Outlook 2024 - Sustainable Future: Rising above 2023 challenges for a bright 2024

2023 unfolded as a year of recalibration, influenced by a complex interplay of global factors. From China's slower-than-anticipated post-COVID recovery to geopolitical tensions affecting trade, the year was marked by challenges that tested the resilience of the sector. High interest rates particularly impacted capital-intensive renewable projects, while technical hurdles, such as increased failure rates in wind turbines, added to the industry’s trials. Following a surge in 2020 and relatively muted performances in 2021 and 2022, 2023 emerged as the correction year. Heading into 2024, we expect several factors to catalyze the recovery of the clean technology sector.  

Shifts and shocks in China's market

Our strategy at the onset of 2023 included an increased exposure to the Chinese market, given its significant contribution to both the demand and supply of clean technologies. However, this strategic move encountered headwinds. The anticipated post-COVID recovery fell short of expectations, leading to a subdued market in the year's first half. International investors reduced their investments in China, influenced by fears of geopolitical tensions. Domestically, investors shifted their focus toward other burgeoning sectors, such as artificial intelligence, further impacting the cleantech sector’s performance.

In the latter part of the year, there was a noticeable resurgence of activity in several crucial industries, including in the sales of New Energy Vehicle (NEV) sector, encompassing fully electric and plug-in hybrid vehicles and in the bidding activity in the offshore wind sector. However, despite positive industrial developments, investor confidence in China remained tepid, and this improved market environment is not yet reflected in market prices.

Navigating global headwinds in Energy Storage

The energy storage sector remains a pivotal segment in our portfolio. Predominantly driven by the electric vehicle (EV) market, which accounts for 70% of lithium-ion battery demand versus 20% for stationary energy storage systems (ESS), and 10% for consumer electronics, this sector saw mixed trends in 2023.

In China, the world's largest EV market, there was a noticeable slowdown in early 2023 (after the phase-out of the national subsidy program), followed by a resurgence, particularly in plug-in hybrid vehicles. Despite the end of its 11-year subsidy scheme for EV purchases, some local governments continued to offer aid and tax rebates, contributing to a revival in demand. As a result, EV sales in China are projected to achieve a year-over-year growth of approximately 29%. 

Internationally, Chinese battery manufacturers have faced challenges due to protectionist measures implemented in the U.S. and Europe. In the U.S., the challenges were intensified by domestic manufacturing tax credits and the classifications of China as a "Foreign Entity of Concern." This scenario was exemplified by the difficulties in the Ford- CATL batteries factory project. Additionally, initially projected to be robust in 2023, U.S. demand ended up being lower than expected, prompting carmakers to reevaluate their expansion plans.

Despite a +47% YoY increase in demand for the first nine months, battery manufacturers exposed to European markets did not see a corresponding uplift in their stock prices. The European Commission has launched an official investigation into potential illegal subsidies benefiting Chinese electric vehicle imports, which could have a damaging impact on European producers. However, unlike in the United States, Europe allows Chinese battery manufacturers to set up factories, and several have already done so, indicating a fundamental difference in approach between the two regions.

In such a tumultuous year, the energy storage sector emerged as one of the primary negative contributors to the overall theme (contributing a negative 11% to the Sustainable Future product's performance at the end of November). At the start of the year, battery manufacturers were compelled to scale back production in response to a slowdown in demand. This decision had a cascading effect on the entire upstream supply chain. As demand began to revive, production gradually ramped up back to normal rates. Despite investor's woes, this year's expected global battery demand is still ~1,080 GWh, marking a significant 40% growth year-over-year.

For 2024, the global battery demand is projected to continue growing at approximately 40%. However, it is expected to decelerate to around 20% annually within three years, reflecting a normalization in electric vehicle (EV) adoption. Geographically, China is at the forefront of the EV market, with over 37% of new car sales being electric. This is followed by the EU-5 countries (France, Germany, Italy, Spain, and the U.K.), where electric vehicles account for 27% of new car sales, while the United States lags behind, with electric vehicles comprising only 9% of new vehicle sales.

