Investment implication of U.S. transition policy

Assessing the impact

• We think the new Act will do little to lower current inflation but its nearly US$400 billion in tax incentives, rebates, grants and loans is likely to trigger greater investment in, and demand for, low-carbon energy infrastructure and technology. We see it cutting low-carbon technology costs, creating incentives for private investment and spurring domestic manufacturing.
• The Act’s investment and demand push could also help spur innovation in certain nascent transition technologies, like carbon capture, utilization and storage (CCUS), next-generation nuclear and clean hydrogen. We think this innovation spending could reduce the “green premium” in currently hard-to-abate sectors like heavy industry and transport.
• The policy shift will likely diversify the geographic footprint of low-carbon technology manufacturing, which is now dominated by China. We see it reducing U.S. reliance on China for minerals and metals needed for renewable energy.
• The legislation could influence other countries to adopt similar policies. Trading partners left disadvantaged may be spurred to compete to fund deployment and innovation of transition technologies.
• The larger incentives in the Act are prompting competition concerns in the European Union (EU). The European Commission has called for similar state subsidies and has just passed the world’s first carbon border tax to help protect domestic industry. We don’t see much impetus for similar policies in emerging markets (EMs) that lack the same capacity for public spending. Plus, it has typically been more difficult for EMs to attract private capital at scale.
• The Act risks some economic inefficiencies if the technologies and sectors at which the subsidies are directed do not ultimately prove to be the lowest cost. And we see potential barriers to implementation. The transition will likely drive sharp demand shifts in the economy, reinforcing supply constraints and bouts of higher inflation. The transition is one driver of the new regime of greater macro and market volatility. We believe this new regime means inflation will be more persistent longer term and supports our preference for inflation-linked bonds and infrastructure debt.
• The Act’s investment implications depend on the extent to which its effects are already in market prices. Our current assessment is that the broad sector and macro effects are not yet fully priced. We believe portfolios that include transition-linked investments are likely to add returns over time as an accelerating transition gets more fully priced. This means looking at sectors and companies that could benefit from coming investment. Yet it bears constant monitoring at a very granular level. If some assets seen benefitting become overpriced, we would tilt portfolios away from them, even as we see the transition accelerating.
• We believe investing in companies that are carbon-intensive today is not necessarily at odds with the transition. With global energy demand still increasing, we believe demand for traditional energy is likely to be sustained in the medium term in most transition paths, even as renewable energy supply is built out.

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Breakdown of public spending

The Inflation Reduction Act, signed into law in August 2022, earmarks nearly $400 billion of public spending in the form of tax incentives, rebates, grants and loans, according to the Congressional Budget Office (CBO) estimate. Yet given that more than half of the incentives are uncapped — meaning the credits are available to as many as wish to take advantage — some analyses suggest the true fiscal cost could be more than double that. Below we detail some of the specific measures in this and other recent legislation.

Clean electricity

Tax credits for electricity make up the largest component of the total public investment under the Inflation Reduction Act. See the chart below. That’s partly by extending and expanding clean electricity tax credits for the next 10 years, with extra credits for projects that meet labor and domestic production rules.

Low-carbon tech R&D

Across three recent pieces of legislation, over $100 billion of funding is directed to early-stage support for new low-carbon technology, including CCUS, nuclear fusion and hydrogen. See the pie chart below. Investments range from basic energy science, national lab infrastructure and critical materials research to demonstration and regional “hub” funding for scaling hydrogen and CCUS.

Significant public spending

Breakdown of public investment in this year’s major climate-related U.S. legislation, December 2022

Transportation

Investments and incentives are available for EVs, related infrastructure and workforce development – as is support for communities with heavy air pollution. The new Act includes $2 billion of grants to support domestic production of hybrid, plug-in EV and hydrogen fuel cell vehicles. Purchasers of an EV receive tax credit of up to $7,500 if the vehicle is new and up to $4,000 if it is used. The cap on the number of EVs per manufacturer eligible for tax credits has been removed. Tax credits also apply to sustainable aviation fuels and biodiesel.

Manufacturing

Tax credits are provided for solar panels, wind turbines, batteries, critical minerals processing and clean hydrogen. We see potential for the law to help scale CCUS as well as direct air capture through both demand-side (tax credits) and supply-side (R&D) incentives.

Buildings

Measures include rebates for high-efficiency electric appliances and whole-home energy retrofits, with incentives for heat pump water heaters, electric wiring upgrades and insulation. The residential energy efficiency tax credit is enhanced and extended for 10 years. There are also incentives for energy efficiency in commercial buildings and new homes.

Traditional energy and other

Some public land can be used for fossil fuel development. But penalties are now imposed for methane emissions above federal limits. Complementary legislation was discussed to help speed up the permitting process for energy infrastructure – but its passage now seems less certain. Some $27 billion is also set aside for a Greenhouse Gas Reduction Fund to help fund state and local green banks and source private investment. In agriculture, there’s funding for conservation and restoration programs.

