As hydrogen equities rode the clean energy rally of 2020, ETFs have launched to offer exposure to a potentially significant part of the future energy mix, however, does the hydrogen economy narrative have enough steam to be more than just wishful thinking?
Having launched in February, Europe’s first targeted product, the L&G Hydrogen Economy UCITS ETF (HTWO), is front and centre in demonstrating some of the tailwinds and headwinds facing its underlying theme.
At inception, HTWO’s largest allocation was a 22% weighting in FuelCell Energy. Rising from roughly $3 to $28 in under three months, the stock is a prime example of analysts’ fears of hydrogen being the latest in a long line of ‘frothy’ themes.
Still above JP Morgan’s $10 target price, FuelCell shares have fallen 56% in the seven weeks to 29 March, down to little over $12. This kind of volatility is endemic across many energy transition thematics and underlines the adage that timing is crucial.
As Athanasios Psarofagis, ETF analyst at Bloomberg Intelligence, said: “If history is any guide to the growth in thematics, you need to be early and maybe just hang on for a few years – first-mover advantage is a real thing.”
Somewhat allaying current valuation and volatility concerns, new research by JP Morgan Cazenove concluded the hydrogen ‘revolution’ might be here to stay, and therefore the recent correction should not be seen as a curtain call for the theme.
Beyond a spell of hydrogen hype, JP Morgan said the new crop of hydrogen-related companies are being buoyed by political commitments by blocs such as the EU, and corporate emissions reduction activity driving hydrogen investment.
Zero-sum energy transition
A more long-term concern for hydrogen is what role it will play in the future energy mix, versus the at-present more well-known electric alternatives in transport and home heating among others.
According to JP Morgan, sectors such as refining, ammonia, steel, and heavy-duty vehicles are expected to lead the hydrogen transition. Areas where the technology is already being integrated – refining and ammonia – will likely move at the fastest pace and face the lowest costs, while EU steel producers have already set hard volumes targets for hydrogen-derived steel production by 2030.
On the other hand, JP Morgan said hydrogen currently lags in areas such as heating, cement production, and power generation. Furthermore, the company found hydrogen grid-scale energy storage remains more expensive than other storage options, and the costs of hydrogen fuel cells need to fall by around 45% to compete with internal combustion engines.
Overall, the firm remains positive about future cost reductions in ‘blue’ and ‘green’ hydrogen as well as in electrolyser manufacturing. Provided carbon capture policy remains supportive, the company added blue hydrogen will remain cost-competitive until 2030 but concluded investors need to be realistic about which sectors the energy can compete for demand.
Can ETFs ride the wave?
Should investors still choose to back hydrogen, the discussion about which instrument to use then becomes relevant.
According to Peter Sleep, senior portfolio analyst at 7IM, hydrogen ETFs face the same dilemma as other thematic categories: trying to balance over-concentration in a small number of pure plays, against increasing granularity by investing in companies where the ETF’s theme is not the core business.
Legal & General Investment Management’s (LGIM) HTWO aptly illustrates this trade-off. On the one hand, it invests in companies with only partial hydrogen exposure – like Toyota, Daimler, and Hyundai – and will therefore be affected by factors not related to the exposure it is trying to capture.
On the other hand, it launched with a 22% weighting in one stock and 28 holdings in total. This narrow focus means investors are exposed to significant single stock bets, Briegel Leitao, associate analyst, manager research, passive strategies, at Morningstar, noted.
While this trade-off is difficult to reconcile, Bloomberg’s Psarofagis said targeted thematics, such as hydrogen ETFs, offer a stronger basis for ‘dark green’ exposure than broad market strategies with exclusionary criteria.
Overconcentration in pure plays and over-diversification into non-hydrogen companies are risk factors but future development in hydrogen could see companies gain in number and scale which will increase the quality and size of ETF constituent lists.
For now, the choice to invest in hydrogen ETFs comes down to an individual’s judgment on the role of hydrogen in the future energy mix, and whether composition teething issues can be overlooked, to allow thematics to complement their core holdings.
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