Environmental Sustainability – It’s Just the Beginning

By Veronica Zhang, Deputy Portfolio Manager and Analyst

This quarterly commentary marks the first since the launch of the Environmental Sustainability Fund in July 2021. Since launch, numerous announcements from the U.S., Europe and Asia have focused on furthering the push to reduce the global environmental footprint. This includes policies designed to continue pressing industries to reach emissions, waste reductions, and subsequent net zero targets.

A few of note include President Biden’s target for solar to provide 45% of the U.S.’s electricity by 2050, which followed his earlier executive order for zero-emissions vehicles to make up 50% of new car sales by 2030. Ever the nation’s leader in electrification, California announced all new construction commercial and multifamily residences would be required to have solar and battery storage capabilities starting in 2023.

Across the pond, the European Commission released its “Fit for 55” legislation. This translates climate goals into concrete action via further application of emissions trading, increased use of renewable energy, a faster roll-out of low emission transportation, and an alignment of tax policies with the European Green Deal objectives.¹

Following a decade of planning and small-scale rollouts, China finally officially launched its carbon emissions trading scheme (ETS). It will initially focus on the power sector, which accounts for 40% of China’s CO2 emissions, but will eventually cover petroleum refining, chemicals, non-ferrous metal processing, building materials, iron and steel, pulp and paper, and the aviation sectors.² Upon full implementation, it is expected to be the world’s largest carbon trading market.

The delta between where we stand currently in our environmental footprint and where we need to be in a few short decades is tremendous. We see significant value from product and technology advancements that will undoubtedly disrupt the status quo – and are uncovering the companies best positioned to win share and lead that innovation.

Mixed Bag: Inflation and Supply Chain

The portfolio weathered a choppy quarter as global supply chain disruptions and weather-related logistics delays pushed demand to the right. Exposure along the value chain in each of our sustainability sectors resulted in a mixed bag performance-wise, although we are seeing pockets of opportunity develop as the inflation story continues to play out. Companies with best-in-class supply chain management are able to weather the bumpiness in cost inflation, while the backdrop for green infrastructure, renewable project development, and agricultural innovation continues to remain strong amidst unchanged or higher demand projections and policy support.

Renewable Energy Still in High Demand…

Our largest sector allocation is currently Renewable Energy, where management commentary and channel checks have reinforced the strong demand heading into 2022. However, hiccups in on-time project development and equipment sales due to the semiconductor shortage and freight crunch dampened optimism in the short term. Wind blade manufacturer TPI Composites (1.8% of fund net assets) felt the brunt of the inflationary and supply chain impact and took down EBITDA (earnings before interest taxes, depreciation and amortization) targets on increased input costs (resin, carbon fiber, logistics), which we expect to be transitory and passed through to the end customer in contract re-negotiations.

On the contrary, rooftop solar project developer Sunrun (2.5% of fund net assets) raised 2021 sales guidance on both its first and second quarter earnings announcements (25%-30% in 1Q, 30% in 2Q) and continues to recognize incremental synergies from its Vivint Solar acquisition completed last year. Growth vectors (battery, electric vehicles or “EVs”) continue to open its sales channels, but has been overshadowed by installation costs having increased approximately 5% over the past six months (natural gas prices have increased more than 100% in the same timeframe) in an industry accustomed to cost deflation.

With strong policy support in the form of tax credits and more innovation and streamlining through efficient installation, lower cost of capital, and higher component efficiency, rooftop solar remains cost competitive relative to the traditional alternatives—even more so with the integration of batteries, which we believe should see exponential adoption over the near term.

…But Is Only One Driver for Secular Growth in Smart Resource Management

Smart Resource Management makes up the infrastructure and manufacturing plays to renewable and mobility growth in this era of electrification. Electricity demand is expected to increase +50% from current levels by 2050, with that growth in tandem with the rapid decarbonization of electricity supply. As a result, the grid must grow sustainably, beyond just addressing the rising share of renewables. Mass electrification (EVs, battery storage, and new unforeseen use cases) will drive the need for expansion and upgrades, as well as new capabilities at the distribution level to support two-way flows. The capex required to re-haul an aging piece of embedded infrastructure is enormous, and presents attractive opportunities globally along the entire value chain.

In Q3, the sector led in fund performance, aided by a well-received acquisition announcement from Quanta Services (2.9% of fund net assets), a specialty infrastructure solutions provider for the utility sector. Quanta seeks to acquire Blattner (not held by the fund), a renewable power and storage engineering, procurement and construction (EPC) at accretive multiples pre-synergies. Following the transaction, Quanta will be the largest service provider from renewable energy generation to transmission and distribution, which we believe are the core areas that should benefit from the U.S. grid infrastructure upgrade occurring over the next decade.

Advanced Materials Mixed on Inflationary Environment

Advanced Materials includes the entire value chain around the electrification of mobility. The ongoing announcements by auto original equipment manufacturers (OEMs) on future rollouts of their EV product suite over the past years and most recently in rapid succession over the past months (Ford, BMW – neither held by the fund) requires a high level of metals and semiconductor use. Both of these have been impacted by the inflationary trends over the past year. We are selective on our investments in this sector, with a strong bent toward valuation, particularly taking advantage of short-term dislocations amidst an extremely strong demand backdrop.

The quarter reflected mixed performance, with outperformance from companies closer to the consumer offset by those bearing the crunch of higher raw material costs. EV manufacturers (BYD, 3.3% of fund net assets; Tesla, 3.1% of fund net assets) continue to gain share in their respective markets amidst a tight demand backdrop, while auto semi manufacturing leader Infineon (3.6% of fund net assets) continues to build its order book given the global shortage.

Agriculture Technology: Steady as She Goes

Results in the agriculture technology sector were mixed in the quarter. In general, companies that sit closer to the end consumer, such as Beyond Meat (0.8% of fund net assets) and Oatly (0.5% of fund net assets), lagged as margins tightened due to increased input cost inflation. On the other hand, commodity producers, such as renewable diesel producer Darling Ingredients (1.7% of fund net assets), contributed to performance given healthy renewable diesel prices.

In the near-term, those companies higher in the supply-chain – such as Darling Ingredients and agriculture equipment manufacturer Deere (2.5% of fund net assets) – should benefit from the continued inflationary environment, which has sent crop and crop chemical prices soaring.

Download Commentary PDF with Fund specific information and performance.

Originally published by VanEck on October 22, 2021.

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