How will the Ukraine crisis affect the energy transition?

We see three main financial market risks resulting from Russia’s illegal and shocking invasion of Ukraine. These will have important consequences for energy transition investors

The Russian invasion of Ukraine represents a devastating attack on Ukrainian and European democracy and our first thoughts are with the people of Ukraine, who are courageously fighting to defend their freedom and sovereignty.

As investors, we have to consider the implications of this crisis for our clients. We see three major risks affecting equity investments in the energy transition, as well as financial markets more broadly.

Risk 1: Inflation, especially prolonged higher prices for energy and raw materials

Inflation around the world was already at multi-decade highs before Russia invaded Ukraine. This was particularly the case for energy prices.

Given that Russia accounts for a significant part of the world’s oil (c.12%) and gas supplies (c.17%), the current situation creates clear risks around energy flows. This concern has caused oil, gas and power prices across Europe to continue their steep recent rise.

Russia is also a major supplier of platinum group metals (PGM) and agricultural commodities. It also has production capacity tied in to many industrial value chains. The inflationary impulse from the conflict – and associated ratcheting up of sanctions from the West – could be quite significant.

These further inflationary pressures and constraints in supply chains across Europe may continue to weigh on corporate earnings.

Risk 2: Economic outcomes of inflation

The second risk concerns the potential economic outcomes of inflation. These include tighter financial conditions, higher energy prices, and potential wage increases – and what they may mean for economic growth.

History has shown that energy shortages and conflicts resulting in higher energy prices can slow down economies significantly. The risk of such a slowdown was already there before the escalation in Ukraine, and it is certainly higher now.

Risk 3: Potential shift out of equities

The final risk is around a broader shift in investors’ attitude to risk and a resultant sell-off in the wider stock market.

This could result in equity outflows (after a period of enormously strong flows into equity funds around the world) and a return to bonds as investors look for perceived safe havens.

How will these risks affect energy transition equities?

We believe that all three of these risks could impact energy transition shares to some extent.

The sector has been more exposed than most to higher raw material prices and logistics bottlenecks. The current situation will not help these ease.

Valuations in the space have retraced from their 2021 highs. However, the equity risk premium (ERP) still remains lower than previous levels, creating a risk that valuations could fall further. (The ERP is the extra return, over the yield on government bonds, that equity investors expect to receive. The ERP shrinks when stock prices rise, because their future growth potential shrinks, and grows when stock prices fall).