Companies must invest more in renewable energy and clean power generation for a net-zero carbon economy by 2050. This creates a big investment opportunity during the global energy transition.
Matthew Landon, Global Investment Strategist
Investing in the energy transition
The global economy is going through a period of dramatic change. Pandemic lockdowns and geopolitical tensions have revealed the vulnerabilities that can arise when global supply chains become too deeply intertwined after decades of globalisation. Policymakers around the world are responding.
Europe has felt the impact more acutely than most other regions. Supply-chain vulnerabilities, particularly in relation to energy, have pushed inflation higher and squeezed household budgets.
Policymakers have responded with huge stimulus packages, and companies are positioning themselves to benefit from these incentives. In our view, this environment is creating the potential for attractive long-term investment opportunities.
Europe’s energy crisis
After an impressive rebound from the pandemic, Europe’s recovery was hindered by Russia’s invasion of Ukraine. Sanctions pushed up natural gas prices, putting upward pressure on inflation and affecting manufacturing production across the region.
Warmer temperatures helped Europe to get through the winter relatively unscathed. However, policymakers cannot rely on the weather to bail them out in future, especially with alternative sources of energy likely to become scarcer as Chinese demand increases. A longer-term solution is needed to secure supplies of energy, food and other critical resources.
Europe, like most other regions, has responded with stimulus packages. As this money starts to flow through the economy, we are seeing dramatic changes in the way companies spend capital, with implications for order books across the supply chain. We believe increased public spending in the real economy will encourage private investment, and are keen to gain exposure to the leaders of the next cycle.
European policymakers have been acting decisively
Taking a step back, industrial policy isn’t a new phenomenon in Europe, particularly when it relates to the energy transition. Since its Emissions Trading Scheme in 2005 (the world’s first and largest carbon market), Europe has been leading the fight against climate change. The 2019 EU Green Deal continued this momentum with a set of policies designed to make Europe climate-neutral by 2050.
To support this move towards a greener future, the EU has implemented its stimulus measures at scale. The cornerstone of these efforts is the EU Recovery Fund, a €2trn package announced in response to the COVID-19 crisis.
More than a third of this funding (in the form of both grants and loans) has been allocated to the EU Green Deal. Funding proposals from member states suggest southern European countries are particularly well positioned to benefit (figure 1).
Figure 1: Each country has submitted funding plans
The top chart shows funds allocated through the EU Recovery Fund by country.
Additional spending has since been committed under the REPowerEU programme. Meanwhile, the Green Deal Industrial Plan seeks to boost the competitiveness of Europe's net-zero industry and drive the shift to climate neutrality.
Europe has been investing for the energy transition
Europe’s industrial policy goes beyond just energy.
The underlying goal of all EU projects is to boost Europe’s competitivness on a global scale. Above all else, that includes securing essential supplies, none of which are more important in today’s world than semiconductors.
Europe is home to some of the most important semiconductor firms but is still too reliant on imports – holding just a 10% share of the global microchips market. The EU Chips Act announced in April 2023 seeks to mobilise more than €43 billion of public and private investments to double this market share by 2030.
Several measures are being put in place to create a more sustainable economy in the future, but some damage has already been done. For instance, Europe has been warming at +0.5 °C per decade from 1991 – 2021, twice the global average pace. Buildings will need to be adapted and infrastructure built to manage summer fires, and air conditioning could be the next big thing.
Public investment is only half the story
It is easy to miss the forest for the trees. Public financing is only the beginning, and these measures are designed to kickstart huge amounts of private financing required for the green transition.
Industrial policy plans in Europe and the U.S. are likely to impact companies in different ways. While the U.S. Inflation Reduction Act offers tax credits to manufacturers to encourage investment in renewable energy, the EU framework makes this more challenging to implement. That may change, but for now we are already seeing the impact of Europe’s alternative stimulus measures.
Order books are starting to fill out for essential suppliers and analysts have been upgrading profit expectations for companies exposed to this trend. Some have significantly increased their capital expenditure in sustainability-focused projects, even at a time that the cost of capital is rising.
A key focus is on materials and the construction of Europe’s buildings. According to the EU, buildings are responsible for 40% of energy consumption and 36% of greenhouse gas emissions. The European Commission has estimated that almost €300 billion of investment will be required to reach its targets for improving energy efficiency in the sector – with implications for companies throughout the supply chain from materials to construction.
Sensitivity analysis by J.P. Morgan Investment Bank suggests the impulse from this increased spending could see potential upside of 29% on operating profits this year alone for a representative building materials company. The long-term implications could be even more significant.
