The $100 trillion opportunity for energy investors

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[00:00:07.930] - David Brett

Welcome to the Investor Download the podcast about the themes driving markets and the economy now and in the future. Welcome back. This is the second show in our two part series on the energy transition. If you missed part one last week, I urge you to go back and listen. It was all about chasing bubble, growth areas and risks. In this show we're going to look at the opportunities it presents and how investors might seize them. Your host again is Adam Fastrup, Head of Multi-Asset Americas, and he's again speaking with two big investors in energy, David Boyce, CEO of Schroder's Greencoat in North America and Fund Manager Mark Lacey. Later in the show Mark references the acronym ACWI. That stands for the All Country World Index. It's a stock index designed to provide a broad measure of global equity market performance. They'll get to the opportunities later in the show, but first up they'll discuss how reliant long term investments are on policy. You'll hear from Adam first. Enjoy.

[00:01:13.210] - Adam Farstrup

So I think this gives another sort of good pivot point for us to talk about, which is and David, you really started to touch on this, it's the role of policy in all of this and you touched on it tangentially through your point about costs coming down. But when we look at this you've had a tremendous amount of excitement in the market around government policy for the energy transition. So in the US. We've had the Inflation Reduction Act. In Europe we have the Repower EU plan and numerous other plans. Even in China we see numerous government policies to support the clean energy industry in China. So I have a two part question and we'll start with you Mark. From a global perspective is the energy transition thesis just dependent on this government policy and on environmental policy in particular or can the sector actually move ahead even without these government policy supports?

[00:02:17.000] - Mark Lacey

Yeah, it's a key question because I think investors can get too hung up on policy if they think it's a long term driver because you have to step back and look at what the Inflation Reduction Act is. It's not about saying, okay, we're going to just stimulate investment in renewables and we're going to give every company tax incentives. It's about onshoring of capability for the US. It's about onshoring those skills and seeing the investment base as a long term opportunity for growing those industries in the US. And it's a very well thought out policy because obviously it's a tax incentive. You have to be generating profit in the first place to actually benefit from effectively the net subsidy. However, at the same time you have to be aware there is obviously a potential risk if too much of it gets priced into equities. And what I mean by that, if there is for example, a Republican government coming into power and they're much more aggressive in terms of diluting the policy, again, you shouldn't invest on the basis of all of that policy is discounting in those equities. You have to basically price that in and factor those risks into decision and the weighting that you're willing to take in those individual equities and some of those equities, you may say zero going into that scenario.

[00:03:43.510] - Mark Lacey

But if you look globally, what we have is a global buy in into renewables. Whether it's Brazil getting to 28% of electricity and renewables by 2027. Whether it's India targeting 450 gigawatts of renewable power generation by 2030, which would almost use up the entire international offshore wind market if they were to achieve that, or whether you've got the EU recovery plan. It's all about basically accelerating the energy transition from a need from a climate perspective. And it's about not being left behind as well from an energy security perspective. The great thing about renewables, which is different to the oil and gas industry, is the oil and gas assets were always typically found in very suspect places, particularly for offshore oil. And you didn't actually own the asset. You became a net importer. Most countries can have access to wind or solar and they will own the assets themselves, so energy security doesn't become a problem ove time/

[00:04:42.180] - Adam Farstrup

And David, as you sort of think about this as an operator of long term assets, of long lived assets, how does it play a role into your decision making?

[00:04:53.350] - David Boyce

Well, I'm with Mark. I don't want to say sceptical, but you have to think about these subsidies and what role they're playing. The Inflation Reduction Act is an interesting one, and from my perspective, it's a little bit of a mixed bag. And I'll explain. I mean, for wind and solar, we had the same subsidies that kind of got extended under the Inflation Reduction Act. And there was a time in the United States when those subsidies were a difference maker, right? They drove down the effective price of power and that took a nascent industry and gave it some legs. My personal feeling on it for wind and solar is that a lot of wind and solar today and where the technology and the cost of power production is today from those resources probably would be in good shape without the federal subsidy. The tech has advanced, the costs have been driven down. What's really exciting to me is that without the subsidy, it can go head to head with fossil, right? That fundamental is there. Now, the IRA, it passed, it's certainly a policy direction the current administration wants to take the country. And for wind and solar, it's turbocharged those things.

