- Yves Siegel
Market Commentary: Clean Energy and Traditional Energy Can Coexist...
Clean Energy and Traditional Energy Can Coexist and Each Prosper in the Coming Decades
Our Infrastructure Income and ESG Infrastructure Strategies reflect Sam Partners’ core belief that a balanced portfolio of clean energy, utilities, and midstream energy stocks can deliver attractive risk adjusted returns. Our investment thesis is underpinned by the notion that clean energy and traditional energy can coexist, and both prosper in the coming decades. Progress made at the recent United Nations Climate Change Conference (COP26) provided affirmation that the decarbonization train is on the right track. However, the speed of the locomotive may be slower than ideal and traditional energy will be required during this transition period. Indeed, the energy sector continues to be the best performing S&P 500 sector year-to-date, and with clean energy, is likely to be at the beginning of a multi-year upcycle.
Clean energy has a long runway for rapid growth ahead, as evidenced by the recently concluded COP26, and trillions of dollars earmarked for decarbonization—this is not in dispute. However, traditional energy has a role to play in a decarbonized future. The existing infrastructure will be vital in facilitating the adoption of clean energy technologies such as hydrogen and carbon capture and sequestration. As we’ve noted before, fossil fuels are vital to our everyday lives from providing the building blocks for the petrochemical industry to supplying power when the sun doesn’t shine and the wind doesn’t blow.
Traditional energy companies are adapting to and embracing this brave new world. They too are making pledges to reduce their carbon footprint and, in the process, focused on generating attractive returns on investment and returning cash to shareholders via dividends and stock repurchases. They are also investing in clean technologies, albeit, in a measured way that is producing good returns. While perhaps under-appreciated, traditional energy companies have substantially solidified their financial position—they’ve been reducing capital expenditures to a maintenance mode, paid down debt, and provided investors with attractive and sustainable dividends for the foreseeable future.
KEY TAKEAWAYS FROM COP26
It’s very difficult, if not impossible, to have unanimity among 190 countries comprised of different economies, political systems, interests, and priorities. Further, the lack of an enforcement mechanism to hold countries accountable for their commitments adds another degree of difficulty (pun intended).
In his closing remarks at COP26, UN Secretary General, Antonio Guterres stated that “our fragile planet is hanging by a thread” and “we are still knocking on the door of climate catastrophe." We hold a less alarmist stance. In our view, the ultimate impact of global warming by the turn of this century is less than certain; it needs to be balanced by the social and economic impact of climate change policies over the near and intermediate terms. It won’t be easy to get public support for decarbonization when families and individuals are experiencing poverty, energy shortages (as witnessed in Europe and Asia) and rapidly rising inflation.
We believe that climate policies need to be pragmatic and balanced against economic realities in order to produce the best societal outcomes.
COP26: HITS AND MISSES
There were some achievements:
1. The Global Methane Pledge: Signatories representing 60% of global GDP agreed to reduce overall methane emissions by 30% compared with 2020 levels by 2030. Notable absences from the list of signatories were Australia, China, India, and Russia. Related to the Pledge, the U.S. released its Emissions Reduction Action Plan
2. U.S. and China agreed to accelerate actions separately and jointly to strengthen implementation of the Paris Agreement (i.e., U.S.-China Joint Glasgow Declaration on Enhancing Climate Action in the 2020s)
3. After 6 years, the Paris “rule book” was completed, establishing a global carbon trading market
4. The Glasgow Financial Alliance for Net Zero announced that “over $130 trillion of private capital is committed to transforming the economy for net zero”
5. Over 100 countries pledged to halt and reverse deforestation and land degradation by 2030
And some disappointments:
1. Net zero commitments by participants, known as Nationally Determined Contributions (NDCs), are insufficient to limit global warming to under 2 degrees. The consensus amongst scientists is that to fulfill the Paris Agreement, CO2 emissions need to be 45% less than 2010 levels by 2030 and reach net zero by around 2050. However, the pledges of two of the world’s largest emitters fall short. China (#1) has committed to reaching peak emissions by 2030 and achieving net zero emissions by 2060, while India (#3) has agreed to reach net zero emissions by 2070 (participants did however agree to update their targets by the end of next year)
2. No consensus was reached on ending fossil fuel subsidies
3. Coal and fossil fuels will be “phased down” but not “phased out”
4. Developed countries have not made good on their commitment to provide $100 billion in financing to developing nations—many did, however, renew $100 billion pledges through 2025
5. No agreement was reached on a plan for carbon pricing
Energy Continues to Outperform: Clean Energy Higher in October on Favorable Tailwinds
In October, SAM’s Infrastructure Income Portfolio produced a total return of 6.7% compared with 7.0% for the S&P 500 and 8.0% for its customized benchmark. SAM’s nascent ESG Infrastructure Portfolio generated an 11.7% total return. Year-to-date, our income strategy has outperformed both the S&P 500 and its benchmark with a total return of 33.1% compared with 24.0% and 27.4%, respectively. The big winners in October were the clean energy stocks, which generated a total return of 16.5% as measured by the S&P Clean Energy Index (SPGTCED). We suspect the COP26 buzz combined with the news surrounding the Biden administration’s $1.2T bipartisan Infrastructure Investment and Jobs Act (IIJA) helped to propel these stocks higher. (More on this later…)
The S&P 500 Energy sector posted a one month return of 10.2%, marking the best performing of the eleven S&P 500 sectors with a 52.4% return year-to-date. Yet after such a stellar performance, Energy is the only S&P sector that remains below its pre-pandemic high (reached in January 2020). The Alerian Midstream Energy Index (AMNA) and the Philadelphia Stock Exchange Utility Index (UTY) posted returns of 6.1% and 5.3%, respectively, last month.
