Biden’s Infrastructure Plans to Favor Growth in Green Energy Companies
After the Biden administration passed a $1.9tn COVID relief package within its first weeks in office, policy experts already have their focus set on another $2tn infrastructure bill expected later this year and potentially an even larger amount over the next couple years of the Biden administration. A report by Goldman Sachs’ economists suggests that the U.S. may increase infrastructure spending by $2tn to as much as $4tn over the next ten years. Given that President Biden largely campaigned on increasing green energy and reaching net zero emissions by 2050, Morgan Stanley policy analysts expect the majority of the infrastructure bill to increase investments in renewable energy contracts such as wind turbines for on- and offshore wind parks, geothermal power plants and solar panels. On top of that, Biden’s economic plans also listed a target of up to ten million jobs in the green energy industry.
After the Georgia run-off election gave Democrats the upper-hand in the Senate and thereby secured them complete control of Congress, the Biden administration will be able to pass their spending bills as long as they can get moderate Democrats to support them as well. These big spending plans are, however, expected to at least partially be financed by an increased burden on the American taxpayer. One such measure was recently introduced in form of a wealth tax on America’s richest 0.25% of families by Senator Elizabeth Warren. Given the narrow one vote advantage Democrats hold in the Senate, we do not believe that such extreme tax bills will be passed as the progressive Democrats still need their moderate party-colleagues to support their tax plans. Yet, we do see it as an indicator in which direction the Democrats’ tax plans are headed. As a large part of the Democratic party still strongly disagrees with the tax cuts introduced by the Trump administration in late 2017 we believe that it is more likely that the green infrastructure bill will to some extent be financed by an increase in the corporate tax rate to about 26% potentially combined with an increase in tax rates for higher income earners.
One potential way to take advantage of the current situation is, in our view, to overweight green energy equipment manufacturers, specifically wind turbine suppliers, and to underweight U.S. corporations that are most likely to be negatively impacted by an increase in the corporate tax rate.
The Biden Administration Plans to Increase Investment in Green Energy…
We created a basket of 20 companies in the renewable energy sector with 14 companies more focused on wind energy production and 6 on solar energy which might benefit from the infrastructure plans. Our tilt toward wind energy and wind turbines results from market expectations being more favorable compared to solar energy in the U.S. and Europe. Annual installations of wind turbines are expected to peak by year-end 2023 but based on company inventory and order levels, and an increased tilt toward green energy in European politics as announced in the EU’s green new deal program we believe that annual installations will continue to increase until 2025 and beat current market expectations by 12.8%. In the U.S., the share of wind energy of total energy production has been steadily increasing since late 2013 by 9.1% per year. Specifically, new off-shore wind turbine installations are set to continue rising until 2026 at unprecedented levels. Given the Biden infrastructure bill and a steep expansion of off-shore wind energy facilities we expect the share of wind energy of total production to increase by 9.9% annually vs. 9.1% currently priced in.
We Expect Wind Turbine Installations to Beat Consensus by 12.8%
Figure 1: Installations of Wind Turbines
Renewable energy companies are generally expensive trading at higher multiples compared to their fossil energy peers. An initial screen of 100 renewable energy companies shows that they are trading 1.7 standard deviations above their historic forward P/E median multiple, which is expensive considering that a large portion of these companies showed a net loss on their 2020 income statement. Instead, our green energy basket consists of companies that have generated positive operating income over the past 5 years and are collectively trading at only 0.6 standard deviations above their historic median P/E multiple. For this basket featuring companies such as Siemens Gemesa, Abo Wind AG, Alumas Group PLC and First Solar Inc., we project a CAGR of 12% to 14% as demand for green energy in the U.S. and Europe will increase over the next several years.
Figure 2: Newly Built Off-Shore Wind Turbines to Peak in 2026
Figure 3: Wind Energy Production to Gain Market Share Quicker Than Expected
… And Pay For It With Corporate Taxes
Just as much as the tax-cut in late 2017 was a gift to investors, any potential hike in the corporate tax rate to finance stimulus or infrastructure bills will serve a blow to U.S. corporate earnings. The same way the S&P 500 experienced an 18% increase in EPS in the 6 months following the tax cut we believe that U.S. equities will revise EPS downward by 4% to 7% after the announcement of an increased corporate tax rate.
To capture the negative earnings effect of a tax hike we built a basket of equities that we believe will be most directly impacted based on certain company characteristics. First, small cap stocks will be most affected in the U.S. as those companies tend to operate mostly within national borders and lack access to the kind of sophisticated tax advice that large corporations such as Apple or Google enjoy which means that small cap stocks will feel the full impact of a potential tax increase. Small cap stocks are also those that benefitted the most from the tax cut in 2017/18 as their earnings increased by an unusually large 42%, much larger than the earnings increase for large cap stocks.
U.S. Small Are Most Sensitive to Changes in Tax Rates
Figure 4: U.S. Small Cap Earnings
Second, only companies with tax rates significantly below 26% as well as positive EBIT will be required to pay higher taxes on their pre-tax earnings and therefore lose market value. Third, we selected companies with below average debt ratios, and hence low interest payments, as interest is tax deductible and has the potential to mitigate an increased tax burden. Out of the resulting 169 U.S. securities we then selected the top 20% based on 12m forward P/E as those tend to be the most overvalued stocks and historically stand to lose the most when tax rates are increased. We see significant downside risk for this basket of stocks in a tax hike scenario, however, we also note that the Biden administration is likely to hold off on any tax increases as long as the COVID pandemic continues to bring hardship on small businesses across the country. Once the economic recovery is well underway and the pandemic has been brought under control we believe that a tax increase will become more likely which could potentially be toward the end of 2021 or in the first half of 2022.