investment viewpoints

    Strategic impetus for sustainable energy in Europe

    Strategic impetus for sustainable energy in Europe
    Erika Karolina Wranegard - Portfolio Manager, Fixed Income

    Erika Karolina Wranegard

    Portfolio Manager, Fixed Income

    Energy security has climbed the European political agenda recently, supporting the low-carbon transition. High metals prices act as a short-term headwind but authorities remain committed to a cleaner future, with the region’s central bank working towards “greening” its monetary policy framework. 

    This report, which explores EU’s overarching green policy initiatives and its market implications, is the concluding part of our latest quarterly assessment of global fixed-income markets, Alphorum. In our previous reports in this series, we focused on what fixed-income scenarios could result from the current market shock, what the central bank’s war on inflation means for developed-world bond markets and the new duality within the sovereign Emerging Market universe as well as credit opportunities in these volatile times and lessons from past oil shock episodes.

     

    Need to know

    • The recent geopolitical developments in Ukraine have made energy security a priority area, particularly for the European Union
    • There will be some short-term headwinds for renewable energy, from the supply of key raw materials, but in the long term, the energy transition will accelerate, in our view
    • European policymakers have re-emphasised commitments to net zero through both regulation and monetary policy. Increased capex from sovereigns and corporates is thus likely to focus on a sustainable future

     

    Headwinds for renewable energy, but the long-term outlook is positive

    For renewable energy, in the short term there are undoubtedly some headwinds. Both Russia and Ukraine are key suppliers of energy-transition metals. These include copper, nickel, lithium and aluminium, which are used in the manufacture of green technologies, including wind turbines, solar panels and – significantly, given the surge in electric vehicle (EV) sales over the past 18 months – EV batteries (Russia also produces a third of the world’s palladium, which is used to reduce the emissions of traditional internal combustion engine vehicles). Supplies of most of these commodities were already struggling to keep up with demand, and price spikes for some of them in the wake of the invasion almost paralleled the surge in gas prices. With the war continuing to impact supply, renewable technology manufacturers are likely to suffer higher input costs as existing contracts play out.

    At the same time, concerns over energy security are not only redrawing the map of fossil-fuel supply lines but are also fomenting a resurgence in interest in previously out-of-favour energy solutions. There is admittedly a risk that formerly financially or reputationally unviable fossil-fuel projects are put back on the table. However, in the long run, the need for energy security is likely to accelerate the transition away from fossil fuels and towards renewables in many countries, pushing forward the green agenda.

     

    Reducing uncertainty through policy and regulation

    The European Union (EU) has reasserted its commitment to pushing towards net zero as quickly as possible. On 8 March, the European Commission announced an outline for REPowerEU, a joint action plan for more affordable, secure and sustainable energy, which is expected to reduce EU demand for Russian gas by 41% this year, the International Energy Agency estimates. Launching the plan, Commission President Ursula von der Leyen said the aim was to “accelerate the clean energy transition” by switching more quickly to renewables and hydrogen power. A week later, the EU’s 27 economy ministers agreed to introduce the proposed carbon border adjustment mechanism (CBAM), essentially a tariff on imports of products coming from countries where it is cheaper to pollute.

    These announcements build on a number of existing European initiatives designed to turn sustainability from an ambition into reality. The five EU missions, formally launched in the run-up to COP26, includes a commitment for 100 climate-neutral cities by 2030, as well as a plan to restore Europe’s oceans and waters and establish 100 ‘living labs’ to lead the transition to healthy soils by the same date.

    Meanwhile, in January the European Central Bank (ECB) launched a stress test to be conducted in the first half of 2022, with the aim of assessing how prepared European banks are to deal with potential shocks stemming from climate risk. It described this as a ‘learning exercise’ for banks and supervisors alike, with the results to be published in July 2022. As well as the stress test itself, the exercise included peer benchmarking to assess the sustainability of banks’ business models and their exposure to emissions-intensive companies. With Eurozone policy and regulation leaning heavily into sustainability, net-zero aligned companies are likely to benefit from more favourable financing conditions, including reduced capital requirements.

     

    Investing in the new reality

    As mentioned elsewhere in Alphorum, there is a strong move towards higher capex among corporates as well as for increased fiscal spending by sovereigns, much of which will be focused on adapting to the green transition. Hard-to-abate sectors like steelmaking, construction and heavy manufacturing will invest in developing more efficient processes and researching alternative materials. Meanwhile, greater investment in recycling and the development of the circular economy will aid dematerialisation, reducing both emissions and input costs – especially as the use of virgin resources is increasingly legislated against. Another environmentally friendly trend which will be given a boost by the increased need to ensure security of supply is onshoring, which is already a growing focus for many businesses given ongoing global supply-chain issues.

     

    Greening bond purchases

    More specific to the fixed-income universe, the ECB has reasserted its intentions on the ‘greening’ of its monetary policy framework. A key question arising for the central bank, now that it is committing to a degree of quantitative tightening, is how aligning monetary policy to the terms of the Paris Agreement can be carried through as bond purchases are reduced. In a speech on 17 March, Isabel Schnabel, ECB Executive Board Member, gave some clear and welcome direction on this issue. Schnabel pointed out that while the size of the bank’s portfolio is solely determined by monetary policy considerations, its structure is not.

    “We could actively tilt our portfolio towards the Paris objectives once we have decided on how the market neutrality principle, which is currently guiding our bond purchases, should be modified,” she commented. “If markets misprice the risks associated with climate change, an allocation according to the market neutrality principle may not favour an efficient allocation of resources.”

    The message to corporates, banks and investors is clear — the EU is more focused on a sustainable future than ever; and you should be too.

     

    To read the full Q2 2022 issue of Alphorum, please use the download button provided.

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