Electric car manufacturers recently announced disappointing results. A few days later, the news reported that Automotive Cells Company (ACC) - a producer of battery packs for electric cars - had raised €4.4 billion to build three new plants. How can this be reconciled? And what does this development mean for the investment in Northvolt Ett that APG previously made for client ABP? A conversation with Sven Smit and Kjell Geilen, both working as investors at APG.
In his role as Senior Portfolio Manager Credits, Smit and another colleague are responsible for investments in European high yield bonds and leveraged loans. These are sub-investment grade rated loans, meaning they are “at the high end of the risk spectrum” of debt investments, as Smit describes it. Geilen, also Senior Portfolio Manager Credits, is an analyst for the automotive sector and in that role he is also closely involved in the investment in a loan to battery technology producer Northvolt Ett, which APG made on behalf of client ABP some three years ago.
What made the investment in Northvolt Ett attractive?
Smit: “Our pension fund clients have high ambitions in terms of responsible investment. They want their investments to contribute to energy transition, and the loan to Northvolt fits that ambition. We were given the opportunity to invest in a subordinated loan at the time, which helped build a factory for batteries for the EV market (market for electric cars, ed.). Electrification of the vehicle fleet contributes to the energy transition and the reduction of greenhouse gas emissions. In addition, this plant runs on power from renewable sources. In northern Sweden, where this plant is located, there is a surplus of renewable energy, from hydropower but also from wind. Moreover, much of the materials from the Northvolt battery packs can be recycled at an adjacent plant also owned by the company, and used to produce new batteries. And, of course, the expected return on this debt is attractive.”
Several auto manufacturers have announced that they are putting production and development of electric cars on the back burner and putting more of their energy into hybrids. What does that mean for the battery market?
Geilen: “Growth in the electric car market has slowed substantially. But European emission standards for cars are stringent now, and next year car emissions must be reduced even further. You’re not going to meet those standards with hybrids alone; more electric cars need to be sold for that. Moreover, the EU has decided to allow only electric cars on the market by 2035. There is a huge push from the EU to switch to battery or hydrogen cars, or at least technology that has zero emissions. Hydrogen is not yet a realistic alternative because sustainable production of hydrogen is simply still very expensive. Battery technology is currently more efficient. In the longer term, we therefore expect the sales market for batteries to pick up. Partly because batteries are becoming more efficient and cheaper, so more people will consider an electric car as a serious alternative. Currently, the battery still comprises 30-40 percent of the value of an electric car, making it still relatively expensive.”
And what does it mean for investing in Northvolt Ett in particular?
Smit: “It’s important to keep in mind that Northvolt Ett already has purchase contracts worth 55 billion Euros with companies such as BMW, Scania, Volvo Cars, and Volkswagen Group. This gives Northvolt Ett a high degree of certainty about a certain level of sales. That aspect has a positive impact on the risk profile of this investment. In addition, APG is pre-eminently a long-term investor. This loan has an original maturity of 10 years, which is long for many investors in subordinated document. There is a good match between the time Northvolt Ett needs to build this plant and the long-term perspective we have as a pension investor.”
What is the risk of a subordinated loan?
Smit: “In the event of bankruptcy, lenders of a subordinated loan are only repaid after other creditors have been paid. In the case of Northvolt Ett, there are also loans that would have 'priority' over our subordinated loan in such a case. For that higher risk, the subordinated loan also gets a higher coupon. The shareholders are again ‘subordinated’ to all creditors.”
Chinese producers dominate the world market of batteries for electric cars. Can Sweden’s Northvolt Ett compete with them, given the much lower labor costs in China?
Geilen: “The higher labor costs in Sweden are offset by the low energy costs due to that surplus of renewable energy. That really puts Northvolt Ett at the bottom in terms of costs, especially given the skyrocketing energy prices. If you add all that up, they at least have a huge cost advantage over other European players. China does indeed produce even cheaper. And car manufacturers usually produce local for local. So, for a European car manufacturer that wants Chinese batteries in its cars it is currently attractive to move all the production to China, and then bring the cars here. However, there will soon be much more focus on emissions from the entire supply chain, due to legislation and regulations. Currently, companies are only required to report on scope 1 and scope 2 emissions, but soon scope 3 will be added. That means you also have to report on your suppliers’ emissions, and for the majority of companies that’s where the lion’s share of the emissions is. This increasing focus on emissions from the entire supply chain works to Northvolt's advantage.”
Smit: “On top of that, since the start of 2023 on, the EU’s Carbon Border Adjustment Mechanism has been getting phased in, which requires a levy to be paid on carbon emitted during the production of carbon-intensive products entering the EU. That, too, contributes to a global level playing field for auto manufacturers, and given their low emissions, a player like Northvolt Ett will then be at an advantage.”
Can you talk a bit more about the risk profile of this investment? How do you determine that?
Smit: “In addition to the purchase contracts, what was important to us in this case was that the project is supported by several big, important shareholders, including Volkswagen. As a European car manufacturer, it is important to them to not be completely dependent on suppliers outside Europe for batteries, especially Chinese producers. To fund growth in Europe and the United States, Northvolt has already raised $13 billion in share equity. That does say something about the shareholders' commitment.”
Geilen: “The shareholders are important customers as well. It is in their own interest to get those batteries if they want to be able to build their electric cars and trucks.”