By Tom Nelson - Head of Natural Resources
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The speed and scale of the energy transition demands comprehensive, far-reaching action.
It is now clear that historic approaches to the challenge, such as divestment and screening, are unlikely to be enough to counter the extent of systemic climate risk that exists within institutional portfolios.
The energy transition requires a new investment framework to support both thought and action. This framework encompasses both winners, the companies likely to benefit most from decarbonisation, and losers, those unable to adapt to a low-carbon world.
The foundation of the framework is based on three principles (or factors) and we encourage asset owners to consider all of them:
- Principle/Factor 1: The energy transition is as much a diversification of energy sources as it is a rise of renewables. As we explain in “Burning the Midnight Oil”, asset owners should not be surprised to see renewables surpass coal and gas, rather than replace them.
- Factor 2: This is not binary. From an investment perspective, not all renewables are necessarily “good” investments and not all companies currently relying on generating income from carbon are “bad”. There are good and bad investments on both sides – including forward thinking hydrocarbon companies and impractical or unworkable renewable solutions.
- Factor 3: To ensure sufficient positive exposure to the companies that will enable the energy transition, a dedicated investment is required. Investment in the energy transition must be positive and proactive to ensure sufficient protection from climate risk in asset owner portfolios. This ensures your approach considers the merits of divestment or an ESG screen or impact investments alongside limited allocations to renewable assets without consideration of their Scope 3 carbon footprints.
Applying this thinking, through the investment framework, should ensure that asset owners can blend cash-flow generation from mature energy companies, as they invest less for growth and reduce costs, and capture the growth potential from renewables, as they deploy new technologies to seek ‘giant’ status.
A new framework for a new world
The framework divides the investable universe into four quadrants, as follows.
Predicting which companies will be hurt most by climate risk requires an assessment of a considerable number of unknowns. A decisive move to tackle climate risk and support a successful transition is arguably more straightforward. We believe that asset owners should be considering an active investment in businesses set to benefit from the transition to a low-carbon economy.
These are the poster child assets of the energy transition – new or growing companies that will act as the engine of profound change in the way people work, travel and obtain and use their energy.
We call this the global environment universe as it actively reduces carbon emissions and includes companies that benefit from the structural growth areas of a de-carbonising economy.
The universe provides significant diversification from major equity indices, such as the MSCI All Country World Index or the FTSE 100, with which it has no or little overlap.
Figure 2: The global environmental universe compared to traditional approaches
One of the most important traits of the global environmental universe is its inclusion of Scope 3 carbon. Ae we set out in “Implications for Asset Owners” Scope 3 emissions come from the entire corporate value chain and, for example, comprise an estimated 90% of the carbon emissions attributable to the MSCI All Country World Index.
Quantifying these emissions requires the assembly and interrogation of specific data, which is why our research approach includes a partnership with the only public, fully transparent ranking of the world’s largest companies by their Scope 1, 2 and 3 carbon emissions.
Successful allocations to sustainable growth assets, based on comprehensive data and selected from the global environmental universe, should not only afford access to growth companies but also provide an effective hedge against a portfolio’s existing carbon risk. This can also enable an asset owner to create effective diversification opportunities away from traditional asset allocation.
These are companies either embracing the transition or aware of it and preparing to transition. Many of them are oil companies – facing questions about their future in a world where people want less of their end product, what their survival strategy might look like and how the investment community will treat a sector generating significant cash flows and dividends but responsible for large carbon emissions.
A typical global oil & gas company faces three strategic choices:
- Option 1: Business as usual, with little or no concession to the prevailing threats around the business model or changes in investor needs, perhaps a reduction in frontier exploration, high-cost oil development and a marginal pivot towards natural gas.
- Option 2: Run the business for cash and return it to shareholders. This liquidation strategy implies no growth capex, significant asset sales and a slow wind-down of all operating activities.
