By Nick Hedley
The Inflation Reduction Act, which rose from the ashes in recent weeks, will accelerate the transition to a more sustainable economy – and institutional investors should position themselves accordingly, allocators, researchers and scientists say.
The bill includes $369 billion in spending on climate and clean energy programs, alongside measures to reduce healthcare costs for consumers and boost corporate income tax collections. After being unexpectedly revived, it advanced through the Senate and the House before being signed into law by President Joe Biden.
While it is a watered-down version of the package initially proposed by Democrats, and includes compromises allowing new gas pipelines and other fossil fuel infrastructure, climatologist Michael E. Mann says it is “the most aggressive climate investment ever taken by Congress – this is a big deal.”
Estimates by research firm Rhodium Group show that the legislation will cut U.S. greenhouse gas emissions by around 40% by 2030, compared to 2005 levels. That compares to a 24% to 35% reduction under current policy.
Clean energy will rise from 40% of the electricity mix in 2021 to a 60-81% share in 2030, while industrial emissions will “turn the corner” thanks partly to carbon capture incentives, Rhodium Group says. And tax incentives will see electric vehicles accounting for 19-57% of all vehicle sales by the end of the decade.
“It’s a critical step forward in tackling the climate crisis, but not yet quite enough – we need at least a 50% reduction by 2030 to be on a path to avoiding dangerous 3°F planetary warming,” Mann, director of the Earth System Science Center at Pennsylvania State University, tells Markets Group.
Risks and Opportunities
First, the act raises the risk that coal, oil and gas companies will have to write down the value of their assets, and that some of their projects will become completely “stranded” as demand declines, says Vivian Claire Liew, an adviser to sovereign wealth funds and the founding CEO of PhilanthropyWorks.
“The U.S.’s grit in strategizing and realizing this Hail Mary act confirms the global commitment to decarbonization, and also encourages or pressures other countries to substantiate and elevate their climate commitments,” Liew tells Markets Group.
In addition to dimming the outlook for fossil fuel investments, some groups have warned that the legislation could weigh on shareholder returns more broadly.
In a letter to members of the Senate, a coalition of 253 state and local chambers of commerce and trade associations argued that the act would do little to fight inflation, but would discourage investment, undermine economic growth and harm investors.
In particular, the coalition believes the plan to enforce a 1% excise tax on stock buybacks “would only distort the efficient movement of capital to where it can be put to best use and diminish the value of Americans’ retirement savings.”
Others, however, are bullish, arguing that the legislation will provide new opportunities to invest in clean energy, electric vehicles, commodities, and mitigation technologies – without closing favorable tax dispensations for private equity firms.
If the bill is passed into law, it will significantly enhance policy certainty, partly by extending the tax incentives for green energy projects by at least a decade. This will encourage institutional investors to invest further into the clean energy transition, says Ben Squires, chief investment officer at Australian fund NGS Super, which has about A$13 billion (US$9.2 billion) under management.
“Taking a leap of faith is not something that institutional investors like to do, so having a clear policy direction will certainly help,” Squires tells Markets Group.
NGS Super recently sold its holdings of oil and gas companies as part of its plans to reduce investment risk and achieve a carbon-neutral portfolio by 2030.
The Inflation Reduction Act, as well as firmer decarbonization commitments by the European Union, China and Australia’s new government, will “increase the momentum” of the clean energy transition, bringing risks and opportunities for investors, Squires says.
Jon Winkelried, CEO of private equity firm TPG Capital, says the bill will likely spark “substantial investment in climate-related technologies and solutions,” thereby creating attractive opportunities.
TPG’s investments in the climate space include Summit Carbon Solutions, which is developing one of North America’s largest carbon capture and storage systems. Under the new legislation, tax credits for these types of projects will be increased from $50 a ton to $85 a ton of CO2 captured and stored.
TPG co-founder Jim Coulter says the act is unlike previous attempts at climate mitigation, which focused on adding taxes to greenhouse gas emitters. “This bill is almost 100% incentives… And obviously, that serves us well.”
An analysis by Princeton University’s Jesse Jenkins and other researchers shows the legislation will drive nearly $3.5 trillion in cumulative capital investment in new energy supply infrastructure in the U.S. over the next decade.
“If that investment is going to happen, you probably have to at least double your money,” Coulter says. “That's a very substantial potential profit pool for investments, and that should open the aperture of deals that will make sense for us given our high hurdle.”
The legislation will also drive technological advancements that will be exported elsewhere, creating new investment opportunities outside of the U.S., Coulter adds.
Like other private equity firms, TPG and many of its portfolio companies will be partly shielded by the tax hikes put forward in the legislation.
To cover the costs of the clean energy program while also reducing the budget deficit, the act requires a minimum corporate tax rate of 15% for companies that generate more than $1 billion in annual profits.
However, a clause that would have closed the “carried interest loophole” was ultimately removed from the bill before it advanced through the Senate and House. In effect, this means that the minimum corporate tax rate will not be applicable to businesses owned by private equity firms.
Meanwhile, Maria Vassalou, co-CIO for multi-asset solutions at Goldman Sachs Asset Management, says clean energy investments will likely boost future economic growth “and may present attractive investment opportunities.”
However, the transition will significantly alter the commodity landscape and increase the importance of a handful of countries rich in copper, nickel and lithium, she says.
While this reliance on “green” metal producers – mainly in emerging markets – will bring risks, BlackRock thinks it provides opportunities for investors in commodities.
“Going green and electrifying the power base will be incredibly metals intensive,” says Olivia Markham, natural resources portfolio manager at BlackRock Fundamental Equity.
Thanks to improved capital discipline in the sector, commodities companies could continue to outperform on a relative basis, she says.
