As the world faces a multitude of global crises ranging from volatile energy prices and continued economic strain to unprecedented climate change effects, 2023 marks an even more urgent need for the transition to clean energy sources.

The Intergovernmental Panel on Climate Change recently issued a stark warning that nearly half of the world's population is exposed to severe risk due to climate change, meaning a whopping 3.3-3.6 billion people are vulnerable. And already we’ve seen how costly our reliance on fossil fuels can be as citizens grapple with increasingly unaffordable energy bills. In light of this demanding situation globally, it’s paramount that we accelerate the adoption of efficient renewable alternatives as soon as feasibly possible.

But what is feasibly possible in 2023? What’s the energy decarbonization outlook for the year ahead when considering the challenges of inflation as well as the opportunities with China? And how will these factors influence how investors should allocate energy into their portfolio over the short and long term? This report provides a high-level look at how we at Purpose see the year ahead.

2022 – The Year of Energy Regression

Last year in the markets, inflation and a still-expanding economy caused bond yields marched higher, creating a tough environment for risk assets. Equities were hit across the spectrum: European markets were weighed down by what is likely a recession that is already taking place; and Asian markets similarly struggled in light of China’s zero Covid-19 policy and their real estate sector going through a controlled detonation.

All of these factors on top of unprecedented geopolitical shifts in recent years added significant noise to investing in the energy decarbonization space. But while there were numerous headwinds in 2022, we also saw:

1. The largest climate policy to pass in the U.S., which will further accelerate spending into alternative energy in years to come;
2. Rising energy bills, which make switching away from legacy fossil fuel sources more and more economical; and
3. Energy indices— both clean energy as well as traditional fossil fuel ones— drastically outperformed market indices.

Despite the headwinds, the S&P Clean Energy Index and Invesco Solar ETF were down a mere 5% in 2022, which is what some would consider an "up" year where the S&P 500 and the Russell 2000 got clobbered. Meanwhile, the S&P Oil & Gas Exploration & Production Index was the clear winner having returned +45% on the year.

But, although comparatively energy sectors performed well last year, we call 2022 “the year of energy regression” because this was the year where we saw countries around the world having to burn more coal after realizing that they didn’t have enough energy supply once Russian natural gas went offline. In conjunction, demand for oil and gas rebounded after countries opened up following the Covid-19 crisis. Since the sector  significantly underinvested over the last few years, when demand came back, there weren't enough supply, which led to an increase in prices.

2023 – Key Themes in Decarbonization

In the year ahead, three themes should dominate the dialogue surrounding energy decarbonization:

1. Inflation,
2. China, and
3. Natural gas.

Below we give our take on all three from an investing and portfolio building perspective.

Shifting Inflation Narrative

Of course, the first thing that will no doubt influence the energy space is inflation. The market is currently pricing in the Fed to hit peak policy rate around June and then pivot lower. Is that likely? We are not so sure—we're in the pause camp and think rates are likely to remain elevated throughout 2023 with the pivot likelier to happen in first half 2024.

Runaway inflation is a way more difficult problem to solve as the Fed is limited in their toolkit, so between a rock and a hard place, the Fed is likely to err on the side of keeping interest rates higher as they then have the option on the table to reduce rates quickly to stimulate the economy as seen from prior recessionary cycles.

While overall headline inflation has been coming down with “Goods and Energy” segment seeing a broader supply response, the inflationary path of “Services excluding Food & Energy” remains unclear as the labour market remains strong with very little slack in unemployment. Food inflation remains stubbornly high as a result of logistics disruption, labour shortage, weather volatility, and elevated energy and feedstock costs in many parts of the world.

Given our view of the likely path of the Fed and that we believe that inflation is likely to stick around through 2023 and, companies with pristine balance sheets and strong free cash flow should be best positioned to grow and take share as weaker peers are likely to shutter their growth given the higher cost of equity and debt.

The days of "growth at all costs" during the 2020/2021 period is over. Financial analysis and deep dives into specific energy decarbonization opportunities will prove key to identifying companies that can maintain their growth profile without introducing significant dilution or solvency risk.

China: The Hidden Dragon

The sector factor to watch this year is China. While western civilizations are all dealing with their own issues (Canada economically sensitive to all things housing, Europeans unwinding their economy that's built under the assumption of cheap Russian gas, U.S. in the process of taming inflation that might lead down the path of a hard landing, etc.), China is now on the upswing as they go through their own Covid-19 re-opening.