[00:06:23.520] - David Boyce

But what's interesting are all of the other things that it touches the IRA and what's included in that legislation standalone storage, hydrogen manufacturing, things like that. Those are the next kind of basket of things that, quite frankly just need a bit of support to kind of get over the hump and get some projects built and get some technologies advanced and move it along. And I think that's really the value for the American people in the IRA. It's what it spurs on and what it helps that's coming along next. In the interim, quite frankly, it just drives down wind and solar power to very low levels. I mean that's just really economic power for your average ratepayer. That's the role it's playing right now, although you're giving it up as a taxpayer if you're a consumer of electricity, of course, which we all are, it's coming back around to your pocket.

[00:07:30.770] - Adam Farstrup

So I don't want to over egg the policy conversation, but I guess it does bring another question, which is sort of the flip side of it, which is do you ever worry that this web of complex incentives brings in sort of non economic players into the space where sort of the economic incentives as an investor become harder to tease out? I mean, both of you have said don't invest based on the policy. This is a long term game. But does it create other sources of risk that you do have to manage?

[00:08:05.470] - David Boyce

I mean, for the IRA, for example, Mark described it, they're tax incentives and the reality is most of the developers that develop wind, solar storage and other things simply don't have the tax liability in the current year. So how has that got solved in the past and how will it continue to get solved? You're going to do a lot of tax structuring and you're going to bring in parties, large financial players like a JP Morgan or Bank of America or Wells Fargo that essentially monetise those tax benefits for you. Now there's a finite universe of large financial institutions that understand the industry, understand tax investing, and also have predictably a tax liability for the next ten years against which to apply the credits, right? That's a very finite universe. It has been since we had renewables in the states. With the IRA there really is a danger when you start stacking up all of these subsidies and the need to monetize them in some way. There is a real danger that we just simply run out of this tax capacity, these tax investors. That's not fatal, I don't think, anywhere in the process, but that you're going to lose a bit of efficiency if you can't use those tax benefits on kind of a real time basis.

[00:09:39.810] - David Boyce

So I think that's the risk is the market big enough to consume all those tax benefits?

[00:09:46.590] - Mark Lacey

There is another disrupting group here as well, which is largely overlooked is that the conventional energy players Shell, BP, Exxon, Chevron, Conoco, they also benefit from the Inflation Reduction Act. It's the bit that's completely overlooked. I'm using those companies as examples, but all these companies are in hydrogen, they're all in carbon capture, they're all in biofuels. They're also predominantly the large cap integrated companies in Europe are in offshore wind, onshore wind, solar, they're even in lithium in the case of Galp. They will actually, they have the tax pools to actually claw some of those subsidies into their group and we're talking considerable amounts of money as well. So there are these potential disruptive companies out there, which is why we focus on the transitioning conventional companies just as much as we focus on the energy transition companies from an investment perspective.

[00:10:53.190] - Announcer

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[00:11:06.170] - Adam Farstrup

I wanted to turn a little bit back to the scale of the opportunity here and we touched on this a little bit at the beginning of the podcast, but can you give me a sense of the scale of investment needed in global energy infrastructure globally and in the US? And here, you know, I'm talking about just the basic needs. I mean, David, early on in the podcast you talked about retirement of existing plant and equipment and the needs to replace that. Then we have sort of increases in electricity demand coming from economic growth, from the electrification that we see happening all around us. So it would be great if both of you could sort of talk about the kinds of scale you see in this space.

[00:11:50.570] - Mark Lacey

If you take the conventional oil and gas market globally, which is pretty well established, everyone would agree you're just under $500 billion per annum of investment. It peaked at just under a trillion back in 2014 and we went to an oversupply situation, but it's now comfortably running at $500 billion per annum to basically service an oil market which is around 102 million barrels a day, and a global gas market which is almost comparable in size on an equivalent basis. At the moment, we are spending roughly in terms of clean energy generation, just clean energy generation, offshore wind, onshore wind and solar, around about $450 billion per annum. It needs to be just under a trillion dollars per annum in order to meet the 2050 net zero targets. It needs to be just under a trillion dollars per annum to get renewables from 20% of the overall energy mix to closer to 85%. And that doesn't even include the fact that obviously electricity as your final share in energy consumption is going to go from 20% to 45% as everyone drives more and more EVs. So when you include that what we need to spend on transmission and distribution markets, we're currently spending around about $350 billion per annum.

[00:13:19.020] - Mark Lacey

We need to be spending closer to $600 to $700 billion per annum. I've not included the capex numbers on batteries and storage or energy efficiency and clean mobility. When you add it all up, Adam, it's comfortably over $2 trillion per annum feeding into the energy transition market. That's outside of the traditional oil and gas market and that's a cumulative comfortably $100 trillion over the 2020 to 2050 period. Never has the energy market from a public perspective or a private perspective ever seen this much capital that's needed going into it in a 30 year period. So it's going to be transformational from an infrastructure perspective, but also from an investment perspective for investors. And that's a really important message for everyone listening to this podcast.