Alongside providers of the required commodities, BlackRock says “already green” companies and carbon-intensive firms with credible decarbonization plans are set to drive portfolio returns going forward.
A New Energy Landscape Looms
One of the emerging technologies that is expected to gain further momentum thanks to the act is green hydrogen, which is touted as a clean replacement for gas in heavy industrial processes, heating and transport.
The analysis by Princeton’s Jenkins, as part of the Repeat Project, says investments in hydrogen production will likely increase to $3 billion annually by 2030 – triple the levels under current policy – and to more than $50 billion by 2035.
According to Bloomberg New Energy Finance, the production tax credits will immediately make green hydrogen cost competitive versus traditional hydrogen-manufacturing technologies, which rely on fossil fuels.
However, the biggest investment boom, according to Repeat Project’s analysis, will be in domestic solar PV and wind. These technologies are set to attract some $321 billion in funding in 2030, versus $177 billion under current policy.
Traditional fossil energy companies will benefit as well, albeit not nearly as much.
The legislation sets aside 2 million acres of federal land and 60 million acres of offshore blocks each year for oil and gas development – a clause that has been met with much criticism from climate activists and scientists.
Many others, however, say it is a worthwhile compromise.
An analysis by Energy Innovation, a nonpartisan energy and climate policy research house, shows that for every ton of expected emissions from the bill’s fossil fuel provisions, 24 tons of emissions reductions will be delivered.
Samantha Gross, director of the Energy Security and Climate Initiative at Brookings Institution, notes that the bill fights demand for fossil fuels via its clean energy incentives for households, and this is the best way to lower emissions.
“The fossil fuel demand reductions that the bill would bring about vastly outweigh the provisions encouraging fossil fuel production, and the industry may never drill much of the land that might be leased,” Gross says.
Moreover, gas producers will need to take extra steps to prevent methane leaks, since the bill includes a provision to charge, for the first time, methane emissions from along the oil and gas industry’s value chain.
Repeat Project estimates that the act will lead to a 13% decline in the use of petroleum fuel and an 8% decline in gas use by 2030, compared to 2021 levels. This implies reduced valuations for booked oil and gas reserves, and incrementally reduces the incentive to invest in new production facilities, Jenkins says.
Mike Sommers, president and CEO of the American Petroleum Institute, says while the organization is encouraged that the act will likely open the door to more federal onshore and offshore lease sales, and will expand and extend tax credits for carbon capture, “we remain opposed to policies that raise taxes and discourage investment in U.S. oil and natural gas.”
Given the different interests at play, investors warn that the transition could bring volatility.
Sally Auld, CIO at Melbourne-based private wealth manager JBWere, recently told Markets Group that “there’s serious capital that wants to be put to work” in the shift to a more sustainable economy.
“But the transition won’t be smooth – we left it too late and we’re now suffering the consequences of a lack of investment. Volatility in energy prices of late is testament to this,” Auld says.
Will the Legislation Tame Inflation and Boost Growth?
According to a Penn Wharton Budget Model (PWBM) study, the act will very slightly increase inflation until 2024, and marginally decrease it thereafter.
The Congressional Budget Office described the legislation's estimated impact on inflation in 2022 and 2023 as “negligible,” and Wells Fargo says it largely agrees with this assessment, adding that it will not change its outlook for inflation or monetary policy over the next 18 months.
Lundy Wright, partner and portfolio manager at Weiss Multi-Strategy Advisers, says the act was misleadingly named, given that it will do little to tackle inflation, particularly in the near term.
“Still, since a longer-term clean energy plan has been glaringly lacking from recent policies, this element of the bill is a positive step, even if its immediate impact is very low,” Wright tells Markets Group.
It is also positive that Medicare will now be able to negotiate the prices of a handful of prescription drugs. “This low-hanging fruit has been lobbied against forever, so finally breaking through on this issue is a win for consumers,” he says, adding that it will not result in significant losses for pharmaceutical companies.
“For the time being, the takeaway from this bill is some small steps in the right direction of fairness, some momentum for the Democrats to have passed a spending bill, plenty of suspect political talking points, and a lot of long-term hopes,” Wright says.
However, the bipartisan Committee for a Responsible Federal Budget argues that the act will do more to tackle inflation than some believe. The deficit reductions will be steeper than PWBM and others expect, while measures to reduce healthcare, electricity and transport costs for households and businesses “will likely help combat persistent inflation.”
According to Repeat Project, the legislation will lower annual U.S. energy expenditure by at least 4% in 2030 – a saving of nearly $50 billion per year for households, businesses and industry. That excludes savings from lower oil and gas prices as demand for fossil fuels recedes.
Rhodium Group’s analysis suggests energy cost savings of $112 per household by 2030.
Moody’s Analytics, meanwhile, says the legislation “will nudge the economy and inflation in the right direction.”
The Inflation Reduction Act will provide financial help to millions of lower-income and elderly Americans with their health insurance premiums and prescription drug costs, the research firm says.
“It is also the first meaningful effort by the federal government to address climate change and its long-run corrosive economic effects. Moreover, all of this is more than paid for and will thus reduce the government’s future budget deficits, which seems sure to soon become a more pressing economic problem.
“While modest legislation, there is plenty to like in the Inflation Reduction Act,” Moody’s Analytics says.
Rhodium Group says while the legislation alone will not get the U.S. to its 2030 target of cutting emissions in half, it will lower the costs associated with additional action.
“All eyes will now be on the Environmental Protection Agency, the Department of Energy and other federal agencies as well as states to push the next wave of policies that build on the act and get U.S. emissions down to 50-52% below 2005 levels in 2030.”
Congress could also assist, particularly by promoting policies where there has been recent bipartisan agreement, including in electric power transmission, CO2 pipelines, and building energy efficiency, the group adds.