Why the green subsidy race is a “win-win” situation for climate investors

Europe and the US are vying for leadership in manufacturing clean energy technologies. We look at their competing plans and what it means for equity investors – by Isabella Hervey-Bathurst

 
Last year’s Inflation Reduction Act (IRA) is the most momentous piece of climate legislation in US history. It comprises $369 billion of funding for the energy transition, making the US the best place in the world for investments like building a renewable project or producing green hydrogen.

It also fired a starting gun for a new era of competition over clean technology. The IRA is not just about stimulating demand for green technologies like renewables and electric vehicles (EVs), but about encouraging companies to make those products in the US by offering generous subsidies.

Europe, long a global leader in climate policy, now risks seeing investment capital and talent flow towards the more attractive jurisdiction, potentially jeopardising its own energy transition plans. Last month Europe presented its answer to the IRA, with European Commission president Ursula von der Leyen saying that “Europe is determined to lead the clean tech revolution.” So what is Europe actually proposing?

What is changing in Europe?

It can be difficult to understand how the EU’s various announcements fit together, and what is actually new.

• The Green Deal (December 2019) brought in the 2050 net zero goal, a target to reduce emissions by 55% by 2030 (vs a 1990 baseline), plus a number of industry-specific initiatives and targets designed to pave the way to net zero.
• Next Generation EU (December 2020) was a direct response to the economic damage caused by Covid, and included the ‘Recovery and Resilience Fund’ which earmarked c.€250 billion for green investments.
• RePowerEU (March 2022) was a response to Russia’s invasion of Ukraine and the ensuing energy crisis, increasing the 2030 renewable deployment targets and launching a plan to eliminate dependence on Russian gas. It came with a headline funding number of €288 billion.

The new Green Deal Industrial Plan (GDIP) builds on the above and has four key pillars: regulation, finance, trade and skills. It’s an acknowledgement that Europe needs to use industrial policy to make sure the EU has the industrial capacity to make net zero happen.

It also aims to support key industries that may be at risk of flight to the US by allowing member states to match the financial aid offered elsewhere. It wants to scale back the role of China in the supply chain by reshoring clean tech materials processing to within the bloc, via a Critical Raw Materials Act.

Crucially, it recognises that progress has been too slow so far, and aims to address some of the causes, like onerous permitting processes for renewables, and skills shortages. It takes almost six years to complete a wind project in Germany; addressing hurdles such as these could be very powerful.

How does it stack up vs the US?

Funding: Given the somewhat overlapping nature of the European plans, available funding has been estimated to be anywhere between €400 billion and €750 billion. While the GDIP has been criticised for offering little ‘new’ funding, there is seemingly more money available for clean technologies in Europe than in the US under the IRA. However, as some of the credits available under the IRA are uncapped, some analysts have suggested the true subsidy figure could be closer to $800 billion over ten years, rather than the $369 billion headline.

Targets: Both the EU and the US have 2050 net zero targets. Europe’s 2030 renewable energy target is 70%, compared to c.37% today, whereas President Biden has announced an 80% 2030 renewable target, from c.20% today. Both targets imply a rapid pace of deployment. Both regions aim to produce 10 million tonnes of green hydrogen per year by 2030.

Clarity and ease of doing business: It is too soon to judge the power of the GDIP. That said, the IRA appears to be an easier framework for companies to operate under. The IRA offers tax credits with 10 years of visibility. We don’t have this degree of simplicity from the EU, where the funding mechanisms may vary from loans to grants to CFDs (contracts for difference). Furthermore, member states implementing their own state aid mechanisms may add to the complexity by fragmenting the regulatory backdrop.

A significant area (admittedly outside of the GDIP) where Europe clearly does have a more robust framework than the US is in carbon pricing. This has been very successful in recent years and has a clear roadmap ahead to cover more emitters, bringing a good degree of regulatory clarity. The US does not have a federal carbon market.

Why this matters to investors:

A win-win scenario: From an investment perspective, this is not about US companies vs European companies. Many of the key companies set to benefit from the IRA are global – indeed, often European – companies.

Consider the Danish wind turbine producer Vestas, for whom the US is already its largest market, or the large French electrical equipment company Schneider, which already makes almost a third of its revenue in North America. These are the same companies that will benefit from an acceleration of the energy transition in Europe. For them, the regulatory competition is a win-win.

An open question for nascent technologies: The situation is more fluid for nascent technologies where dominance is still up for grabs. Take green hydrogen, for example, which has been identified by all the major economic blocs as essential for achieving net zero goals. Today it is an almost negligible market, but the next 10 years will be critical for scaling the industry. As things stand, the level of subsidy on offer under the IRA for green hydrogen production is irresistible. Will Europe’s hydrogen CFD plan match the US in simplicity and generosity? And if it doesn’t, will the domestic European hydrogen companies who have been busy sinking capital into capacity in Europe get left behind their US counterparts?

The impact of supply chain fragmentation: Geopolitical concerns have been an important accelerant for the energy transition over the last 12 months (on both sides of the Atlantic), but is ‘reshoring’ a long term positive for the effort to tackle climate change?

Where technologies and supply chains are already well established, is it actually an efficient use of capital to recreate capacity in different regions? An ultimate consequence could be more volatile supply/demand relationships, and perhaps even higher cost technologies.

Investors will have to keep a close eye on regional dynamics.

The risk of subsidy reliance: On a related point, companies that build assets that are only competitive because of a government subsidy may become reliant on those subsidies. As investors, we want to find the companies with strong business models and durable competitive advantages, not just those that are benefitting from near term subsidies.

Some protection from Chinese competition? The elephant in the room is that China is already incredibly dominant in a number of key technologies and materials required for the energy transition. For example, more than 90% of solar panels are produced by Chinese companies in Asia, and around 60% of lithium is processed in China. Both the IRA and Europe’s new policies are aimed at reducing or, as von der Leyen put it, ‘de-risking’ China’s role in the clean technology supply chain. This could offer Western (or other non-Chinese) companies some respite from relentless Chinese competition.