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Cost reduction

As the Inflation Reduction Act was passed relatively quickly following its announcement, we have since seen more detailed analysis of its potential impact. Many analyses have come to the same conclusion: the law’s many fiscal incentives will result in substantial cost reductions across many types of low-carbon technologies over time, resulting in their greater deployment. The chart below compiles a number of direct cost reduction estimates. Taking the midpoint of these estimates, we could see costs falling by about 20% for EVs all the way up to 70% for clean hydrogen.

Cheaper tech

Inflation Reduction Act potential tech cost reduction, 2022

Implication for trade and geopolitics

The implications for trade and geopolitics are quickly being noted, too. The incentives linked to domestic requirements – to build up domestic sourcing and production of minerals and metals needed for renewable energy – were aimed squarely at China, a key supplier now. We have seen some criticism about the subsidies and incentives in the UK and Canada. But the competition tensions over the Act have been most notable in Europe given the region’s ongoing energy crisis. The Act’s incentives are so large that some European companies are starting to consider moving low-carbon technology manufacturing facilities to the U.S. from Europe. That has prompted the EU to consider a response, recently focused on providing similar state subsidies.

This has become a hot topic of diplomacy between the U.S. and EU, as seen with French President Emmanuel Macron directly challenging the U.S. at a summit last December. This flashpoint in the economic relationship and Europe’s response will be key to watch in coming months, in our view. The EU has also recently agreed a deal on another transition-related competitiveness policy – the carbon border adjustment mechanism, where the carbon content of imports will be taxed. This will bring climate policy directly into global trade rules for the first time.

Transition-related policy developments are quickly progressing around the world. Europe’s drive for greater energy security has also prompted it to double down on efforts to build low-carbon energy infrastructure. The clearest example of that is the European Commission’s RePowerEU Plan.

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More volatile and persistent inflation

We think the Inflation Reduction Act will have notable longer-term macro and investment implications. On the macro side, we think it supports our view that that we are now in a regime of more persistent and volatile inflation because it will drive shifts in demand and investment. We believe the tax credits and incentives will spur some forms of private investment.

If this happens quickly, it creates the potential for mismatches between demand patterns and the way the economy is set up to supply it – even if the shift to renewable energy could reduce the marginal cost of energy over time and boost the economy’s long-term productive potential. These mismatches of demand and supply risk more volatile overall inflation, in line with our arguments in A world shaped by supply from January 2022. One example: EV producers facing constraints on battery materials and components. The transition to a lower-carbon world is one trend, along with geopolitical fragmentation and aging workforces, that is likely to keep supply constrained longer term and keep inflation persistently higher.

Investment implications

When it comes to forming an investment view, we think it’s important to assess whether the Act’s implications for the macro outlook and for companies are reflected in market prices. Where they are not reflected, we see investment opportunities. Inflation-linked bonds are one example. Inflation-linked bonds don’t currently reflect the persistently higher inflation we see on both tactical and strategic horizons.

Infrastructure debt can also help portfolios amid higher inflation. We believe infrastructure can help diversify returns and provide stable long-term cashflows. Infrastructure earnings tend to be less tied to economic cycles than corporate assets. Contracts can span decades. And infrastructure assets can help hedge against inflation, with fixed costs and prices linked to inflation.

Overall, we think the effects of an accelerating transition are not fully priced now. That’s why we think assets that stand to benefit from transition opportunities are likely to add returns over time as the transition accelerates and becomes more fully priced. We find opportunities in the following areas:

• Where the Act provides investors with long-term certainty, such as the 10-year investment and production tax credits for wind and solar, and fixed incentives for solar polysilicon manufacturing.
• Where changes to existing rules will allow new investors to crowd in, more easily co-invest or transfer tax credits, including government entities, non-profits and foreign investors without a U.S. tax base
• In the manufacturers of consumer EV parts, charging networks and the decarbonization of buildings – depending on some of the constraints we’ve mentioned previously.

What is in the price bears constant monitoring. It is possible that assets set to benefit from the transition could become overvalued. We would then consider tilting portfolios away from them as we would any other asset whose expected returns we assess – even if we still see the potential for strong earnings growth in the long term.

Considering high-carbon exposures

How do we think about high-carbon exposures in the context of the transition? As an asset manager, BlackRock’s fiduciary role is about helping clients achieve the best risk-adjusted returns – and that means we treat the transition like we would any driver of investment risk and return.

Many companies that are carbon-intensive today are developing credible transition plans, reducing their exposure to the transition. With global energy demand still increasing and the west seeking to wean itself off Russian energy, we see continued strong earnings for traditional energy suppliers, even with rapid buildout of renewable energy alternatives. Yet oil and gas capex has dropped by nearly half since 2014. See the chart below. That low level of capex increases the prospect of mismatches between supply and demand. These mismatches could be a feature of the transition if high-carbon assets are reduced faster than low-carbon replacements are phased in. So a portfolio that excludes exposure to sectors like traditional energy is unlikely to be as resilient to the expected bumps in the road during the transition, in our view.

Oil and gas investment declining

Capex expenditure in oil and gas

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