Energy transition – from a public and private markets’ point of view

Adam Farstrup: The pandemic resulted in a range of profound shocks, one of which was to highlight the vulnerability of supply chains and energy supplies to external forces. Soon after, the conflict in Russia and Ukraine drove this point home. It has meant that for major economies around the world decarbonization has become a priority not only on environmental grounds, but on grounds of national security.

We see this imperative of decarbonization as one of the “3Ds” – demographics, decarbonization and deglobalization – which are driving seismic change through the global economy.

These forces are interlinked. With energy so crucial to growth and to the policy goals of decarbonization and deglobalization, I put four key questions to Mark Lacey, a London-based Schroders fund manager specializing in global energy transition; and David Boyce, CEO of Schroders Greencoat in North America, an investor specializing in renewables infrastructure.

Question 1: We’ve had an extraordinary period for energy investors. In 2019 to 2020 clean energy stocks surged, only to unwind in 2021 to 2022 while the traditional energy companies enjoyed a recovery. Has the race been run for clean energy?

Mark Lacey: “Euphoria” best describes the attitude towards energy transition equities on the public market during the 2020 period. We saw the sector essentially go from a massive discount relative to the broader market to a considerable premium. What we've seen since then is a consistent derating in that sector – something we would say is unbelievably healthy.

At exactly the same time as that derating, as you’ve pointed out, the conventional energy sector has rallied enormously. These trends have emerged as the market is becoming aware of a wider energy crisis.

The bigger picture of course is that when you look at the demands on the energy system over the next 10, 20 or 30 years, we're going to be short of energy unless we put a lot of investment in the ground.

Ultimately, the magnitude of investment in the energy transition sector is going to have to be almost as much as five times the historic run rate of fossil fuel capital expenditure. And the role of the conventional energy companies such as Exxon or Shell is that you'll see these companies adapt their business model to cater for huge growth in those new energy transition technologies.

We have had a mini bubble in energy transition equities. From this point the valuations look extremely attractive relative to the forward growth rates. And if you look at the energy complex as a whole, we've got a huge investment period ahead of us, starting from an unbelievably low valuation.

David Boyce: The macro trend is absolutely there. We are in a transition of how we think about power globally and specifically in the US. There is an increasing demand for electricity and there's old plant retiring. Long term is the way to think about it: it should not be seen as a tech blip that runs up superfast and then runs right back down. We are transitioning how we use energy in the world, and there's no one technology that's going to accomplish it at all.

Question 2: We see this sort of bubble mania in some of the renewable sectors that makes it feel like a technology race. Does that matter to you as a public markets investor, Mark?

Mark Lacey: We run a diversified and a wide universe approach to investing. There are times when hydrogen stock valuations, for example, have looked mad in terms of the multiples you'd pay for certain companies.

But given the retracement, and given many are that much closer to profitability, we can move the portfolio into this area.

We've had a tilt towards gas-weighted names for quite a long time, which has obviously paid dividends. The reason for that is we see gas as a very important transition fuel. As David rightly pointed out, this is not going to be switched off overnight: you're not going to see power generation in markets such as the US suddenly switch from gas to renewables at a stroke.

Question 3: On the point of technology, how do you deal with new developments that could emerge as significantly cheaper, such as nuclear fission or green hydrogen? How does that play out in the decisions you're making today?

David Boyce: Is there lurking out there some magic technology that is going to revolutionize the planet? Can it be deployed at global scale overnight? No. The reality is there will be more technologies coming out. Nuclear is a good one. There will be an evolution where new technologies sit side by side with existing technologies. We're going to be in that transition as we shift from one to another for a long time.

Mark Lacey: It's funny, isn't it, that everyone goes straight to nuclear as the potential disruptor. But when you look at the cost of energy, what we've seen is nothing but a shift up in nuclear costs over the last ten years. From our perspective, small module reactors could be an exciting technology. But as David said, that is not coming onto the market overnight. A best-case scenario might be for a small modular reactor to sit side by side with wind and solar. Wind and solar have both undergone huge technology change and development in terms of efficiency over the last ten years.

Question 4: What other risks do you see investors being exposed to in the energy transition?

David Boyce: One caution I would put out there is acceptance of technology. The example I use is smart grids. There are many innovations linked to smart grids, including information use and efficiencies. But while those things are wonderful and we have seen operating models, there's a resistance. You have a potentially conservative group of customers and a finite group of customers. Who is going to make the investment and transition their whole grid over when their number one job is reliability?

I think people somewhat forget that making things that work is not enough: they've actually got to work in the real world. You need that acceptance factor.

Mark Lacey: When you mention risks, where do I start? Take the energy transition sector: we have so many developers coming through our door with projects under way. But then you discover they can't access the grid. Grid connection is going to be a big problem globally. There are already queues to connect projects, and one of the quickest ways to destroy the net present value of any project is to delay it by one or two years.

Another risk as we go through the energy transition space is rising mineral intensity, initially in lithium, for example, and later in other metals such as copper. This, too, could cause delays in projects, leading to pricing and profitability erosion. These are two obvious areas that we can highlight as risks, and they both demonstrate why you need active management in this space.

I don't think the last three years are an anomaly. We are going to see these mini cycles continue through the decades ahead, as energy transition technologies and investment rates roll out and accelerate.