How Schroders leads in decarbonizing portfolios through investment in the energy transition and active ownership

A new regime in financial policy and market behavior is unfolding and the patterns of the past decade are facing a period of adjustment. At Schroders, we call this The 3D Reset; a new regime shift that will be driven by three key factors: deglobalization, decarbonization and demographic change. In a podcast with The Sustainable Finance, Mark Lacey, Head of Global Resource Equities and Carol Storey, Active Ownership Manager, discussed the global energy transition and how active ownership can help companies on their decarbonization journey.  

This is a summary of an episode from The Sustainable Finance Podcast with Paul Ellis on July 16, 2023. To listen to the full podcast, please click here.

Q: What does the current backdrop look like in the energy transition? How does Schroders think about decarbonization?

Mark Lacey:

As a starting point, it’s worth highlighting that when we speak about the energy transition, we mean an overhaul of the entire energy system for the long-term. This not only means investing a huge amount in renewables, but also working closely with conventional energy companies on their decarbonizing journey. So the way we see things at Schroders is not that you have renewable companies over here and conventional energy companies over there; it is all one energy system.

Right now, the current pathway on emissions is unsustainable for our planet. Renewable generation needs to go from 20% of the energy mix today to 85% going forward.

 The energy system faces massive challenges:

1. We need to decarbonize power generation and transportation. Currently, these two areas make up around about 54% of global emissions that is currently unsustainable.
2. Global electricity usage is increasing due to population growth and overall consumption levels. 

Therefore, a huge amount of capital is needed to decarbonize across the entire value chain. The gasoline networks have to change to become electrification networks. The gas-fired power generation has to be changed to renewable power generation. With renewable energy, there is a need for a huge amount of storage application as well, as it’s not windy and sunny all the time. We also need to change our transmission and distribution networks to really cater to this massive change. 

Q: The energy transition is pushing huge investment into renewables. However, where do conventional energy companies fit in this transition?

Mark Lacey:

Conventional energy companies have an important role to play in the energy transition, as they are needed to provide the transition fuels for the global clean energy transition. Major oil companies such as Shell, BP, Exxon are starting to change where they allocate capital. They are already invested in hydrogen, carbon capture, and biofuels as well as offshore wind, onshore wind and solar. By 2030, it is believed that over a third of their investments will be directed to non-oil and gas investment.

Our approach to investing in these conventional companies is long-term. We examine whether these companies can adapt and transition their business model at a rate that can be profitable and progressive in their journey to lower emissions.

Q: Schroders really focuses on a value chain approach to stewardship with companies that you invest in. In what ways is this being reflected in your stewardship activities?

Carol Storey:

Schroders has a firmwide climate program that covers around 1,000 companies to 2030 and, last year, involved around 170 analysts and portfolio managers. Our approach is systematic; we focus on engaging with the whole economy, which includes oil and gas companies, industrial companies, utilities and renewables. We select companies using a combination of emissions data, the companies’ own target data, and our own exposure as an investor.

Our stewardship activity involves engaging companies on their:

• Net zero ambitions, targets and plans – are these credible and realistic?
• Climate risk and oversight – is the board prepared and does it understand the risks and opportunities relating to climate change for the organization over the long-term?
• Social issues relating to the energy transition – how are company responses to climate change impacting workers, local communities and other stakeholders?
• Sector-specific topics such methane emissions in relation to the Oil and Gas sector, and Sulfur Hexafluoride (SF6) emissions concerning the Electric Utilities sector.

For conventional energy companies, we discuss opportunities for diversification outside oil and gas. Our investors identify those that are best placed for capital allocation and investment as the world transitions towards sustainable energy. I also want to highlight that there are still significant opportunities for greenhouse gas emission reductions – from both carbon dioxide and methane - from the operations of oil and gas companies.

The ultimate goal of our stewardship is to ensure these companies can provide good resilient investment returns as the world transitions and to encourage best practice across the industry.

Q: How does nuclear energy play a role in this transition to a low carbon economy?

Mark Lacey:

Nuclear energy is being explored as a potential solution to the energy transition as it could be one of the most reliable forms of clean energy generation. We are seeing growing support for nuclear, with political commitments over the coming decade including plans for hundreds of new reactors around the world. Five of the world’s largest economies – the US, India, the UK, Japan and China – have announced targets to substantially increase nuclear capacity.