The automotive sector is likely to continue as the predominant market for batteries. The ESS segment might experience faster growth, although it hinges on the resolution of current high inventory levels and lengthy interconnection processes.

In terms of battery technologies, nickel-based batteries (NMC/NCA) still command a majority market share of around 60% but are gradually ceding ground to nickel-free lithium iron phosphate (LFP) batteries. LFP, utilizing iron and phosphorus, is more cost-effective (10-30% cheaper per kWh) but offers lower energy density (30-40% less in kWh/kg) compared to NMC/NCA.

When it comes to new technologies, sodium-ion batteries are not as popular as they once were due to the drop in lithium carbonate prices. Although solid-state batteries are still being developed, it will be a few years before they can be mass-produced. At the moment, the industry is focused on reducing costs and improving supply chain efficiency.

In summary, we believe that the most strategic approach to engage in the battery sector involves diversified investments in leading battery manufacturers, both Chinese and Korean. These firms are better positioned to weather potential demand fluctuations. Additionally, we seek to maintain our exposure to critical battery component makers with a technological edge, such as those specializing in carbon nanotubes.

Solar industry: overcoming 2023's hurdles, heading towards 2024's improvements

The solar industry was another area of focus in 2023. In February, we strategically reduced our exposure to this sector (from 30% to 20%), particularly in residential solar. Despite this adjustment, we were still significantly impacted by the widespread market sell-off in solar stocks.

In the U.S., the implementation of Net Energy Metering (NEM) 3.0 in California significantly impacted the economics of solar-only installations, leading to a slowdown in residential demand. Europe had a period of high growth due to the Russia-Ukraine conflict and energy security concerns. As a result, channel distributors accumulated a significant amount of inventory. According to the latest data from EUDP Research, there are currently around 65GW of unsold solar panels in E.U. warehouses, which is more than the 60GW of new annual installations.

It is expected that due to the surplus, distributors will have to sell their products at lower prices to meet their financial obligations. This was evident from the results of SolarEdge and Enphase, which are major players in the market for residential inverters. Both companies experienced a decline in business in Europe and the U.S., which was attributed to high inventory levels in Europe and reduced consumer demand in the US, particularly in the southern and western states where retail power prices were lower.

In the utility-scale segment, the year's first half fared somewhat better than residential solar. However, rising interest rates began to affect new project financing, leading to a decline in investor sentiment. Despite these challenges, the solar sector continues to be integral to the energy transition, possessing a vast untapped market and low penetration rate, accounting for only 5.5% of the global power generation mix. Yet, 2023 witnessed a significant correction and compression of multiples across the industry (e.g., the forward price/earnings ratio of the MAC Solar index went down from 18.8x in December 2022 to 14.4x today).

The high inventory issue in Europe's solar panel and inverter markets is expected to be resolved in the first half of 2024, leading to increased demand for residential solar component manufacturers. The substantial reduction in solar module prices, which saw standard monocrystalline modules dropping to around $0.12/w (representing a 40% YTD decline), could further boost solar deployment. Despite the ongoing challenges, global solar deployment is projected to reach new heights, with 392GW expected in 2023 (56% YoY growth) and an even more ambitious target of 485GW for 2024. This growth is indicative of the sector's resilience and potential for expansion.

Facing unforeseen challenges in the Wind industry

The wind industry, which we initially expected to rebound in 2023, encountered unforeseen challenges. Despite the normalization of raw material prices and strong governmental support, the sector experienced setbacks, including prominent developers abandoning offshore projects (as illustrated by Orsted) due to unfavorable economics, primarily influenced by high interest rates. Additionally, there was an unexpected increase in wind turbine failures and project delays driven by political factors.

The Western wind industry's aggressive expansion and competitive bidding overlooked crucial economic and technical risks. In contrast, China's government-driven approach led to a resurgence in project biddings, particularly in offshore wind, later in the year.

Although there have been some obstacles, wind power technology remains a viable option from an economic, environmental, and technical standpoint. Moving forward, it is crucial for project developers to be more cautious and take into account all potential risks to ensure sustainability. It is vital to prioritize quality control and thorough testing before introducing new technology. In addition, improving permitting and grid interconnection policies is critical to streamline project implementation and enhance industry prospects.