- Option 3: Develop expertise in renewable energy and evolve the business model into an energy transition company. This is likely to include an increased focus on natural gas, a significant reduction in oil-related capex, and a shift towards low-cost areas of development.
We expect most of the industry to follow option 3 – this is the Cash Returns quadrant of the framework. The best examples of this so far are the European integrated oils sector, such as Royal Dutch Shell, Total and BP.
All three companies have taken direct exposure to solar, wind, electric vehicle charging, battery technology and biofuels, while tilting their oil & gas activities away from high-cost oil and towards global gas. They have also engaged with shareholders and pressure groups on the evolution of their business models.
Engagement is a strong feature of energy transition investment, irrespective of which portion of the framework an asset sits in.
Unlike the monolithic hydrocarbon companies that dominated the last century in energy and financial markets, the renewable energy companies of today are shareholder-friendly, consumer-facing and open to direct and constructive engagement. In many cases they behave more like consumer companies.
They need to: competition is fierce, and the prize is enormous. We expect investors in Cash Returns companies to engage closely with all aspects of corporate performance, and that this will be of mutual benefit over the long-term.
For those oil & gas companies lacking the volition to evolve, typically by pursuing option 1 above, we expect the energy transition to be increasingly Darwinian. Their future does not look bright.
For those pursuing option 2, there is a precedent for companies in mature, unloved industries that cut spending, focus on profitability and return cash to shareholders to deliver stock-market returns in direct contrast to prevailing market sentiment.
The tobacco sector generated returns well in excess of the general equity market from the late 1990s, despite the headwinds of regulation, changing purchasing patterns and divestment onwards. In fact, it was the best-performing equity sector of all over this period.
Will this happen to large oil companies? It is hard to make the case. The likelihood is that their attempts to wind down will be dictated by the speed of the energy transition which, as we have argued in previous chapters, could occur with greater rapidity than previous transitions between dominant energy sources.
It can be very clear to an asset owner when a company indulges in green washing – paying lip service to environmental concerns.
What can sometimes be less clear is the viability of unproven technology - from lower quality, over-valued companies in parts of the renewable energy sector where barriers to entry are lower and there is less technology differentiation.
Both should be considered Green Bubble assets.
For example, the precipitous decline in levelized cost of renewable energy technology, while a gift to asset owners, has meant some equipment companies have struggled to maintain margins. The number of MWs of solar installed in 2017 more than tripled versus 2011 but the total market size in dollars remained the same1.
The lithium-ion battery manufacturing industry shows similar characteristics. In both segments, a company needs structurally lower costs and superior technology in order to compete profitably over the long term, and perhaps the more attractive investments are those complementary products leveraged to the volume growth but not necessarily the price falls.
We have also laid out our thinking in “The Rise of Renewables” [insert link] on the false promise of carbon capture and negative emissions technologies – at least in the timescale required of the energy transition. Some companies are or will be affected by a drop off in demand for cobalt, reflecting the evolution of battery design and technology, as we have seen in “Electric Dreams: the path to an autonomous electric future”, These are also classic Green Bubble assets.
The top right hand quadrant of the framework, Sustainable Growth, is crucial.
Applying the framework correctly and obtaining the right level of access to the global environmental universe requires a dedicated solution to address winners and losers. We have already looked in previous sections how the transportation and renewable energy sectors are likely to fare.
Here, we apply the framework to the most carbon intensive sectors to provide insight on how these companies can be assessed as the world transitions.
Demand for copper persists
Copper appears to be a structural winner of the energy transition. Whatever the battery constituents for electric vehicles, the increase in wiring for an electric motor adds copper to the vehicle. This explains why the values of copper mines have remained high when up for sale over recent years.
But will demand growth for copper accelerate meaningfully? It is hard to make the case. Copper is a mature metal that has been used for thousands of years. Demand growth has averaged between 2.5-3% per annum since the 1950s despite various new sources of demand – from air-conditioning tubes to Chinese infrastructure build-out.
