This stems from the wave of investment and capacity expansion over the last decade, in turn commoditising and fragmenting this sector.
“Overall, the solar industry has been a terrible long-term investment,” Webber added.
Cathode materials, essential components in lithium-ion batteries, represent a recent example, he explained. While suppliers to this industry have dramatically scaled up their production, there has also been a wave of new entrants building capacity.
“The industry structure has, therefore, fragmented and despite the strong growth the market has gone into oversupply with margins and returns on capital under pressure for all involved.”
In the EV space, meanwhile, established pure-play manufacturers are now being joined by a raft of new entrants.
This has been fuelled by various start-ups being able to raise capital and list via special purpose acquisition companies (SPACs), explained Webber. In line with this, here has been an explosion of new models introduced by incumbent carmakers.
“This competition will be good for volume growth, and some suppliers will do very well, but it will likely be a lot more challenging for the automakers competing for market share with the consumer,” he noted.
Fragmentation is also happening in renewable energy power generation amid a large increase in the number of companies seeking to build and own renewable assets.
The new competitors include newly established developers funded by capital markets, incumbent utilities making the shift to cleaner generation and, most recently, several traditional oil and gas companies reallocating capital budgets from fossil fuels to renewable power.
“In this environment of plentiful funding and an increase in competition, successful companies will be those that have a clear and sustainable competitive edge,” said Webber.
Capitalising on tailwinds
Schroders believes that the better industries to remain invested in will be those with a reasonable number of rational competitors – due to high barriers to entry and the potential for product differentiation.
One example the firm sees with such a competitive environment is the wind equipment industry.
This follows a major shakeout in the wind turbine sector over the last decade, with market share consolidating naturally around the strongest companies. “Furthermore,” explained Webber, “there have been no major new entrants in recent years, and the key players have different propositions, so the wind industry is one where we believe the prospects of achieving profitable growth at good returns look strong.”