China's top leaders have committed to refocusing their economic direction away from Covid-19, prioritizing growth through increased domestic consumption. To get this up and running, there are plans in place for accelerated fiscal expenditure along with a looser monetary policy that could include reductions in required reserve ratios and interest rates—all intending to drive the Chinese economy forward.

Despite the positive direction of economic recovery, it's important not to put the cart before the horse as consumers can't save the Chinese economy alone.

China has seen a remarkable economic transformation over the past two decades—particularly in real estate. Though their successes have been striking, they are not without challenges that must be addressed to keep momentum going forward.

A key point of note is how important the real estate sector to the Chinese economy:

• Real estate accounts for ~30% of China's GDP,
• 70%+ household wealth tied to real estate,
• 90% of real estate ownership versus equities at ~10%, and
• Provincial and local Governments tap into the real estate market, earning significant revenue through leasing land to developers and builders.

Source: Centre for Economic Policy Research

China’s economy is undergoing major restructuring, with a controlled detonation and re-wiring of a whopping ~30% of its GDP.Despite initial stability earlier in 2022, the industry soon started to crumble at year end, leaving leaders struggling for an effective response.

The stimulus packages announced are helpful steps. One respected analyst I follow aptly coined the phrase, "Turning this behemoth around is like trying to turn the Titanic around with a switch from a mulberry tree."

This restructuring effort will take significant time and resources, so we are hesitant that there will be a quick rebound in the sector, despite all the broad outperformance in sectors related to China’s re-opening including commodities relevant to construction and broad China indices.

That being said, we are not in the business of market timing and given the risk-reward presented out of China, we believe some attention needs to be paid for the developments here and increased China exposure could be constructive for risk-adjusted return in 2023.

Despite the challenges with the broader Chinese economy, there are broad implications to mobility and power sectors that are likely to recover quicker versus other sectors given the uncertainty in timing of the recovery.

1. Autos: New energy vehicles (NEVs), which includes plug-ins, and battery electric vehicles (EVs) will continue to see outsized sales growth while internal combustion engine (ICE) vehicles continue their decline despite ending of cash subsidies for NEVs. The entire value chain associated with EVs stand to benefit including battery manufacturers, battery housing, and critical minerals such as lithium.

2. Renewables: Renewable energy capacity expansions are expected to remain robust through 2023, supported by a debottleneck in solar silicon supplies and surging wind tenders. Solar module manufacturers hold greater appeal than upstream polysilicon suppliers, while wind operator can benefit from decreased turbine costs and capacity growth.

Despite the phaseout of wind and solar photovoltaic subsidies, China is rapidly accelerating its renewable energy capacity over 2022-2027 with it projected to account for nearly half of global installation as estimated by the International Energy Agency. Strategic market reforms in conjunction with ambitious targets outlined within the 14th Five-Year Plan combined with determined provincial government support provide a solid foundation for continued growth and long-term revenue stability in this sector.

3. Natural Gas: City-gas distributors are the beneficiaries of a more "normalized" gas environment as the country continues to pivot away from coal and a key beneficiary of increased economic activity out of China.

4. Construction: There are several catalysts on the horizon with supportive policy measures in the real estate sector being implemented with a timeline of Q3 2023 for gradual signs of a pickup that lines up with a seasonal peak in construction. Carbon capture for cement production remains key to reducing net greenhouse gas (GHG) emissions as the construction industry contributes to 13% of total GHG emissions globally.

Natural Gas: Is Winter Over?

The last theme that should dominate the year is natural gas. The "Widowmaker”—the U.S. natural gas price spread between March and April—which demonstrates seasonal winter pressure or lack thereof, is making headlines yet again.

That this spread has plummeted indicates a much lower risk of inventory shortfall by 2022/2023’s winter season end, thanks to a much warmer winter around the world so far, which drastically reduced the need for heating.

European gas storage injected slightly in the last couple weeks (blue line) of December versus the seasonal draw.

While we are not in the business of predicting weather patterns, winter is not over until it's over. There is a remote possibility that we experience a colder tail end of winter similar to 2014 where we see a significant jump in natural gas pricing in North America.

Despite the short-term weather volatility impacting natural gas economics, we remain constructive in natural gas long term as the most logical energy transition fuel of the next decade where North American producers are structurally the lowest-cost producers with Russian natural gas going offline.

Freeport LNG, an LNG export terminal out of Texas, is slated for a February restart after an eight-month outage that will increase demand for natural gas. Longer term, a whole slew of LNG projects are coming online in the next two to three years including LNG Canada that will further increase demand.

2023 – Portfolio Allocation

In light of this outlook, going into 2023, we have made some notable changes in the Purpose Climate Opportunities Fund (TSX: CLMT) that factor in the key themes we've outlined.

