Decarbonisation is Europe’s last chance to prosper

The three biggest categories of carbon emissions in Europe, according to the European Environment Agency, are energy supply, industry and transportation. Europe has set ambitious targets for electric vehicle adoption and subsidies for clean energy. These things are good for decarbonisation, but according to experts they’re also the low-hanging fruits. Steel and concrete are vital building materials, but very difficult to produce in a less carbon-intensive way. Future technologies might change that but, in the meantime, carbon capture technology is the only solution to carbon emissions in our industry. This technology is currently expensive so forced regulation of carbon capture will make many things more expensive to produce, and thus carries potential inflation.

The EU Emissions Trading System is a system that is designed to incentivise companies to be more carbon efficient, but as the EU has realised, it cannot work in isolation. European companies will just set up production outside the EU and import the capital and final goods, so the EU is preparing a carbon border tax. This mechanism will put taxes on goods produced in high carbon-intensive countries, forcing other countries to become greener or lose production.

In the age of social unrest and with democracies under pressure, the developed world needs a shared identity. Decarbonisation and nationalism are potentially the powerful ideas of the left and right in the political spectrum that could converge to a shared identity and propel society in a new direction with less social unrest and a prospering Europe.

European companies gaining from decarbonisation 

Back in late 2019, we wrote a research note on the green transformation and said that it would be one of the biggest themes in equity markets over the coming decades. Whereas the largest companies of today are rooted in digitalisation, we are predicting that some of the largest companies in the future will be those that solve our environmental problems. The challenge is huge and very costly and will most likely create green technology companies of a scale never seen before. This is because our carbon emission problems are by nature global and exist in our physical world.

The publicly available opportunity set in green technology is still limited for investors, but many new companies are rushing to public equity markets in a bid to raise equity capital and build out these technologies. We have managed to find 40 European companies within green technologies that in different ways provide exposure to the decarbonisation policies of the EU towards 2050. The companies span wind, solar, hydro, fuel cells, bioplastic, electric vehicle car-sharing services and recharging stations, as well as recycled materials, insulation materials for better energy efficiency in housing, uranium mining (a bet that EU will designate nuclear power as a green technology) and energy storage.

We have no opinions and don’t provide any investment recommendations of the companies on our decarbonisation list. Instead, we show the distance in percentage terms to the current consensus price target; investors can then do their own due diligence. It is important to note that green transformation stocks have experienced a lot of volatility this year and so this is a long-term investment theme, where investors should be patient and prepared for volatility.

The key risk in Europe’s decarbonisation theme is foremost equity valuations, as investors have aggressively discounted the future across all companies with a green technology profile. High equity valuation at the starting point of investing is on average associated with lower future returns, so investors must be careful when investing in the green transformation. Many of the green technologies are maturing, but there are still uncertainties around which technologies will be the big winners, so investors should expect many companies to fail in delivering on growth and expectations. Higher commodity prices and higher interest rates are also big risks for green transformation stocks, as they potentially compress profitability unless green companies can pass on the higher input costs.

Inflation and weaker USD will benefit European equities

The accelerated path to a green society on all levels will push our physical world and technologies to their limit. The green transformation will be the single biggest contributor of inflationary pressures over the coming decades, combined of course with onshoring of production from Asia and urbanisation in the developing world. On top this the massive wealth and income inequality will be met by policies favouring labour markets over capital markets, which will lead to higher median wage growth and demand in the economy again supporting inflationary pressures.

Higher inflation will be driven by the US stimulus which will most likely lead to a weaker USD. In previous weak USD cycles, European and EM equities have done better than US equities, but there are other reasons to be overweight Europe. Equity valuations are more attractive and US equities have never outperformed European equities to the degree that they have since 2007. This period has coincided with growth outperforming value and rapidly declining discount rates on cash flows.

European equities have begun to outperform US equities since early November 2020 when Pfizer announced its mRNA vaccine effectiveness. The vaccine announcement marks for now the turning point for interest rates, inflation expectations, and value stocks. These trends benefit European equities as they generally exhibit a lower cash flow duration than US equities, higher weight to financials and other cyclical industries. But all the factors above could turn out to be wrong; in that case, what could still drive European outperformance? The revolution in green technology is Europe’s chance to dominate an important technology vector of the future and regain its position in global equity markets.