What happens is that, as new uses boost demand, prices rise and substitution and thrifting occur. Car radiators now use aluminium, plumbing tubes are made of plastics and EV car manufacturers are designing high voltage architecture to reduce copper use. Tesla is looking to reduce the copper wire harness both by cutting the length needed and replacing some with aluminium wiring. The Tesla 3 is reported to have 1500m of copper wiring compared to 3000m in the Tesla S.
For now, long-term copper demand looks healthy simply because it is used for so many things – especially as the world electrifies. However, it is more reasonable to expect demand growth to be maintained than to rapidly accelerate – not least because supply would struggle to keep up – placing copper in the Cash Returns portion of the investment framework.
Automation inside mines
We have seen the impact of EVs and automation on the transport industry. But what of its potential impact in the mining industry? Can it help Carbon Risk assets themselves transition into Cash Returns or even Sustainable Growth quadrants?
EVs and autonomous or remotely operated vehicles are increasingly being introduced in underground mines as they reduce the need to extract fuel fumes and can allow quicker access to orebodies after blasting.
These innovations can not only increase efficiency but also improve the carbon footprint of mines and even open up the possibility of accessing smaller or lower grade deposits. A mine of the future could see only autonomous or remotely operated EVs – with a narrow access shaft and tunnels, no ventilation and less waste to be mined.
The cost savings could be large enough to mean many resources could be converted to reserves at much lower prices, thereby increasing the supply of these materials at a reasonable cost. It would also clearly improve the health and safety performance of the mining industry and reduce the considerable human cost.
Engaging with miners
Companies that pay little or token attention to their impact on the environment are unlikely contribute to and benefit from the energy transition. They are far more likely to be left behind.
We know that Sustainable Growth and some Cash Returns companies are distinguished by their approach to engagement.
Companies in a high intensity sector such as mining face material issues such as emissions, labour management, waste management, biodiversity and land use. The mining sector overall does not rate well on environmental, social and governance metrics and the majority of stocks are in the bottom two segments of MSCI’s seven rating levels scale. On engagement alone, this places many stocks in the Carbon Risk portion of the framework.
This tells us things are far from perfect in the sector. We encourage asset owners and their asset managers to engage and challenge management teams to push, probe and complain about matters such as data and disclosure, standards, checks and audits, and remuneration.
Markets are quick to price in failure. Vale SA is a miner with a very poor record on environmental, social and governance issues. In late January 2019 it suffered another dam failure that led to multiple deaths. The company saw $18 billion wiped off its market capitalisation in the first four days following the incident.
Without substantial change to operations and practices, Vale SA is a clear Carbon Risk asset. But engaging with companies in all four quadrants of the energy transition will remain fundamentally important throughout the energy transition.
Positive thinking, positive acting
The energy transition demands positive investment. The framework explains and facilitates that positivity.
While engagement, assessment of hydrocarbon assets and other components all play their part, none are as important as dedicated, concerted and separate investment in Sustainable Growth assets.
Applied correctly and holistically to a portfolio, the framework can help an asset owner to reduce under-exposure to the enablers and beneficiaries of decarbonisation and provide a hedge or insurance to offset the systemic exposure to carbon in current portfolios.
In this series, we have provided context and explanations of the energy transition, supported by data and examples to demonstrate the likely winners and losers, before presenting the framework for action. We will continue to provide more examples, case studies and data across assets, sectors and asset classes as the energy transition plays out – to support asset owners implement the framework.
We introduced this series by stating that the climate challenge is an existential threat.
It is one of the greatest tests ever faced by humanity. According to the Intergovernmental Panel on Climate Change (IPCC), the UN body for assessing the science related to climate change, humans have until just 2030 to meaningfully reduce carbon emissions and, more broadly, should target limiting temperature rises to 1.5ºC, rather than 2ºC.
We encourage readers not to lose sight of this. We can get there if we act quickly.