The crossroads of the energy sector: short-term challenges vs. long-term needs

Three industry experts from Federated Hermes, discuss the energy sector: Martin Todd, global equity and sustainable portfolio manager, looks at the strong performance of the sector this year and what to expect in 2023. In addition, Mitch Reznick, Head of Sustainable Fixed Income, discusses the upward trend in non-renewable green and sustainability bonds, which have risen from 10% to 62% in three years. Finally, Perry Noble, head of infrastructure, examines how investors are responding to pricing models and reacting negatively to political uncertainty.

Martin Todd, Sustainable Global Equity Portfolio Manager

Despite a market down more than 20% this year, energy continues to soar. The sector has remained top performer within Global equities for the second year running, posting a 30% gain in 2022.

Driven by energy security concerns with the ongoing conflict in Ukraine and demand underpinned by re-opening post-Covid, not only is energy creating divergence in market performance, but also value. With notable profit upgrades, energy remains the cheapest GICS sector trading on a prospective 8x earnings with and expected dividend yield >4%.

As the saying goes, the cure for high prices is high prices. Both in reducing demand and luring in new supply as new entrants compete away super-normal profits. Some level of demand destruction is likely – in NW Europe, BNEF is predicting a 17% drop in demand this winter vs the 2016-2020 average. Supply, however, is also limited and OPEC’s October production cut is likely to underpin prices, much to America’s chagrin.

In 2023, we expect headline costs for renewable energy to continue to decline and the build-out of both solar and wind to accelerate in pace. There is, however, no escaping the dependence on fossil fuels within the global energy mix, nudging up to ~82% vs ~81% in 2021. More concerningly, coal powered energy has risen to record levels in 2022 (IEA), as energy security took precedent over decarbonisation.

This tug of war between supply and demand in global energy markets are somewhat consequential of conflicting time horizons. Sound energy policy requires a multi-decade strategy, mis-aligned with 3-5 year political cycles in much of the West. Political mixed-messaging hinders planning and windfall taxes on profits could deter long-term investment in an industry that’s already scaled back capex materially in recent years.

For equity investors there is clear value in Energy, albeit with need to be weighed against political risk, namely windfall taxes. Clean energy sources will continue to be increasingly cost competitive next year, and we expect more opportunities in the space as the pandemic supply chain problems dissipate, and higher energy prices encourage greater adoption.

Mitch Reznick, Head of Sustainable Fixed Income

From the start of 2019 through the end of October 2022, non-financial corporates issued some $730 billion of green and sustainability bonds. The Energy sector comprises some 10% in count and around 6% in volume of that total issuance through that period. And while that is not terribly material, there is a very interesting trend that lies beneath.

Based on common sense, one would think that all or nearly all sustainability bonds in the energy space would be issued by renewable energy companies. That was the case in the early years of this brief period of time. In 2019 and 2020 fewer than 10% of issuers of labelled bonds in the Energy sector came from non-renewable sub-sectors (e.g., Refining & Marketing, Integrated Oil).

However, something happened during the surge in sustainability bond issuance of 2021. Suddenly nearly 50% of issue volume in the Energy sector came from such non-renewables as Coal Operations, Pipeline, and Exploration & Production. This trend carried into 2022 when non- renewable green and sustainability bonds reached some 62% of Energy-sector volume. How did the composition of the Energy sector’s composition of non-renewables go from around 10% to over 60% in a short period? 

In the period prior to COP26 in the autumn of 2021, the global exuberance for decarbonisation spilled into the capital markets. As shown by the surge in companies that had their decarbonisation targets approved by the Science-based Target Initiative, companies wanted to signal to the capital markets that they were serious about reducing their carbon footprints. As such, issuers needed to finance these objectives and were easily able to issue labelled bonds into a market keen to invest in positive change. Coal miners, pipelines, and exploration-production companies dropped onto that wave and sold green and sustainability bonds. Of course, the observed “greenium” on offer made for an attractive drop-in as well.

We have no reason to expect that this trend won’t continue into 2023. We will listen to the case that the sustainability financing is a catalyst to greener pastures into the future for an Energy issuer. However, unless the financing is leading to a credible transition or material decarbonisation of the issuer, we struggle with a sustainability financing from companies, that, for example, generate some 90% of their revenue from coal operations.  Sustainability financings in the non-renewable Energy space have great potential, but we suggest reading the large print on the label.

Perry Noble, Head of Infrastructure

Global energy prices have experienced a period of extreme volatility following Russia’s invasion of Ukraine. The invasion exposed Europe’s reliance on Russian commodities leading to a renewed focus in the EU and UK on security of supply. Elevated energy prices are contributing to broad based inflation that is increasing the cost of living. Affordability is a significant challenge for many households.

In response, governments’ ambitions globally to build resilience and reduce reliance on imported energy have increased markedly. Fundamentally, this should be a positive development for achieving Net Zero. Delivering a low-carbon energy system critical for the transition to Net Zero – installation of new wind and solar power capacity; electrification of transport; increasing blue and green hydrogen production and utilising utility scale Carbon Capture Usage and Storage (CCUS) projects – also reinforces security of supply and contributes to reducing reliance on volatile commodity prices. This, coupled with a need for infrastructure to manage the impact on the system of an increasing proportion of intermittent renewable power generation, should broaden the potential investable market for private capital. 

We see this trend continuing throughout 2023 and the next decade as the requirements for markets and governments, driven by carbon pricing and more ambitious climate commitments, accelerate the path to decarbonisation. By 2050, widespread adoption of technologies that are not yet on the market, as well as significant additional deployment of proven technologies, will be required to meet Net Zero ambitions. Major innovation efforts must occur in the near term in order to bring these new technologies to market in time to meet the 2050 deadline.

There is a risk however, that rushed, short-term decision making, intended to support households and businesses during a period of high energy prices, inadvertently deters private capital from making the long-term investment commitments required to support the transition to Net Zero.

Investors respond positively to carefully considered pricing models designed to promote essential new technologies, which they can rely on. Whilst they react negatively to policy uncertainty and drift. Devising a path that successfully addresses the short-term challenges faced in the current macroeconomic environment, whilst avoiding compromising what is required longer term to combat the climate emergency, will be critical to the outlook for energy markets globally.