There are currently 439 nuclear reactors in operation globally, with an estimated 413GW of operating capacity in 2022, accounting for around 10% of global power production. Under the International Energy Agency’s (IEA) Net Zero Scenario, the nuclear industry would need to nearly double its capacity by 2050. With governments under pressure to articulate how they intend to meet the decarbonization commitments they have made, it’s unsurprising that nuclear plans have returned to the energy agendas of many countries. Of course, more recent concerns over energy security are another factor driving a re-emerging interest in nuclear power.

However, it is unlikely that we will see nuclear accelerate in the near future due to safety and waste concerns and the ability to mobilize investment.

Q: What are you thinking about nuclear as an emerging topic related to shareholder engagement and stewardship activities at Schroders?

Carol Storey:

It’s still relatively early days for us on nuclear and we currently don’t have a large exposure to this industry. The areas we will focus on include health and safety, and how the industry consults with stakeholders - such as local communities and governments - and deals with their concerns. Management of radioactive waste will also be a key focus and of course, the impact on water resources from cooling systems used by nuclear processes.

Q: Moving onto hydrogen. There seems to be an awful lot of capital that is moving into projects and being invested in companies that are focusing on clean and green hydrogen development. So when does this start to play a significant role in our energy system?

Mark Lacey:

Hydrogen is already used in a variety of sectors today and its production makes it a major carbon dioxide (CO2) emitter. The hydrogen molecule is very flexible and can be used as a raw material for many processes. But in terms of the scale and amount of hydrogen we need, we're going to need an incredible amount of hydrogen to decarbonize sectors outside of transportation and energy generation.

The primary focus will be on green hydrogen, which is the production of hydrogen from electrolysis of water using renewable power as the input source. Electrolysis is the process of using electricity to split water into hydrogen and oxygen.

To really accelerate the hydrogen market, investment is needed in the transportation, production, storage and distribution. This is where the traditional energy companies comes in and play a really important role too. This is what these companies do already with a safe track record which is very important and further highlights the need to invest and engage with conventional energy companies.

Q: What are the biggest challenges that face the energy transition?

Mark Lacey:

We are in a transition on how we think about power globally, but this change cannot happen overnight. This is an overhaul of the entire infrastructure of how we produce power. Therefore, there is real possibility for the potential for cost overruns and delays in deploying new technologies such as nuclear fission and green hydrogen as well as delays due to constraints on mineral availability, which could lead to pricing and profitability erosion.

Additionally, there is the risk that the energy transition may not happen as quickly as expected, leading to a lack of investment in the necessary infrastructure. There is already a problem globally with grid connection delay for solar and wind and smart grids may not be as effective as expected in terms of cost savings and efficiency. Furthermore, there may be resistance from utilities to accept new technologies due to their need to provide reliable and inexpensive power to customers.

It is likely that new technologies will come on the market and sit alongside existing technologies such as wind and solar, but this transition will take a long time.

It’s worth concluding that the energy transition will be inflationary in the short term but in the long-term, it is likely to be deflationary.

Q: What are some of the emerging risks that are relevant to engagement from the standpoint of policy and regulatory constraints?

Carol Storey:

The biggest risk to the transition is that we forget about the people at the center of it. This is the idea behind the Just Transition, which, at its core, signifies a people-focused transition. We need to think about the workers and communities that rely on coal and oil and gas for their income and how they are being supported through the transition. We need to think about the affordability and availability of energy, and the resilience of the energy grid.

We must consider human rights risks in the supply chain of critical minerals. Minerals for the transition may be sourced from areas experiencing ongoing conflicts or inhabited by large indigenous populations. It's important that these communities are treated equitably and their rights are respected in any project development. We also need to think carefully about how land is being used. As an increasing amount of land is being used for biofuels, we need to look at whether this is competing with crops, with food sources, or if it contributes to issues like deforestation.

In our response to these risks, we are collaborating with the PRI Advance Initiative, a stewardship initiative focused on human rights in the metals and mining, and renewables sectors. We have expanded our engagement objectives for companies on the Just Transition. This includes asking companies to consider the social impacts of their transition plans and engage with communities and workers. We are currently establishing a set of engagements with utility companies, focusing on the treatment of indigenous communities during the development of renewable energy projects.

Learn more about decarbonization and the 3D Reset.

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