This year has seen alternative energy assets go up like a rocket and down like a stick.

Following strong inflows and price increases last year, alternative energy ETFs have seen significant price falls over the course of this one. While the S&P 500 is up about 18% year to date, Lipper’s Equity Theme, Alternative Energy, is down about 3%, and the world’s largest alternative energy ETF has fallen more than 30%.

Sector assets snowballed from the second quarter of last year as alternative energy ETFs rallied hard following the first quarter’s pandemic meltdown. More than £13bn has gone into Alternative Energy ETFs over 12 months to end July. And, despite the correction assets are still growing, with the classification being the third most popular European ETF classification for Q1 2021 (table 1).

Table 1: Global Alternative Energy ETF flows over 12 Months (GBP bn)

Source: Refinitiv Lipper, 25 August 2021

What Went Wrong?

There are two aspects to this unwelcome volatility—as I explain with lots of unnecessary handwaving here.

First, there’s the macro aspect. On the face of it, President Biden’s advocacy of a Green New Deal, the EU’s similar Green Deal, not to mention the urgency added by the recent IPCC report, are all massively positive for the sector. Or so you’d think. But all that green infrastructure spending is potentially inflationary, which puts pressure on rates. The threat of rising interest rates increases the cost of capital, to which many of the small- and mid-cap firms that make up this sector are very sensitive. Renewable energy projects have a high up-front investment that pays off over the long term. Higher interest rates decrease future cash flows, so renewables stocks are sensitive to the threat of higher rates.

Another factor this year was the return to favor of “dirty” stocks. The prospect of a broad post-COVID recovery pushed oil and gas prices higher than before the pandemic, attracting investor attention at the expense of renewables.

And, not least, investors got spooked by high valuations and cut their exposure. Like I said: up like a rocket, down like a stick.

Pump Up the Volume

That’s not all there is to this, though: the way in which alternative investment collectives have been constructed have amplified the gradients on this rollercoaster year-long ride. Take the world’s largest alternative ETF as an example: over the 12 months to end July, the iShares Global Clean Energy ETF (ICLN) and iShares Global Clean Energy UCITS ETF USD (Dist) attracted £6.39bn—the bulk of this before January. The underlying index was originally composed of 30 stocks, increased in April to more than 80. Many of these companies are small- and mid-caps, a factor which motivated the decision on index expansion.

This will no doubt smooth out the volatility, but will also lead to reduced exposure to the alternative energy sector. Given the amount of money chasing assets in a still nascent sector, it’s hard to see how this isn’t an inevitable trade off, at least for now.

Alternative energy’s ascent and descent over the past year have been led by solar and wind stocks. There are good reasons to back this area of the market. They are relatively mature, proven technologies when compared to other sustainable areas. It’s one reason why institutional investors pick this—the perceived lower risk when compared to other, less developed, sustainable technologies.

However, solar and wind are not the only approach to alternative energy ETFs. Battery ETFs performed more strongly, though still lag the S&P 500 year to date. For example, WisdomTree Battery Solutions and L&G Battery Value Chain are up about 14%.

Battery technology is a vital piece of the sustainability ecosystem. What happens when the wind doesn’t blow and the sun doesn’t shine? You need batteries to store the energy from when it does. Battery technology is progressing, but it’s not there yet, which is why this is such an important investment area.

Battery ETFs are not necessarily a less-diversified play on alternative energy, as the portfolios are made up of a broad range of companies with battery exposure, from global car manufacturers through Japanese electronics companies to Chinese chemical manufacturers. These funds are a paradoxical combination of a more specific renewable focus, through a basket of companies that tend to have a more diluted exposure to alternative energy than intuitively “broader” funds.

Should We Worry?

As reported in the Financial Times, the MSCI noted that ownership of renewable energy stocks is almost as crowded a trade as technology stocks were at the height of the 1999 dotcom boom. There is a limited supply of assets of significant scale, and a lot of money flooding into a small portfolio/narrow index means funds must buy significant stakes in many of their holdings.

There are, however, limits to the comparison. In the late 1990s, many dotcoms burned through cash as analysts tried to figure out what they did, failed, but got on the bus anyway. We know what alternative energy companies are for, and why their success is so important.

Solar, wind, biomass, battery, etc—these are not fin de siecle dotcom companies, although there are similarities in the way investors have flocked to alternative energy companies. Some, no doubt, will have business models that are not sustainable. But there’s a difference—addressing climate change is a material and pressing issue. This isn’t too big to fail—it’s too important to fail. Though (important proviso) this is true of the sector, not of its individual companies. Some of these will certainly go to the wall, and one trigger could be rate increases, fears over which made investors so skittish at the start of the year.

Reasons to be Cheerful…

… parts one, two, three … and more. From a top-down basis:

• The US has rejoined the Paris Agreement and the Biden administration has committed to a Green New Deal.
• Other governments are increasingly regulating in favor of sustainable energy, while also investing more in renewable infrastructure.
• Institutional investor demand for sustainable assets—increasingly backstopped by regulatory requirements—is long-term support for alternative energy.
• Onshore wind and solar power generation is becoming cheaper than fossil fuels, even without subsidies.
• The potential market is vast.

Another caveat to end on, however: it’s certainly possible for a recognized need for something to go hand-in-hand with the failure of the market to fulfill that need. The 1873 crisis—one of the nineteenth century’s largest—was triggered by a chain of US railroad bankruptcies. Yet the railroads were the arteries of late nineteenth-century America (and eventually got built, crisis or not).

Alternative energy is far from risk-free, especially when it comes to the vulnerabilities of individual companies, not least because valuations remain elevated. And individual companies are, one way or another, what are receiving investment. But neither is it, as I’ve argued before, just a bubble.