Looking ahead to 2024, we anticipate continued challenges in the wind industry, including potential project cancellations and impairments, especially if high interest rates persist. Therefore, our strategy is to remain focused on Chinese companies heavily involved in the offshore wind market, poised to benefit from the industry's resurgence. This approach includes investments in wind turbine original equipment manufacturers (OEMs) and submarine cable producers, aiming to capitalize on the emerging opportunities in this segment.

Resilience in value-oriented sectors

Interestingly, sectors with a more infrastructure-oriented  profile, such as grid infrastructure, demonstrated notable resilience amidst market volatility. A recent analysis by the International Energy Agency (IEA) shows a backlog of approximately 3,000 GW in renewable power projects waiting to connect to the grid. This backlog is five times more than the new solar and wind capacity added in 2022. To meet climate objectives, annual grid investments must double to $600bn by 2030, up from the current stagnant $300bn, as power grids are becoming a critical impediment to decarbonizing power. Within the smart grid sector, our approach is to focus on pure players that enable the digitalization and modernization of power grids through both hardware and software solutions. 

Lastly, the water, waste, building and industry sectors maintained a steadier course, benefiting from their inherently less consumer-dependent profiles and more stable market conditions. These industries, often characterized by steadier, less dynamic growth, managed to navigate the year's economic challenges more effectively than their high-growth counterparts  

Policy and geopolitical moves

Further impetus for growth may come from the anticipated detailed guidance from the U.S. Treasury on the Inflation Reduction Act (IRA) implementation. Some might believe that the IRA is something of the past, but actual spending has not even started, and its full impact won't be felt before many quarters, thus offering unexpected upside potential to some companies now trading at depressed valuations.

This guidance is particularly anticipated for the Advanced Manufacturing Production Tax Credits (Section 45X) and Advanced Energy Project Credit (Section 48C). These incentives are designed to bolster domestic production of clean technology and energy-efficient manufacturing.

The 45X credit, for instance, is set to offer a new production tax credit for manufacturing or assembling key clean technology components such as solar panels, wind turbines, inverters, battery components, and critical minerals. Currently, the credit is proposed to be 7 cents per watt for solar modules (noting that the average cost of a solar module in the U.S. is around $1 to $1.5 per watt), 11 cents per watt for solar microinverters (with microinverters priced around $1 to $1.5 per watt), and $35 per kilowatt-hour for battery cells (current NMC battery cells cost about $130/kWh).

Conversely, the 48C credit proposes a tax credit ranging from 6% to 30% for re-equipping, expanding, or establishing industrial or manufacturing facilities for clean technology components. Final guidance and specifics on these tax credits are expected to be released in early 2024.

The clarification of all remaining ambiguities in the IRA could impact investment decisions, production planning, purchasing choices and ultimately boost U.S.' investment in renewable energy and electric vehicles in 2024.

In Europe, two significant policy initiatives have been introduced this year: the Net Zero Industry Act (NZIA) and the Critical Raw Material Act (CRMA). These initiatives are crucial developments aimed at enhancing the production of clean technologies, ensuring secure, sustainable, and competitive supply chains, and supporting the green and digital transitions. 

The NZIA seeks to achieve ambitious targets, including localizing 90% of battery manufacturing capacity in Europe by 2030, which is equivalent to approximately 550 GWh. It also aims to simplify administrative procedures and permitting requirements. Meanwhile, the CRMA focuses on extracting at least 10% of strategic raw materials within Europe and processing 40% of them by 2030. 

These acts form a key part of Europe's comprehensive strategy to strengthen its industrial foundation, ensure enduring competitiveness, and attain climate neutrality goals.

As a result of these policy initiatives, several international companies have already begun constructing factories in Europe. Notably, CATL and Yunnan Energy have already established battery and battery separator manufacturing facilities in Hungary. BYD is also considering opening its first car factory in Hungary to cater to its expanding client base in Europe, demonstrating the region's growing appeal as a manufacturing hub for clean technologies.