Higher oil prices have supported the surge in energy stocks (oil reached its highest level in 7 years and was up 11% in October and 72% year-to-date). OPEC + is staying the course to gradually restore 400,000 barrels per day of production each month, despite the Biden administration’s pleas to accelerate the pace to stem the increase in prices.
Dividend Growth and Share Buybacks Are Poised to Accelerate
Capital allocation was a noteworthy theme emerging from third quarter earnings calls. The energy sector has transitioned to a free cash flow model and a focus on returning cash to shareholders via dividend increases and share buybacks. Several companies raised dividends and others have either completed or embarked on significant buyback programs such as Cheniere Energy (LNG-NYSE), Magellan Midstream Partners (MMP-NYSE), MPLX LP (MPLX-NYSE) and Williams Cos. (WMB-NYSE). MPLX also announced a special distribution to tax efficiently return cash to unitholders. We expect others to join the dividend growth and buyback party next year as balance sheets have been solidified. For example, Energy Transfer (ET-NYSE) has stated that it will be positioned to raise its dividend and/or buyback stock in 2022. The midstream stocks in our portfolio sport an attractive average yield of ~6.5% and we estimate its dividends to grow by 3-4% annually to at least keep up with inflation.
Biden’s Landmark Spending Plans: A Positive for Clean Energy
The $1.2T bipartisan Infrastructure Investment and Jobs Act (IIJA) was passed and signed into law by President Biden on 11/15/21. The historic level of infrastructure investments entails $550B of new spending over five years to bolster the U.S.’ competitiveness, jobs and economic growth. More than 50% of funding is allocated to transportation, which includes $7.5B to help build a national network of electrical vehicle (EV) charging infrastructure. Notably, a significant amount of funding ($65B) has been earmarked for grid-related and clean energy/technology investments to improve grid reliability and resiliency. The bill also includes allocations for climate resilience ($47.2B) including flood mitigation, drought, and wildfire management.
*Transportation funding includes $7.5B for EV charging
Source: Bipartisan Infrastructure Investment and Jobs Act Summary
The IIJA is a positive for clean energy and EV-related names in SAM’s ESG Infrastructure portfolio. However, passage of Biden’s pending $1.75B spending bill on social programs and climate action (i.e., the Build Back Better Act) should be more impactful, containing $550B of spending to address climate change primarily through clean energy tax credits. The Build Back Better Act is still working its way through Congress and the House is expected to vote by month-end, assuming the Congressional Budget Office issues a final report on costs (a sticking point for a group of moderate Democrats holding out).
Earlier this year, the Biden administration pledged to cut greenhouse gas emissions by 50% from 2005 levels by the end of the decade and reach 80% clean electricity by 2030. Trying to meet these goals, the Build Back Better Act contains approximately $550B of spending to combat climate change. More than $300B of the climate spending is earmarked for tax incentives for renewable energy (e.g., wind, solar and nuclear power). There are also substantial consumer rebates and credits to lower the cost of energy and electrical vehicle purchases.
Source: Committee for a Responsible Federal Budget
Given the current administration’s favorable policies and the market’s strong support, we believe there will be tremendous growth in clean energy adoption, technology, and infrastructure. SAM’s ESG Infrastructure portfolio consists of sector market leaders benefitting from these secular tailwinds.
Sam Partners’ Infrastructure Income and ESG Infrastructure Strategies seek to provide sustainable income and growth with capital preservation. This is accomplished by investing in a concentrated portfolio of high-quality clean energy companies, midstream energy companies and utilities that are well positioned to participate in the energy transition to a net zero carbon future. A diversified approach to investments across these sectors should optimize risk-adjusted returns, in our view. Our Infrastructure Income Strategy offers investors a current yield of ~5.5% and growth potential of ~4%; while the ESG Infrastructure Strategy that is more heavily weighted with clean energy stocks and adheres to strict ESG criteria, offers investors a current yield of ~ 3%. In a world starved for yield, we believe these Strategies offer a compelling value proposition.