Jack Bogle, founder of Vanguard, revolutionized the investment management industry when he created index funds back in 1975, bringing to market price competitive strategies that allowed retail investors to follow broad indices like the S&P 500 or Dow Jones. Besides being an inexpensive product, funds tracking these benchmarks have added diversification to portfolios. Since then, passive investments have increased in popularity and in the past 40 years have competed for capital flow with the active strategies that try to beat the market and deliver excess returns. Index funds following broad markets have been a very popular strategy.
After the oil shocks of 1973 and 1979, fossil fuels became inexpensive and used extensively in industries from electricity to transportation and fertilizers to plastics. This also enabled a rapid increase in the mass-produced materials like cement and steel, to the great benefit of the new equity indices that represented a broad range of companies. However, what worked in the past now poses a lot of risk, as global economies begin to transition at differing speeds towards Net Zero.
For example, the S&P 500 currently has about 20% of its weight represented by companies that are heavy carbon emitters, predominantly names in oil & gas, plastic packaging, automakers, gas utilities, trucking, gas distribution, and air freight.
Although in 2022 the strategy of investing in “brown value” is paying off, the same high prices have started to cause demand destruction, thus accelerating the energy transition over the long term. This peculiar coexistence of “green growth” and “brown value” is being misinterpreted by many analysts as the revenge of the old economy. The acceleration of the energy transition is triggering a process of profound, structural changes that will undoubtedly create many winners and many losers.
Keeping a core material allocation in broad indices that represent so many companies with products and services being replaced and disrupted (e.g., internal combustion engine producers competing with electric vehicles) is risky. There are also challenges in the clean energy space, but a deeper look at how innovations are likely to unfold can give us greater insight into the risks and opportunities for green investments.
Solar panels and batteries are not fuels, they are technologies. Producers of both equipment have become more efficient as scale increases, which has been consistently driving down prices. The energy transition is moving economies away from extractive activities like oil and gas exploration, therefore looking at how new solutions are likely to develop is paramount to understanding where the risks and opportunities in the path towards a clean grid are.
The best framework I have seen on this potential evolution was put together by a solar energy enthusiast that I have had the pleasure of speaking to several times. Bill Nussey is a venture capitalist, successful entrepreneur, an experienced engineer as well as the author of “Freeing Energy,” a book published in 2021 predicting the rise and fast adoption of what he beautifully calls “local solar.”
In explaining the profound and transformative potential of solar energy, Bill elaborates on the evolution of technologies and supply chains, which he refers to as “the five orders of cleantech innovation.” They are Components (first order), Integrations (second order), Services (third order), Platforms (fourth order) and Disruptions (fifth and last order).
In the first order we see the foundation of the entire industry. In clean energy, the producers of solar cells, solar panels, batteries and inverters fall into this category. Manufacturing these key components is capital intensive, takes a lot of time to achieve scale and the products are somewhat commoditized, so price competitiveness is a must. Canadian Solar (CSIQ), Enphase Energy (ENPH) and Jinko Solar (JKS) are examples of successful first order companies.
Second order innovation is characterized by the integration of first order components into a new product or market. Bill Nussey sees solar installers as the quintessential example of Integration in the clean energy space. Sunrun (RUN) and Sunpower (SPWR) are two examples of second order companies. Sunrun is the market leader in installation for residential solar rooftops in the U.S. (the company is embracing third and fourth order businesses as we will see below, but Sunrun is still fundamentally an installation company). On the clean energy storage side, second order solutions integrate the different components into a single system. Flow batteries, thermal storage and mechanical storage providers are other examples of second order companies. Energy Vault (NRGV) uses kinetic energy as a low-cost utility scale alternative to lithium-ion batteries.
As solar rooftops are a powerful short-term solution to the energy crisis, allowing users to save money from day one (in particular with the benefits that the Inflation Reduction Act is promoting in the U.S. market), “solar everywhere” is materializing as a milestone in the energy transition. This will combine with long duration energy storage (“LDES”) for a much bigger transformation. So higher up in the value chain comes the third order of innovation, where companies turn second order assets like solar panels and batteries into a service.
These companies provide a pay-as-you-go, or subscription model service that is an alternative to the traditional model based on an upfront installation fee. Microgrid services or energy storage solutions fit into this category. Two great examples are Stem (STEM) and Fluence (FLNC); neither manufactures the equipment, instead they deliver, install, and operate clean energy storage as a service.
The fourth order of innovation is characterized by new innovative platforms that increase the value of services and assets in a commission-based revenue model. Nussey points to Uber and Airbnb as quintessential examples of Platform businesses that gave an opportunity to asset owners of cars and properties to optimize and monetize their value. That is what we are observing in Vehicle to Grid (“V2G”) and Virtual Power Plant (“VPP”) solutions that have optimization software at the heart of their Platforms.
A great example of a company in this space is Nuvve (NVVE), the only pure V2G listed company that enables owners of EV fleets to use the mobile batteries inside the electric cars to provide frequency regulation and peak shaving to the benefit of the grid. Sunrun has been investing into the more potentially lucrative fourth order innovation and already operates a VPP in California. Another exciting name is Voltus, a company that was supposed to go public via a SPAC merger and could become the only listed pure player in the demand response distributed energy space.
Lastly, the fifth and most profound innovation, that of the Disruptors. Nussey sees green hydrogen as a transformative industry that can decarbonize a broad range of other industries, from cement to fertilizers and steel producers to hard to abate transportation in the maritime space to, of course, LDES solutions. While no pure green H2 players have emerged yet, current proxies for the disruptive potential of clean hydrogen are originally first order component manufacturers of the two key technologies (also moving into more elaborate third order Services): fuel cells and electrolysers.
Bloom Energy (BE), the California based manufacturer of solid oxide fuel cells for behind the meter electricity production, and PlugPower (PLUG), focusing on proton exchange membrane (“PEM”) fuel cells for transportation applications, are both examples of companies enabling the creation of a hydrogen economy.
A portfolio designed to represent a comprehensive set of clean energy solutions across the five degrees of innovation described above allows an investor to gain exposure to the companies solving the bottlenecks at the base of the supply chain, while benefiting from the overall revenue growth that all providers of the key solutions will benefit from, without being overexposed to the riskier (but potentially very rewarding) more disruptive fourth and fifth order businesses of newer business models.
We have developed and proposed investment themes that represent key opportunities across the five orders of innovation, from batteries to solar panels, to aggregators of distributed energy assets like V2G and VPP. Our approach is to provide enough diversification, as it is yet premature to call winners and be overexposed to a few companies or hold too concentrated portfolios. At this point investors should hold the most exciting developments across distributed renewable energy, in LDES, and in new models of a circular economy, as well as solutions to allow us to adapt to an already warming planet.
Therefore, thematic index funds, an innovation that followed the broad indices first designed by the late Mr. Bogle, will continue to compete very well with active portfolio managers trying to anticipate who will be the “climate champions” and attempting to capture the favourable momentum of clear long-term winners behind clean solutions. We believe comprehensive green indices should not be used as satellite allocation, but rather as core, in conjunction with a lower exposure to the traditional but not future proof broad indices. The case for green thematic investing as a way to capture the unprecedented value creation that the energy transition triggers is extremely strong.
Authored and published for Nasdaq.com.
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