[00:14:11.030] - Adam Farstrup

Yeah, I mean, it's an absolutely staggering set of figures. And David, if you sort of bring that into sort of the operating space in the US.

[00:14:22.220] - David Boyce

I mean, you know, Mark is just spot on. I mean, the numbers are somewhat mind boggling in terms of how much capital needs to flow into the system to achieve the goals that we're thinking about, but just taking a step back and thinking about the US market alone and not thinking about any green initiatives or targets, right? I mean, just to give you a sense of what's happening in just I need to just provide power to maintain the status quo in the US. Our electricity needs, and this does not include EVs or massive transition from gas to electric heating, right, this is just normal run rate stuff. - we're growing at about 1% in terms of need to increase our electricity supply. So that's no catalyst, no green initiative, 1%. And to put that in perspective, and I just gave a talk in Boston, that's like replacing every power plant in the state of Massachusetts every year just to keep up with the growth in electricity demand. You layer on top of that old plant that's just retiring, right? No power plant lasts forever. So again, with no green initiative or coal is bad, let's retire that or anything. There's just old power plants that need to be retired.

[00:15:53.570] - David Boyce

That's about another 1%. So if you just think about that's just to maintain a status quo in the United States every year, I've got to rebuild every power plant in Massachusetts two times over. That's just massive. And then when you do add on goals where you're trying to around carbon, you add EVs you know, the numbers just start ballooning. And then mark is absolutely right it's not just the power assets alone, it's all the infrastructure to support it. And that goes for new power plants. Obviously that goes for EVs, you know there's a whole kind know, secondary infrastructure that needs to be put in and around all of these things to support them.

[00:16:44.310] - Announcer

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[00:16:54.390] - Adam Farstrup

That brings me really to the final question I wanted to ask both of you, which is, you have this massive scale of investment required, but I suspect that many of our listeners are sitting there thinking about their portfolios and saying, I think in broad asset class terms, right? How much equities do I have? Fixed income? Infrastructure investments? The question is, why can't they capture the energy transition opportunity in sort of that broader portfolio? Is it something that they benefit from a more specialist approach or can they just capture it through those broad asset classes?

[00:17:33.410] - Mark Lacey

I think a holistic approach to investing in the energy sector is going to be absolutely crucial over the next 30 years. As I say, that's not just pure play energy transition equities. You need basically the conventional players, the role of the conventional players incorporated into that at the moment, when you look at Energy Transition equities publicly listed, they're a tiny portion of the global market. You're talking less than 2% of the ACWI (MSCI All Country World Index). And there's no way that they're going to stay at that tiny percentage of the ACWI from a global mandate perspective on a go forward basis, just if you just take into consideration the investment levels that David and I have just mentioned, it's mathematically impossible. And the other area that I would convey as well is that you're going to still have that growth in energy transition equities, but the big companies like Shell and Exxon are still going to be here in 30 years, they're just going to be completely different companie . So energy plays a very important part in everyone's portfolios, but obviously there will be cycles they have to be subject to, which is why active management is essential.

[00:18:43.930] - David Boyce

I think active management is absolutely key. I also think subject matter expertise counts. So with opportunities this big, I suppose someone with no experience could probably get in the way of some of this investment just by engaging. But I think what investors are really looking for is I don't want to just have exposure, right? I want some intelligence behind that and I want to understand, in the case of what we do invest in hard physical assets, I want to understand why did we select those assets? I want to understand that my manager understands the risks around those assets and can manage those as they come about. I think anybody can kind of do what I do and it's kind of throwing a dart at a board and some assets will be great and some assets will be horrible, but I think investors should kind of demand more, right? They should demand the intelligence applied to all these opportunities, whether it's what I do or new technologies or anything in the energy transition, I think they should demand subject matter expertise and I think that they'll find that they'll get much better results.

[00:20:17.590] - David Brett

Well, that was the show. We very much hope you enjoyed it.

[00:20:20.480] - David Brett

If you want to find out more, please head to schroders.com/Insights. And we're endeavouring to record as many of these shows in the studio, on video. And if you want to watch them in their full, unabridged version, then go to Schroder's YouTube channel. If you want to get in touch with us, it's schroderspodcast@schroders.com. And remember, you can listen, subscribe and review the investor download wherever you get your podcasts. New shows drop every Thursday at 05:00 p.m. UK time. But above all, keep safe and go well. Cheers.

[00:20:53.890] - Speaker 7

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