By Andrew Wetzlel, CFA®, Managing Director of Sustainable Investing
It was the best of times; it was the worst of times. This classic Dickens line captures the stark divide between clean-tech fixed asset investment in the private sector and sentiment in the clean-tech corner of the public equity market. At the center of this conflict is the Inflation Reduction Act (IRA) and an increase in financing costs via higher interest rates. Beneath the surface, there are questions around economic development, inflation and costs, strategic supply chain dependencies, politics, and of course, decarbonization. As always, it’s important to start with the facts on the ground.
The IRA was signed into law on August 16th, 2022, creating a roadmap for decarbonization of the US economy. The program is centered on tax incentives intended to stimulate demand for clean power, electric vehicles, heat pumps, and related equipment; and to foster the creation of domestic supply chains supporting the transition to a lower carbon economy through unit-based manufacturing credits.
Over the twelve months since the IRA was signed into law, fixed asset investment across a number of industries has picked up in the US. Bloomberg New Energy Finance (BNEF) counts a total of 84 major clean-tech factory announcements over the last year, representing about $84 billion in private sector investment. Broader estimates capturing clean energy generating projects and expansion of existing facilities to meet demand, point to numbers roughly three times the BNEF totals. Estimates of job creation range from 74,000 to 170,000, depending on the scope of analysis.
The blue line in the chart on the next page shows the increase in manufacturing-related construction spending in the US, which began to pick up after the bipartisan Infrastructure Investment and Jobs Act was passed in late 2021 and accelerated after the IRA was signed into law. There is no doubt that this activity is a stimulant to the US economy, at a time when unemployment is at historic lows and the Fed is fighting elevated inflation. While it is certainly possible that the IRA reduces inflation many years down the road, it is clearly doing the opposite currently.
Beyond any impact on economic growth and inflation, there is the question of program cost to the government and how this plays into the upcoming election cycle. The initial Joint Committee on Taxation (JCT) estimate of program cost for the clean energy-related portion of the IRA was $270 billion. Today, the estimated cost of clean energy tax credits by the JCT stands at $662 billion. Estimates from Wall Street firms such as Goldman Sachs are above $1 trillion. There is no doubt that the cost of the IRA will be a hot topic right through the 2024 presidential election.
While there will be a heightened level of rhetoric on both sides of the IRA debate, many political analysts believe it is unlikely the entire law would get overturned on a GOP win in 2024, though politically contentious EV purchase credits could be at risk. For most of the rest of the legislation, it is important to keep in mind that roughly 70% of the clean-tech activity noted earlier—and therefore much of the job creation—is happening in states with Republican governors.
Beyond short-term tactics, with climate change a given and rapid action required to avert more dire outcomes, decarbonization and electrification is the baseline. This is a long-term transition and therefore strategy matters as much if not more than tactics. The US was clearly behind countries like China in developing supply chains to support the energy transition and electrification. This strategic disadvantage has become clear, driving the need to build domestic capacity. As noted above, this comes at a cost, particularly up front, as fixed asset investment accelerates. Over a longer period of time, supply and demand will not line up perfectly, driving cycles within a longer-term trajectory. We are getting a taste of this currently in the clean tech-related part of the stock market.
Since the signing of the IRA just over a year ago, valuation of the S&P Global Clean Energy (SPGCE) Index has moved steadily lower (orange line in the chart below). Activity on the ground is driving earnings estimates higher, a trend we expect to continue as most (if not all) of the IRA incentives will likely run through the originally planned program timeline. Despite an improving earnings outlook, stock prices have been trending lower, as investor sentiment has become increasingly negative. A stronger economy and upward pressure on inflation is driving interest rates higher, a dynamic that in isolation negatively impacts project-level economics.
Additionally, higher rates put pressure on valuation multiples for higher-growth companies where earnings and cash flows discounting some possibility that portions of the IRA might be at risk in a Republican-sweep scenario.
While uncertainty around interest rates, costs, the short-term balance of supply and demand, and political posturing will likely remain over the next few quarters, the medium to long-term outlook remains bright. With valuations now broadly undemanding and action on the ground supporting future growth, long-term investors should keep a close eye on the clean tech-related part of the market heading into 2024.