Understanding Valuations Amid Rapid Energy Sector Change

Tom Burroughes Group Editor London 27 October 2021

Understanding Valuations Amid Rapid Energy Sector Change

Talk of "bubbles" and "greenwashing" has taken a bit of gloss off ESG investing for some, although the trend remains strong. A week before the global COP26 conference in Glasgow, we interview a London-based firm that believes in harnessing free market capitalism to pivot to renewables such as solar energy.

Is there “bubble trouble” in the hot theme of environmental, social and governance-themed investing? Last week, the price-to-earnings ratio of the tech giant Tesla hit 473 or seven times more than the second-ranked Amazon. 

As policymakers, lobbyists, journalists and others prepare to attend the COP26 gathering of events in Glasgow next week, all is not sweetness and light in the drive to switch from fossil fuels. Skyrocketing gas prices, disruptions to supply chains amid the lockdowns, and concerns of whether renewable energy can provide base load electricity in a harsh winter have given COP26 a political edge. As the costs of change begin to hit mass electorates in their pockets, what happens? But whatever worries there may be, ESG investing appears unstoppable, and there are a number of long-term forces in play. No wealth management offering menu, it seems, is complete without a “sustainability” meal choice. Demand for ESG may be creating overcooked valuations, at least in the short run.

A few weeks ago, the Bank for International Settlements, known as the central banker’s central bank, said ESG valuations were a cause for concern. The BIS warned that the episode bears some resemblance to the dotcom boom and housing bubble pre-2008. When a report like this comes out, it is perhaps a wake-up call to approach ESG investing sensibly for the medium to long term. A fintech business that toils in this ESG space is iClima, based in London. As its name suggests, it is a “green” firm. iClima co-founder and chief executive Gabriela Herculano talked to this news service recently about whether or not ESG is overheated, why she thinks solar will make nuclear energy uneconomic, and the approaches investors should take. 

Why has the "bubble" issue arisen? 
The "bubble talk" has clear links to stock performance in 2020, where several key providers of relevant de-carbonisation solutions performed extraordinarily in the market: Tesla was up over 700 per cent in 2020, Workhorse Group (a last-mile delivery electric vehicle truck) was up over 500 per cent, Plug Power was up over 900 per cent, SunRun is up over 400 per cent, etc. For iClima, climate champions preclude emissions from ever happening and their products and services move the planet away from “business as usual” emissions. Some of the gains made by these champions over the last year have since reverted in 2021 due to a rotation and capital flows from growth to value equities. Now, the "bubble talk" has pivoted to mentioning greenwashing and high valuation levels.

Inasmuch as there is a bubble in valuations, how serious is it in your opinion and how does it compare with other market bubbles? 
A "bubble" in this case refers to valuation levels that are disconnected from fundamentals. Cash is king. A company is worth the present value of the future stream of cash flow. The concern about inflation and potential interest rate hikes increases the discount rate by increasing the risk-free rate. In this case, companies with more growth in the future suffer more. If discount rates increase from 5 per cent to 6 per cent the present value of a 10-year cash flow goes down by 10 per cent. This macroeconomic turmoil is causing valuation concerns for all growth names.

Let’s go back to the idea of fundamentals: Tesla expects to grow EV sales by 50 per cent CAGR until the end of the decade, when it will be selling 20 million electric cars per year. Tesla is not only growing its EV business, but it is developing ground-breaking software for autonomous driving products. That in itself is extraordinary, but it is not all the story. By the end of the decade, we think that Tesla will have a much bigger and integrated distributed energy business, emerging as a global leader providing key solutions from the hardware (inverters, solar panels, Tesla powerwalls and the Megapack) to the software that aggregates decentralised renewable assets. 

So the question about disconnected valuations from fundamentals is answered in a materially different way if you estimate all the future cash flow down the pipeline from these additional operating cash flows. Who is projecting 10 years ahead and bringing that to present value? 20 years ahead? A financial model is as good as the assumptions that you put in. Some of us are modelling Tesla as a major player in EV, autonomous driving software and energy and we are pricing the company that way. Some investors are estimating that Tesla will reach 10 million EVs by 2030 with no other revenue streams. Who is right?