Similar examples can be found across sectors. Expectations for higher profits and stricter regulations have seen traditional energy companies invest in sustainable practices to secure future cash flows. Elsewhere, recent artificial intelligence hype has encouraged spending plans to incorporate AI into business models, and the need to build out Europe’s electrical grid has seen data centers and networks come into focus. We believe the opportunities are significant and far-reaching.
What is the best way to invest in the global energy transition?
There are a variety of ways to gain exposure to these trends, and we believe now is the time to consider incorporating them in your portfolio. Our 2023 Outlook highlighted the importance of identifying and investing in the leaders of the next cycle. This notion of “following the capex” is something we continue to support.
We recently conducted a survey at our investment roadshows and identified that more than 60% of our European clients think a new era of de-globalization and de-carbonization presents a great opportunity. However, most are still underexposed to these themes, largely due to the underrepresentation of real economy stocks in traditional equity indices (figure 2).
Figure 2: Real assets are underrepresented in equity indices
This chart shows how underrepresented real assets are in equity based indices like the MSCI World Index. Going down from a high in ‘10 at about 25% to between 10% & 15% in ’21 and ‘22.
One of the simplest ways to add exposure to real assets is through commodities. For instance, demand for oil is likely to remain strong as China continues to emerge from pandemic measures, while significant underinvestment in traditional energy sources over the last decade will likely keep supply constrained at the same time. Using structured products can help to protect to the downside while allowing for upside exposure.
Other critical commodities for the energy transition, from lithium to cobalt, may offer compelling returns that are less correlated to a typical portfolio.
Furthermore, many companies are likely to benefit from the themes discussed in this piece. Capital investment in energy security should continue to support traditional energy stocks that often offer high free-cash flows and dividend yields. Many of these companies in Europe are also shifting towards greener practices to help ensure longer-term earnings growth.
For a more direct approach to investing in the energy transition, potential opportunities exist throughout the supply chain from the direct beneficiaries in the utilities sector to some of the essential enablers within industrials, materials and technology.
These opportunities exist across regions too. Many investors retain an overweight to the U.S. after a decade of outperformance, but we think that now could be a good time to diversify across regions. Europe continues to be at the forefront of the energy transition and, in our view, could be poised to outperform over the course of the next cycle.
Many readers may be too young to remember the early 2000s, when European stocks drove portfolio returns. History has taught us that periods of regional outperformance tend to move in cycles, and we think the next one could see a comeback for Europe (figure 3).
A macroeconomic backdrop characterised by structurally higher inflation and interest rates, along with a renewed focus on investing in the real economy, could favor the makeup of the European market. We have already seen some of this begin to play out since the market bottomed in October 2022, but we think this trend has plenty of room to run.
Figure 3: Regional outperformance tends to move in cycles
This chart shows the regional outperformance between the US and Europe – tracking the difference in both the MSCI USA and the MSCI Europe.
Past performance is no guarantee of future results. It is not possible to invest directly in an index.
An active approach
Investing in this space is no easy feat. Therefore, we think that investors can benefit from taking an active investment approach, taking advantage of specialist managers that can identify the select opportunities to potentially benefit from Europe’s industrial policy over the medium-term.
Not only that, but several unique opportunities may be better explored through alternatives. Infrastructure funds in particular can potentially boost portfolio yield and returns, while unlocking areas of the market that may not have otherwise been considered. For instance, some private managers have invested in the likes of liquefied natural gas facilities in Europe, battery storage, and more.
We can see a new era of investment in the real economy is under way. That will likely come with higher inflation and interest rates, and that has implications across asset classes.
We think that failure to close long-held underweights to the real economy could be detrimental to portfolio returns in the coming years. We have been advocating for investable opportunities across the supply-chain and across asset classes, looking to identify the leaders of the next cycle. That can be explored through commodities directly, through green bonds, stocks or alternatives – all of which can bring their own value to portfolios.
As always, please reach out to your J.P. Morgan team to discuss the best ways to implement these ideas.
Definitions
The MSCI USA Index is a free-float weighted equity index. It was developed with a base value of 100 as of December 31 1969.
The MSCI Europe Index in EUR is a free-float weighted equity index measuring the performance of Europe Developed Markets. It was developed with a base value of 100 as of December 31, 1998.
The MSCI World Index is a free-float weighted equity index. It was developed with a base value of 100 as of December 31, 1969. MXWO includes developed world markets, and does not include emerging markets. MXWD includes both emerging and developed markets.