The geopolitical landscape, especially between the U.S. and China, will be a key factor to keep an eye on in 2024. Recent diplomatic initiatives, such as a joint statement on energy and climate, indicate improving relations. According to the latest guidance from the U.S. Treasury, it seems that designating Chinese companies as Foreign Entities of Concern does not prohibit U.S. companies from engaging with their Chinese counterparts. Although EV models will not qualify for the $7,500 tax credit if they use battery components (from 2024) or critical minerals (from 2025) sourced from China, it appears U.S. companies are still permitted to license technology from China (such as the Ford-CATL deal). This recent update opens the possibility for collaborative solutions that could have a positive impact on China's stock market, restoring investor confidence that was shaken by post-COVID economic recovery uncertainties and previous U.S.-China tensions.

Navigating interest rates and energy dynamics

In 2023, high interest rates caused a significant drop in renewable energy stock prices. Higher rates made borrowing more expensive, which made it harder for companies to finance their growth. This was especially noticeable in large-scale projects, where developers usually secure long-term contracts for electricity sales before building. Even the residential sector was affected, with customers preferring third-party ownership over loan financing because of the higher interest rates. A decrease in interest rates could lead to a significant recovery in the renewable energy sector, making projects more economically viable and encouraging investment and expansion.

Lastly, energy security should not be overlooked. Thanks to a mild winter, efficient gas storage management, diversified energy sources, and decreased industrial consumption, Europe's success in mitigating energy risks in 2023 shouldn't mask the underlying fragility. The tightness in the global gas market is a concern. Any unexpected event, such as extreme weather conditions or additional disruptions in energy supply, has the potential to increase electricity prices sharply. This could rapidly elevate energy security back to the forefront of priorities.

Renewable energy, being the most direct and efficient method to reduce energy dependency and enhance security, remains crucial in this scenario, especially in maintaining the stability of Europe's energy landscape.

Positioning for  the rebound

Our Sustainable Future strategy is built on strong industry fundamentals and remains resilient. The demand for batteries, a key component of our strategy, is expected to reach 1,500 GWh in 2024 - a 39% increase from last year. This growth is driven by both electric vehicles and stationary storage. Despite the negative sentiment, sales of EVs are increasing, with projections showing an expected 29% YoY growth from 13.6 million units this year to 17.5 million units next year.

Notwithstanding macroeconomic and geopolitical challenges, the solar industry is expected to experience significant growth in the coming years. New solar installations are forecasted to reach 458GW in 2024, marking a resilient 24% YoY increase.

The industry fundamentals of the theme remain solid with strong growth prospects. We believe that the current period presents a strategic opportunity for investors committed to the long-term decarbonization trend, given the temporary setbacks experienced this year.

Catalysts

• More Guidance on the IRA. More guidance is expected on several aspects of the U.S.' IRA, notably about domestically sourced content for utility scale projects which would allow some solar projects that were on the sidelines to move forward and capture an additional 10% tax credit. 

• New Rooftop Mandates. European countries could start implementing rooftop mandates under the REPowerEU plan, for new constructions and home renovations. This would accelerate residential solar demand as well as inventory destocking (of solar components) at a faster pace than anticipated.

• Energy Security Concerns. Escalating energy security issues could significantly boost demand for solar technologies and home energy storage systems in both Europe and the U.S., thereby fostering growth in the renewable energy sector.

Risks

• Declining Retail Electricity Prices. Electricity prices may decrease and remain low (especially in the U.S. and Europe), potentially extending the payback periods for residential solar installations and thereby affecting demand.

• Escalating trade tensions with China. Potential new U.S. tariffs or bans on imports of Chinese goods(e.g., solar modules, batteries, etc.), or new bans/controls from China's export (e.g., China's recent plan to control its graphite exports) may lead to increased tensions and disrupt global supply chains.

• Slowdown in EV Adoption. A lag in the expected adoption of electric vehicles, possibly due to insufficient infrastructure or economic challenges, could dampen the demand for batteries and associated technologies and widen the supply/demand gap.