How serious are such high valuations for those trying to execute ESG strategies and earn robust returns for clients, given their fiduciary responsibilities to clients to deliver financial results? 
Investment managers need to understand risk in our current climate, risks abound. Stocks that once upon a time were considered safe are facing tremendous risks from fast changes in demographics. Is a portfolio with HSBC, Shell, Walmart robust and low risk? Is there value in a company like Marathon Oil that investors with fiduciary duties are compelled to go and buy E&P again? What about stranded asset risk, risk of oil markets becoming irrelevant, risk of carbon taxes? There are many external shocks that can move markets and increase risk.

What in your view does the "bubble" issue mean for those debating different routes into ESG (index-tracker funds, actively managed, public listed markets, private, direct investment routes, other?
I think investors need to understand the transition we are currently enduring. Investors need to understand that battery powered cars and solar renewable energy will dominate because they make economic sense, as the emergence of both technologies has driven prices down by 90 per cent over the last 10 years and we anticipate another 75 per cent in the next 10 years.

On top of that, as batteries and solar combine and converge, they will transform our energy system in the most incredible way. Investors that see the upsides of the electric vehicle and solar scenario will be seeing a lot of early-stage opportunities in the current market. Investors that do not will see a lot of value in BP and all other oil majors.

With ESG, the future is bright and exciting - there will be lots of winners and losers.

Solar technology will disrupt nuclear energy - so much so that it will be game over for nuclear. Nuclear will never compete in terms of price and time to market, as it takes five years or more to plan, build and begin operations in a new nuclear power plant. By that time, solar will be so incredibly inexpensive that nuclear will never be able to compete.

What are your favoured entry points for making ESG work?
Innovation: companies that can preclude emissions from ever taking place (solar and batteries). Tangible, standardised ESG metrics that are better at identifying the most ESG-friendly companies with the most relevant products.

ESG has been a big theme in wealth management in recent months - is a shakeout healthy and do there need to be some re-appraisals of what is going on?
It is more than that. It is needed. Currently, there is a lot of greenwashing going on. In April, iShares launched the Climate Change Readiness ETF which has Marathon Oil, Chevron and Exxon as constituents. Investors are demanding data, disclosures and are starting to question what's really under the hood of their funds.

The drive to "net zero" is a big talking point of governments, although rocketing gas prices, worries about shortages and failures to get infrastructure for batteries etc, means that there could be a lot of pushback by the general public this winter, and maybe in future years. Do you think the industry needs to be perhaps less "ideological" about the green agenda and work at more pragmatic solutions to counter climate change? Does there need to be more attention on nuclear power? 
This is not a political discussion. This is a technological and innovation discussion. The solutions that make economic sense now will have the most upside in the future. For example, the technological innovation going on in solar and batteries will eventually integrate into most of our power grid because it will be so much cheaper to enable green hydrogen to unfold. There are lots of other solutions that will spill over and drive prices down further. The average utility scale solar farm in the US is about 5 MW in size. To build such a similar-sized solar project would have cost $23.6 million in 2010. This plummeted to $4.4 million by 2020 and could cost as little as $1.1 million in 2030 (a 95 per cent capex reduction in 20 years).

Solar changes everything. Batteries change everything.

In helping to frame asset allocation, what is your view about how to address valuations at the moment? Are there sectors you would be overweight/underweight? If so, why?
We are going through a massive transition and shift. As imagined, it is not easy to model. "Business as usual" fossil fuel and unsustainable products are disappearing. Fintech is making large strides in changing the way we think about finance. Cars will become computerised power plants on wheels. Retail will continue to go online. Telepresence is here to stay. The companies that are not in on the products of the future will disappear. Valuations need to reflect all those changes. It is not easy to have a discounted cash flow because it is all about the assumptions you use.

Special purpose acquisition companies (SPACs) get a mention, and there has been a lot of issuance. Can you elaborate on how they fit into this?
Capitalism at its best! Stem, EvGo, Nuvve, Proterra, etc. are some excellent and innovative ESG companies doing incredible work; they went public via SPAC vehicles. Buying into names at the circa $10 price mark is a very exciting investment opportunity for investors that want to be on the right side of the sustainable transition. More IPOs and SPACs will come, and more attractive opportunities will open up. Capital markets are a source of good!

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