Electric Vehicles

We've increased allocations to Chinese EV players to 11% based on China’s re-opening playing out as well as continued NEV growth and ICE phase-out.

BYD out of China as an example is the largest automaker in the world and is quickly ramping up their NEV sales versus peers. With recent NEV subsidies going away end of 2022, they are in a better position to pass on lost subsidies versus some of their competitors.

Recent announcements on their entrance into the premium market have been received favourably as it opens up an avenue to compete across the entire mid-tier to luxury-tier segment. They also have a vertical integration strategy since in addition to being an EV manufacturing, they also have their own in-house battery production and sell them to auto original equipment manufacturers across the board including Tesla and Toyota.

As an example of the extent of their vertical integration, in recent months, they began buying their own auto transport ships to lock down all parts of the supply chain given the record freight costs seen during the disruption of Covid-19.

For the car junkies, check out the YangWang U9 supercar that was announced just two weeks ago: BYD's YangWang U9 Supercar unveiled.

Battery Housing

This is a segment where we have initiated a position in recent months. Battery housing is a critical component for EVs that is less discussed in the headlines and is potentially a better proxy to invest in the broader EV megatrend on sector-wide volume growth and price reductions.

Battery housing servers three primary features:

1. Providing a stable enclosure for the battery system during vehicle performance,
2. Assisting in thermal management, and
3. Enhancing vehicle structural integrity and the ability to absorb crash energy.

Battery housing manufacturers are a great proxy to invest in the overall increased adoption of electric vehicles as increased competition over time will ultimately drive pricing and margins of EV manufacturers lower. Given battery housing represents a low percentage of bill of materials in the production of an EV, it’s likely to continue to be outsourced versus other auto components, such as battery cells, that are increasingly being moved in-house.

China

We've significantly increased our allocations to China from 7% end of 2022 Q3 to 18% today. This includes our increased allocation to EV and battery housing names out of China as well as companies that are involved across the power, construction, and utilities sector. We will be looking for further confirmations of a sustained China economic recover for additional entries.

Natural Gas

While we remain constructive on natural gas long term, we’ve reduced select natural gas exploration & production companies that are less hedged through the winter months on the distinct possibility of a lackluster winter through March.

Meanwhile, we’re maintaining our positions in natural gas producers that are actively involved with carbon capture or have access to premium markets such as California or LNG markets where pricing remains elevated seasonally. We will be looking to add back torquier natural gas names on any potential washout of the space on weaker weather.

Final Thoughts

Picking the right companies in the energy decarbonization space will remain key to outperforming in 2023. The increasing recognitions from governments and corporations that climate change is a real systematic issue will continue to drive capital into enablers of decarbonization as the alternative (i.e., doing nothing) will only drive inflation up over the long term from increased negative impacts to food & energy security and reduced infrastructure resiliency.

Not all companies in this space are created equal: free cash flow and balance strength coupled with a viable business model is necessary to outlast the current down cycle and thrive in the next one.

We remain firm in our thesis that transitioning to renewable energy is critical for achieving long-term energy security, price stability and national energy resilience. According to the 2022 World Energy Transitions Outlook,  80% of the world lives in net energy import countries. But with more abundant alternatives available, this figure can be drastically reduced.

Moving away from fossil fuels towards renewables will not only provide diversified sources of supply but also create job opportunities while reducing poverty levels worldwide—ultimately facilitating an equitable and climate friendly economy on a global scale. This remains the long-term objective of any energy decarbonization strategy: how we get there in the short term is crucial as the world balances energy demand of today that cannot be satisfied with renewables alone.

— Jeremy Lin is a Portfolio Manager at Purpose Investments

Sources:

Charts are sourced to Bloomberg L.P. unless otherwise noted.

“IPCC Sixth Assessment Report,” The Intergovernmental Panel on Climate Change:  https://www.ipcc.ch/report/ar6/wg2/resources/spm-headline-statements/#:~:text=Approximately%203.3%20to%203.6%20billion,are%20interdependent%20(high%20confidence)

“Can China’s outsized real estate sector amplify a Delta-induced slowdown?” The Centre for Economic Policy Research: https://cepr.org/voxeu/columns/can-chinas-outsized-real-estate-sector-amplify-delta-induced-slowdown

“Buildings: A source of enormous untapped efficiency potential,” IEA: https://www.iea.org/topics/buildings

“World Energy Transitions Outlook 2022,” International Renewable Energy Agency: https://www.irena.org/Digital-Report/World-Energy-Transitions-Outlook-2022

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